China Burns Hedge Funds as $562 Million Yuan Bet Turns Worthless

Updated on
The Economic Case for an Appreciating Yuan
  • Options on weaker yuan fail to pay out as PBOC intervenes
  • More than $800 million of contracts to lapse in three months

The battle over the fate of China’s currency is starting to get bloody for the bears.

Seven months after a shock devaluation spurred hedge funds and other speculators to wager on further declines, the yuan’s unexpected resilience has turned many of those bets into losers. At least $562 million of options that pay out if the currency drops below 6.6 per dollar -- its weakest point since the devaluation -- have expired worthless since August. Another $807 million will lapse within three months.

While those figures provide just a glimpse into the potential losses for pessimistic speculators, what’s clear is that the Chinese government has proven a stronger adversary than many traders anticipated. Policy makers have gone to extreme lengths to prop up the yuan -- ramping up intervention, clamping down on capital outflows and waging a rare verbal campaign to restore confidence in the currency. Bears now face a difficult choice: They can abandon the trade, or hunker down for what could become a costly waiting game.

“China wants to have control over the yuan and will do whatever it can to ensure that no one else decides what direction it goes in,” said Hilmi Unver, the head of alternative investments at Notz Stucki & Cie, a Swiss money manager that allocates $3 billion to hedge funds on behalf of clients. “Is it worth fighting against a huge economy and policy maker that could take you out? No.”

Yuan options volatility surface
Yuan options volatility surface

State-run banks have repeatedly intervened to prop up the yuan since August, while authorities have suspended quotas for outbound investment and restricted overseas debit-card transactions to limit capital outflows. People’s Bank of China Governor Zhou Xiaochuan has joined a slew of top policy makers to talk up the currency, saying over the weekend that the yuan has returned to a more “normal, rational and fundamentals-driven” trend.

Their efforts have paid off so far. After the worst start to a year in two decades, the yuan has strengthened 1.6 percent since Jan. 7. It traded at 6.493 per dollar on Friday, the strongest close of 2016, and was little changed in Shanghai on Monday.

Speculative Attack

Of course, that wasn’t what bears were expecting. One gauge of investor pessimism in the options market -- the three-month risk reversal -- climbed to its highest level since 2009 last month, while the yuan’s implied volatility, which tends to rise when traders expect bigger price swings, jumped more than fivefold from August through Feb. 3.

Betting against the Chinese currency became such a popular trade among hedge funds earlier this year that billionaire investor Bill Gross compared it to the speculative attack on Britain’s pound in 1992. Some of the industry’s biggest names, including Kyle Bass of Hayman Capital Management and Crispin Odey of Odey Asset Management, have said they’re wagering on another big drop.

Notional value of outstanding options
Notional value of outstanding options

It’s difficult to gauge how yuan speculators have fared since the August devaluation. While Depository Trust & Clearing Corporation data reveal the value of premiums paid for call options on the dollar-yuan rate (contracts that benefit from yuan weakness), observers can’t know for sure whether the instigators of those trades were bearish or bullish.

Ackman’s Wager

Some of the buyers may be companies managing foreign-exchange risk, or the trades could comprise part of a more complex strategy. Speculators could also be turning to other instruments, like forward contracts, or to proxy currencies, such as the South Korean won, to express their views.

Even when considering those possibilities, though, it’s likely that most of the demand for bearish yuan options since August has come from speculators betting against the currency, according to Mitul Kotecha, the head of Asian foreign-exchange and interest-rate strategy at Barclays Plc. Bill Ackman of Pershing Square Capital Management said in a Jan. 26 investor report that he bought bearish options on the Chinese currency, and that the trade had largely failed.

Some pessimists are sticking with it. Adam Rodman, a hedge fund manager at Segra Capital Management in Dallas, Texas, said he’s holding on to wagers against the yuan, even after marking down the value of his positions in February.

“We haven’t pared down exposure,” Rodman said. Segra, which bought options in November, hasn’t lost money on the trade and still expects the currency to weaken in the next 18 months, he said.

Slowing Growth

At Crescat Capital, an $87 million hedge fund that began betting against the Chinese currency two years ago, founder Kevin Smith stopped buying yuan options in January, shifting his wagers to proxies instead. The Denver, Colorado-based firm owned contracts that lapsed worthless in February after making money on positions that expired the previous month, said Smith, who predicts the yuan will fall as much as 70 percent in the next two years.

The case for depreciation hasn’t gone away. China’s economy, which grew at the slowest pace since 1990 last year, still faces headwinds, as evidenced by a 25 percent plunge in exports last month and industrial production data over the weekend that trailed estimates. The country’s currency reserves have shrunk by more than $790 billion since June 2014, while record debt levels have fanned concern that the financial system is primed for a crisis.

Fed Risk

The currency could also face renewed selling pressure once the U.S. Federal Reserve decides to raise borrowing costs again. Easing concern over an imminent rate increase has been a major contributor to the yuan’s strength against the greenback in recent weeks.

"The reality is that the yuan is overvalued against the dollar,” said Sue Trinh, head of Asian foreign-exchange strategy at Royal Bank of Canada in Hong Kong, who sees the currency weakening to 7.1 versus the dollar in the next 12 months.

Anyone hoping for another major devaluation will be disappointed, according to Roy Teo, a Singapore-based senior strategist at ABN Amro. Authorities are committed to keeping the currency stable, the bond market is opening up to foreigners and the country is set to attract inflows as it enters the International Monetary Fund’s reserve currency basket this year, he said.

No Windfall

“It doesn’t make much sense for them to devalue the currency at this point," said Teo, the top-ranked yuan forecaster tracked by Bloomberg over the last four quarters. He expects the yuan to slip gradually, by about 3 percent, to 6.7 per dollar by year-end.

Bears shouldn’t underestimate the government’s firepower, said Charlie Chan, founder of the $150 million Splendid Asia Macro hedge fund in Singapore. Even after recent declines, China’s $3.2 trillion stockpile of foreign-exchange reserves is almost three times bigger than that of any other country.

“I don’t think anyone will make sudden windfall gains on this trade because it’s a theme that will likely play out over years, not months,” Chan said. “There will be no early gratification.”

— With assistance by Tian Chen, and Saijel Kishan

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