REFILE-Exotic option barriers loom as resistance as Nikkei nears 15,500

Wed Jul 16, 2014 5:22am EDT

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(Refiled to make dateline July 16, not July 15)
    * Brokers need to sell to hedge Nikkei-linked bond potisions
    * Bond redemption triggers clustered around 15,500

    By Hideyuki Sano and Tomo Uetake
    TOKYO, July 16 (Reuters) - Japan's Nikkei average 
faces formidable resistance at around 15,500 points, as a
cluster of barrier options embedded in structured products
require brokerages to sell the Nikkei around that level to
adjust their hedging positions.
    Their selling is likely to have helped cap the Nikkei in
recent weeks, some traders say, though once that level is
broken, the market could rally as there will no longer be such
operations.
    "I think option barriers are one reason why the Nikkei has
not been able to rise above 15,500," said Kyoya Okazawa, the
head of global equities and commodity derivatives at BNP Paribas
in Tokyo.
    Since mid-June, the Nikkei has tested that level a few times
but has so far failed to break above it, underperforming many
other markets. On Wednesday, it was little changed at around
15,384.
    The products that cause such hedging activities are
equity-linked bonds, which brokerages had sold to yield-hungry
investors aggressively, especially since last year.
    They have a couple of key features. The bonds are callable
when the Nikkei rises to a certain extent, often 10 percent and
mostly somewhere between 5 and 20 percent.
    When the Nikkei falls beyond a certain point, mostly 20
percent or more, the bonds will be redeemed at a loss. For
instance, if the Nikkei falls 25 percent, the bonds will be
redeemed at a loss of 25 percent. 
    In essence, investors enjoy a higher fixed-rate coupon in
return for taking the risk of early redemption and a deep loss. 
    On the other hand, brokerages that sold Nikkei-linked bonds
are effectively buying from investors knock-in put options on
the Nikkei.  
    As the price of put options falls when the price of an
underlying asset, the Nikkei in this case, rises, brokers need
to buy the Nikkei futures to offset price moves in their option
positions.
    But when the Nikkei rises near the redemption trigger
levels, as the likelihood of early redemption rises, brokers
need to reduce their hedging positions accordingly by selling
the Nikkei they had bought for hedging.
    Market players say redemption triggers are concentrated
around 15,500 - a level that represents 10 percent above 14,000,
around which level the Nikkei has stayed for much of the period
since the middle of last year.
    Traders say the exact market size of Nikkei-linked bonds is
hard to determine, because some of them are privately placed and
not disclosed to the public.
    But BNP Paribas Okazawa estimates the total outstanding of
the Nikkei-linked bonds could be around two trillion yen ($19.66
billion).
    The details of publicly-offered linked-bonds are available
to anyone, however, so most brokers know other brokers also have
barriers at similar levels.
    "For public offers, everyone can see what other houses are
doing. So they know at what level there are likely to be
selling. And that could make people even more reluctant to buy
around those levels," said a derivative trader at a European
brokerage.
    Option-related hedging could be absorbed if trading is
active, dealers say, but trading volume at the Tokyo Stock
Exchange has been dwindled in recent months as investors'
excitement about Japanese Prime Minister Shinzo Abe's economic
stimulus plans has petered out.
    The average turnover of the TSE's main board has
been around 1.8 trillion yen on average in the past few months,
compared to around 2.4 trillion yen at the beginning of year and
over 3.0 trillion yen May last year.
($1 = 101.7300 Japanese Yen)

 (Editing by Kim Coghill)
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