Another Glorious Chapter in the History of "Financial Innovation" - Satyajit Das

ixus

Last one for today. Maybe there should be a thread for interesting articles?

Another Glorious Chapter in the History of "Financial Innovation" - Satyajit Das

Equity markets corrected significantly in 2008. The correction has brought with it problems for investors who used "accumulator" structures to purchase "cheap" shares, "cheap" currencies and "cheap" commodities. The structures are sold under various names. In financial markets, as everybody knows there is little real innovation but sales and structuring desk are pretty skilled in coming with jazzy names and acronyms for even the most minor product idea or variation on an existing instrument.

Accumulated Greed

The driver for the accumulator structures was the equity bull market, especially Chinese stocks, over the last few years. Chinese stocks rose, at least briefly, to dizzying hits. New initial public offerings ("IPOs") were oversubscribed to an absurd extent and debuted at huge premiums upon listing. In this febrile environment, investors became keen to purchase "hot" Chinese stocks at prices that were below the market. This was especially attractive to investors who had missed out on receiving an allocation of stock in new IPOs.

The typical accumulator contract entailed the investor entering into a commitment to purchase a fixed number of shares per day at a pre-agreed price (the "Accumulator Price"). The Accumulator Price was set (typically 10-20%) below the market price of the shares at the time the contract was entered into. The contract was for a fixed period, typically 3 to 12 months.

The contract was highly conditional. If the market price of the shares rose above a pre-specified level ("the Knock Out Price") then the obligation to purchase shares ceased. The Knock Out Price typically was set (2% to 5%) above the market price of the shares at the time the contract was entered into. If the market price remains below the Knock Out Price then the investor obligation to purchase shares continues.

If the market price falls below the Accumulator Price (this would typically mean that the share price has fallen by at least 10-20% from the commencement of the contract) then the investor would be obligated to purchase shares. In most contracts, if the market price falls below the Accumulator Price then the number of shares it is obligated to purchase would increase (this is known as the "Step Up" feature). For example, if the price fell below the Accumulator Price then the number of shares that the investor is obligated to purchase might double. The typically Step Up was between two times to five times.

Accumulators involve the investor entering into a complex series of option contracts. The investor buys and sells a series of daily options.

A key feature of the product is the ability for investors to accumulate shares at the Accumulator Price that is set lower then the current price of the underlying shares. This key selling point of the structure is portrayed as the "discount" to the market price of the shares. The advantage is factually correct but is a by-product of the economics of the option transactions entered into. It does not represent a financial benefit or "discount" to the current market price of the shares being offered by dealer to the investor.

Cumulative Joys and Pains…

The structure of the accumulator dictates that the investor has limited capacity to gain but risks large losses under certain circumstances.

In the event of the market price of the underlying shares remaining at or about current levels, the investor benefits by being able to purchase the shares at below market prices prevailing at the time the contract was entered. In the event of a rise in the market price of the underlying shares, the call options bought by the investor from the dealer are knocked out restricting gains to the investor. In the event of a decline in the market price of the underlying shares, the options sold by the investor are triggered requiring the investor to purchase shares at high prices relative to the prevailing market price.

The investor generally benefits where the share prices remain relatively stable – preferably, between the Knock Out Price and the Accumulator Price.

Accumulated Woes

The accumulator structure emerged in the early 2000s primarily in relation to shares, especially in Hong Kong and Singapore. Investors used the structures to create leveraged exposure to shares. Accumulators and their variants provided a significant and constant source of revenue for dealers in Asia.

The structures worked well while the stock market remained buoyant. Over the last 12 months Asian stock markets have corrected - China and Hong Kong were down around 60% and 40% respectively in local currency terms.

The fall in underlying share prices affects the accumulator structures. Investors, where the share price has fallen below the Accumulator Price will be obligated to purchase the step-up number of shares. Where the share price has not recovered the investors have significant losses on the purchase shares.

Even where the share price has fallen but not below the Accumulator Price, the increased volatility in the market may result in the investor having mark-to-market losses. Where subject to margin requirements, the investor would have to pledge more cash to cover the mark-to-market losses. One dealer in a masterpiece of understatement opined that: "a lot of investors have underestimated the cash flow commitment."

Accumulated Accumulators

In recent years, the accumulator structure was adapted to other asset classes, mainly currencies and commodities. Accumulators on currency and commodities were severely tested in late 2008.

Exporters had sought to improve foreign exchange rates relative to market prices. The key driver was the rapid appreciation of some Asian currencies against the dollar that reduced export revenues. Commodity purchasers sought to improve the price of commodities, such as oil, using these structures, as prices rose.

The economics of the structures were similar to the accumulator structures in shares (described above) entailing an improvement of purchasing or selling prices by taking on the risk of a significant deterioration in prices. As a humorous aside, dealers marketed these products to corporations as "cost reduction" and "currency enhancement" programs.

In late 2008, the dollar reversed its weakness and appreciated sharply against the Euro, Sterling and just about everything else other than the Yen. At the same time, commodity prices, especially energy and base metals, collapsed as the impending reality of a global economic slowdown emerged. The sharp change in prices triggered losses in currency and commodity accumulators in the same manner as in accumulators in shares.

Currency accumulators seemed to have found audiences globally. Companies in Asia and in Latin America were affected.

In October 2008, Citic Pacific, a Hong Kong listed conglomerate that is 29% owned by China International Trust and Investment Corp ("Citic"), (China's biggest state-owned investment company and an arm of China's State Council), announced realised losses of $104 million and a further $1.9 billion mark-to-market ("MTM") losses on currency transactions.

The losses were more than three times Citic Pacific's $560 million profits for the first six months of 2008. Citic Pacific shares fell 55% on the announcement of losses that exceeded the company's market capitalisation. Citic was forced to inject $1.5 billion into Citic Pacific using convertible bonds to cover the losses. The transaction means that, upon conversion, Citic's stake in Citic Pacific will increase to about 57%.

While full details of the transactions were not disclosed, it appears that Citic Pacific used accumulator type structures that exposed it to sharp declines in the value of the Australian dollar (A$) and the Euro against the US dollar. The structures enabled Citic Pacific to benefit from a strengthening in the A$ above $1=A$0.87 and Euro1=$1.44. When the A$ (often referred to accurately as the Peso of the South Pacific) and Euro fell sharply in late 2008, the position registered substantial losses.

Citic Pacific reported that the transactions had been entered into as hedges "with a view to minimising [the] currency exposure of the company's iron ore mining project in Australia". Curiously, the announcement also stated that the contracts "do not qualify for hedge accounting" which is inconsistent with the transactions being for hedging purposes.

There are suggestions that other Chinese companies experienced problems with similar currency derivative transaction.

In Korea, a number of small and medium sized enterprises ("SME") entered into similar transactions (dubbed "KIKOs" Kick In Kick Out contracts) and have losses around Won 1,900 billion ($1.5 billion). There is anecdotal evidence of similar transactions having been entered into by firms in other Asia countries, especially India, though the status of such transaction is not known.

In Latin America, companies in Mexico and Brazil have registered multi-million dollar losses in similar currency transactions as well as on interest rate swaps and energy hedges. This has resulted in demand stringent for more stringent disclosure of companies derivative positions.

The motivation for these transactions is not clear. Henry Fan, Citic Pacific managing director, told the Financial Times that he was "shocked" by the events. By way of explanation, he added that: "I asked Leslie [Leslie Chang, Citic Pacific's group finance director] how could this happen, and he said he omitted to assess the downside risk".

I will Kill You Later!

Accumulators were known to dealers as "I will kill you later" contracts.

John Kenneth Galbraith, in A Short History of Financial Euphoria, noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

Accumulators may well turn out to be a tale of accumulated woes for dealers and their clients bringing to an end another glorious chapter in financial innovation!



© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).