Photographer: Jerome Favre/Bloomberg

Won't Somebody Please Think of the Asian Structured Products?!

Turmoil ahead.

Here is the recent performance of the Hang Seng China Enterprise Index:

And here is the sales pitch for a structured product known as an autocallable: 

Spot the link?

Risk.net reported earlier this week that the HSCEI, which closed at 8,236.28 on Friday, is nearing a "danger level" that would lead to a bunch of such autocallable products being "knocked in." In other words, a point at which investors in many of these structured products, which allow them to make sizable short-term bets on the direction of certain stock markets, could lose a chunk of their principal.

Such autocallables are typically linked to the performance of two indexes, one of which is usually the HSCEI. As Risk.net notes, the structures tend to come with a three-year maturity and are constrained by both an upside and downside barrier. When the upside barrier is breached, the structure gets "knocked out," and both principal and a (usually hefty) coupon are handed over to investors. When the downside barrier is breached, investors stand to lose some of their initial investment. In the example above, they would get back just 45 percent of their principal. 

For a significant portion of these products, true investor pain is said by banks, including Société Générale, to come when the HSCEI dips below 8,000–a level the index seems more hell-bent on breaching with each passing day in 2016.

The likelihood of losing money in the Asian structured products market will not come as a surprise to many, but Risk.net makes the added point that banks that have been selling these products could face tricky times, too. As with the "Tarf Barf" of August 2015, when trouble in structured products known as Target Redemption Forwards sparked a massive bout of volatility hedging by banks, dealers could once again be left scrambling.

"Banks face hedging problems as the HSCEI moves toward the knock-in points," Risk.net explains. "As spot falls, the desks become long vega–the change in an option's price for a change in volatility–because of the put option sold by the retail investors to issuers. From the bank's perspective, as the reference price moves lower, it becomes less likely that the product will knock out early, and more likely that the bought put option will trigger."

Banks then have to sell puts as they attempt to flatten their risk profiles, but as the knock-in point gets closer (say, in the 8,000-8,500 range), their long vega positions essentially evaporate, forcing them to start buying back volatility at exactly the time it's most in demand. 

The ripple effects of the obscure zoo that is Asian structured product-land are worth emphasizing.

A 2009 working paper by the International Monetary Fund, for instance, found that financial companies had incurred $530 billion in derivatives losses on currency-related structured products such as Tarfs and cutely named Kikos in the aftermath of the financial crisis, noting that "an international pattern of exotic derivatives trading appears to have helped transmit the financial crisis from the U.S. and the European Union to many different emerging market economies."

Moreover, the losses raised thorny questions of whether the banks that sold such investments were "merely meeting their customers' demands" or had used "pressure or deceptive sales efforts to take advantage of [them]," while pondering the degree to which the products created a "negative feedback loop" of cascading risks.

So it's worth repeating a solid six years later: Won't somebody please think of the Asian structured products?

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