The Wall Street Journal reports,"the sudden slide of the Chinese currency over the last week has raised fears that the yuan is nearing levels that could trigger an unwinding of billions of dollars in highly leveraged bets on the currency's appreciation. Traders and strategists say a portion of the yuan's recent decline can be attributed to investors looking to get out of trades before losses soar''.
Daily trading volume in the yuan has exploded recently, tripling to $120 billion a day since 2010, when China allowed trading in its tightly controlled currency. The yuan is now the ninth-most traded currency in the world, according to the Bank for International Settlements, rising from 17th two years ago.
In the past year, trading in derivatives tied to the currency have soared as investors bet on a continued rise in the yuan. According to Deutsche Bank, approximately $250 billion worth of these derivative contracts were traded in 2013, the first year these products took off. Already in 2014, between $80 billion and $100 billion have been traded, the bank says.
The currency, which is also known as the renminbi, is up 33% since 2005. And because the currency is tightly controlled by the Chinese government, volatility is among the lowest in Asia, making the bet seem even less risky.
On Tuesday, the offshore yuan hit 6.1115 against the greenback, sharply up from 6.0984 the day before. Earlier in the day, the currency touched an intraday peak of 6.1250, its highest since it reached 6.1272 on Aug. 22 and the yuan's biggest daily drop since Jan 28, 2011. China's stock market suffered its biggest fall in five months, dropping 2.1%, putting its overall decline at 3.5% since the beginning of the year.
Individual investors and small- and medium-size businesses were among the biggest buyers of options that would profit from appreciation in the yuan, currency analysts say. They bought structured investment products that magnified gains but could lead to big losses if the yuan fell below certain levels. The rising yuan coupled with higher interest rates inside China led even more investors to buy yuan, pushing the currency higher.
Ju Wang, senior Asian currency strategist at HSBC in Hong Kong, said losses on these products were small so far, but if investors believed they would grow significantly if the currency continued to depreciate, "they might take a mark-to-market loss and unwind contracts, so it all depends on expectations"
Ms. Wang said that small- and medium-size Chinese exporters have been big buyers of derivatives because they allowed them to hedge against the rising yuan, which makes their goods more expensive to sell overseas and their revenues, which come in foreign currencies, smaller. In many cases, Ms. Wang said, the businesses are losing money in their operations but make profits because of the hedges, which generate a monthly income.
Greg Yu, the Asia ex-Japan head of structuring and solutions group at J.P. Morgan in Hong Kong, said wealthy clients of private banks also bought these products, mostly in Hong Kong, the biggest market for trading in the yuan, and Taiwan. Products designed to profit from the rising yuan are widely advertised by banks in Hong Kong, where bank deposits held in yuan are up by 50% in the last 18 months to 900 billion yuan.
The derivatives that underlie these products are based on the so-called offshore yuan, which trades in Hong Kong and isn't subject to the strict controls on movements by China's central bank for yuan that trade in the mainland. While the offshore yuan trades freely, it is broadly tied to the yuan price inside China.
The most popular among the derivative products tied to the yuan is the 'target redemption forward." The product is a leveraged bet that pays out every month that the currency keeps rising. But when it falls to a specific level, losses begin to mount quickly.
Geoff Kendrick, head of foreign exchange and rates at Morgan Stanley, says that these contracts vary widely in value and in length. He estimates that banks have sold these target redemption-forward products with notional value totaling $350 billion since the beginning of 2013.
He says that if you take the $350 billion notional outstanding and assume the average contract has a year left, then once the yuan passes a specific threshold versus the dollar, every decline of 0.1 yuan against the dollar, would cost buyers approximately $500 million a month. That means roughly $6 billion in losses. The contracts are opaque so there is no way to know exactly what price the yuan needs to hit for the losses to begin, but Mr. Kendrick says a reasonable estimate is from 6.15 to 6.35 yuan to the dollar.
Mr. Kendrick says he believes the Chinese currency's move will be contained but "we do acknowledge the risk of a volatile move higher in the cross, especially given the large amount of structured product traded over the past few years."
Greg Matwejev, director of FX hedge-fund sales at brokerage firm Newedge Group SA in Hong Kong, said most hedge funds in the region were betting on a stronger yuan as well. "It was like free money," he said. But the fast move downward forced them to sell quickly. "There is still a lot more pain before this trade shows signs of stabilizing. Very few funds are contrarian on this trade and all are seeing red at the moment," he said.
He said if the yuan falls further, investors will be forced to sell their yuan and buy U.S. dollars, adding that if the currency moves beyond today's trading levels of 6.12, it "will set off more panic U.S. dollar buying.
