Thread by @niravstoons

Doing a thread on these Korean Structured Products
And the unintended market effects of these ... cases where tail wags the dog.

First do listen to the excellent podcast (#OddLots is the best Fin Markets podcast by @TheStalwart & @tracyalloway here they speak to @bennpeifert)

https://twitter.com/tracyalloway/status/1219188752423145472

@TheStalwart @tracyalloway @bennpeifert So the main point is the rising amount of savings in East Asia (Korea, Japan) which leads to investments in Structured Products. (They had a similar podcast with @Brad_Setser on Taiwanese Lifers - though more focussed on USDTWD hedging)
...

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Bottom line is - East Asia has a large pool of savings, and needs to be invested some where.

Bonds provide a very low return (global QE pushed down yields), and stocks have too much market risk & volatility.

Enter #StructuredProducts = Bond like coupons, but Stock type returns

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser But there in life (and markets) there is #NoFreeLunch

So what's the catch?
The investor sells the tail risk - If markets collapse by a large amount, they face a large loss
So high interest rate is the premium for selling out of the money Puts ...

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser So #StructuredProducts linked to equities behave like a Bond when markets go up, but a Stock when markets go down.

This structure is a typical Reverse Convertible

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Typical Structure

Customer invests in KRW (Korean Won)
If reference index (e.g. S&P 500) isnt below a threshold (70%) the customer gets 10% interest in KRW

If it falls below a trigger level -> the customer gets the performance of S&P500 but in Korean Won

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Some notes added additional leverage
If the reference Index goes up by 10% then the Note is called back early. (Early repayment of Principle) - as soon as 6months.

Thus if markets go up -> you make 5% (10% x 0.5 years)
if markets go down -> you can lose 30%

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser With falling volatility globally, to get the same type of returns
you got the #WorstOf Reverse Convertible

There are 3 reference indices S&P500, HSCEI (Chinese Shares listed in HK) and either Eurostoxx or Nikkei (typical basket)

If any one of the 3 indices fall 30% you lose

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Also if the note is triggered (one index falls more than 30%) but then it does rally back to being higher than entry level - you get the worst performer of the 3 indices, subject to maximum you get 100% of principle back

The high coupon (say 10%) is paid through the tenor (3-5y)

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser These structures are marketed - saying
right now stocks are high, but if any index falls 30% wouldnt you want to buy on the dip?

Also - the performance is in Korean Won (so no FX risk of USD on S&P or JPY on Nikkei or HKD on HSCEI)

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser So these are scenarios

1. All 3 indices go up 10% or more in 6months -> Note is called, you get 5% return and 100% principal (Autocall feature)

2. All indices remain between -30% and +10% for the life (3y) you get 10% interest annually, and 100% principal at end of 3y ...

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser 3. One of the 3 indices falls more than 30% -> you stop getting interest, and instead get performance of the worst of the 3 indices.

If markets fall 40% and come back up to more than initial level you get 100% of principal back.
Else you get a principal loss

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Optically this looks simple from the investors point.
The high coupon I get is to pay for the downside risk i am taking, and if that does happen, I am happy to buy at that level

But how do banks hedge these structured notes?

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Day One:
Banks hedge buy selling 1-3y puts on all 3 indices and keep rebalancing their Greeks (Delta, Vega, Gamma) of their options.

One difficult risk to hedge is correlation.

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser On such structures - with a single underlying ->

If index falls 10% the bank has to sell more puts, but as you get closer to the trigger (-30%) banks have to buy back their puts when its getting more expensive.
Thus put prices rise (since puts are short expression markets fall)

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser When you have 3 underlying indices

If one index falls a bit (5-10%) but others are stable,
You have to rebalance the hedge.
Sell more puts on the one which has fallen, while buying back puts on the other indices.

Side Effect -> one falling index leads to others falling too

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser If the stocks fall very quickly, more than 15% ... the bank gets long on Delta (long the underlying index) and short Vega (short optionality)

Thus they keep selling the index when its going down
And buying puts when they are going up ...

Side effect 2: Self reinforcing spiral

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser Also these stock indices are in USD, HKD, EUR (or JPY) ... while client is paid in KRW.

This leads to hedging the Quanto risk (Equities and FX correlation)

Typically when stocks fall, EM currencies like KRW also weaken
What if correlation flips for some reason?

@TheStalwart @tracyalloway @bennpeifert @Brad_Setser continues here

https://twitter.com/niravstoons/status/1219830283479896064?s=20