Photographer: Kevin Lee/Bloomberg News

So How Are All Those Yuan Structured Products Doing?

Cross-currency volatility is bad news for those who bought and sold products built on a trading range

Hi, Mr. Chief Financial Officer of Generic China Corp. This is John Doe from sales at Solidly Second-Tier Bank. How are you? Listen, I think I have something that might interest you. Ever heard of a Target Redemption Forward? No? Let me explain. It’s a structured product, kind of like a series of exotic options that pay a monthly income as long as the spot yuan exchange rate remains above the strike price. Now, I hate to mention this, but I want to be up front with you, because you know I value your business. The risk here is that if the yuan falls below a certain level—say, 6.2 against the dollar—the option gets knocked out and you have to pay out double the amount. I personally don’t see that happening any time soon. I mean, with USD/CNH trading in this kind of range, we’re talking practically no-risk money. You’re in? Great!

It’s worth wondering now, days after the People’s Bank of China sprang a surprise devaluation of the yuan on markets, just how all those FX Target Redemption Forwards (Tarfs) are doing. With Tarfs predicated on the USD/CNH rate moving within a predictable range, this week’s events are unlikely to produce good news for companies, like Generic China, that snapped up the products and still have contracts outstanding.

Last year, when the offshore yuan moved above 6.2 against the U.S. dollar, there were already rumblings of losses on the circa $150 billion worth of Tarfs that were estimated to remain. Geoffrey Kendrick, head of Asian currency and rate strategy at Morgan Stanley, wrote in March that more than $3.5 billion had been wiped off the value of these structured products at an offshore yuan exchange rate of 6.2.

He estimated at the time that losses could mount to as much as $7.5 billion if the yuan went to 6.38 against the U.S. dollar. It shot through that level this week.

Source: Bloomberg

Goldman Sachs analysts estimated in a note out on Thursday that some $40 billion worth of Tarfs are outstanding. Amazingly enough the products seem to have been sold relatively recently. "Due to a stable spot over the last few month, older Tarfs issued in early part of this year would have likely [knocked out]. Therefore, the desk thinks that most of the remaining TARFs will have been issued recently," the analysts said. So some very awkward client-sales phone calls are probably happening right now.

While losses on these types of structured products are unlikely to endear John Doe to his buy-side clients, they pose a potential problem for his bank employer, too. As Josh Giersch points out in a gloriously geeky post, losses on Tarfs don’t necessarily mean boom time for the banks that ostensibly took the other side of the trades. Just because clients such as Generic China effectively sold volatility of USD/CNH, doesn’t mean that Solidly Second Tier is short the same thing.

The problem comes from the way such banks have sought to offset, or hedge, the risk of the trades. Even if many of these products were already knocked out or restructured following last year’s turmoil, we’re still betting that plenty of Tarf-related phone calls are being made this week as a sudden burst of FX volatility spurs delta hedging desks at banks to play an unenviable game of hot-potato risk transfer. 

Hi, John? It’s Howard from trading. I just got off the phone with risk, and we need to talk about this Tarf situation. I know, I’ve been watching USD/CNH too. So listen, when we did the trade, we hedged with a bunch of vanilla swaps that roughly matched the expected length of the Tarf contract. But with everything that’s happened and USD/CNH outside the range, and all our clients losing money, expected maturity on Tarfs is extending at exactly the same time those vanilla swaps are turning ATM. We need to buy gamma. You don’t know what gamma is? No wonder you’re in sales. Let me put this into oversimplified English in case anyone ever publishes a transcript of this completely fictional call on the Internet. If we’re long gamma, that means we’ll be able to handle movements in the USD/CNH. If we’re short gamma, which we are right now, all these currency swings are really bad news. What do you mean buying gamma sounds just like what everyone is trying to do right now? Put someone else on the *BLEEP* phone!

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