The introduction of HKEX’s Renminbi (RMB) currency options was driven by the growing demand from market participants for diversified tools for trading and hedging the offshore RMB (CNH) exchange rate.
HKEX’s RMB currency options contracts complement HKEX’s RMB currency futures contracts. These options products are risk management tools against non-linear sensitivities and offer volatility trading opportunities on RMB exchange rates, addressing market demand not previously satisfied by HKEX’s RMB currency futures. In the course of ongoing RMB exchange rates liberalisation process and the associated policy developments, the exchange rates are in transition from policy rates to market-driven rates. This is expected to create higher volatility in the USD/CNH exchange rate. The one-month implied volatility of USD/CNH was around 1% to 2% in the month before the RMB exchange rate reform in August 2015. It has increased sharply to a range of 4% to 10% in the year subsequent to the reform. The increase in spot USD/CNH volatility could provide an opportunity for the introduction of RMB currency options contracts to enable volatility trading and facilitate hedging for market participants.
Furthermore, the global over-the-counter (“OTC”) RMB options market already has a sizeable average daily turnover of approximately US$18 billion3 with an average transaction size of US$150 million as of 2016. Unlike two to three years ago when CNH structured forward positions dominated the market risk profile in the OTC CNH derivatives market, almost all new volatility risks are now hedged by vanilla options which are standardised calls/puts with no special features.
In light of the relative lack of transparency in the over-the-counter (OTC) market, the associated margin requirements by new regulations and the counterparty risks, there is an increasing demand for bringing RMB currency options trading onto the exchange-traded market. The USD/CNH Options contracts listed on the Hong Kong Futures Exchange and centrally cleared through the HKFE Clearing Corporation Limited provide enhanced price discovery, market transparency and reduced counterparty risks in this important and growing CNH options market.
1.MACRO ENVIRONMENT: MARKET DEMAND AND CURRENT SUPPORT
1.1 Two-way volatility drives demand for RMB risk management tools
On 11 August 2015 the People’s Bank of China (PBOC) introduced a new market-based managed floating framework for RMB exchange rate fixing, which is based on the previous close of the onshore RMB (CNY) rate, together with market supply and demand factors with reference to a basket of currencies (the reform). The 1-month implied volatility of the USD/CNH rate increased from 1%-2% in the month before the August 2015 reform to 4%-10% in the year subsequent to the reform.
The internationalisation of the RMB has entered a new stage. Hong Kong’s role as the most critical offshore RMB hub connecting the Mainland and the world has become increasingly important. Hong Kong should continue to build on its own strength and, based on its new role as a “mutual market”, open up bigger room for innovation for the better of its long-term development. Such a new role may be perceived from three different angles: (1) an enhanced offshore RMB market; (2) a RMB risk management centre; and (3) a gateway market. These are elaborated below.
(1) For the offshore RMB market, the impetus of market growth used to heavily rely on RMB appreciation expectations and arbitrage trading between onshore and offshore markets. Now, the market’s depth and breadth have been building up as more and more relevant financial products are introduced and more risk management tools are provided for the use of more and more portfolio management tactics. All these serve appropriately the demand for global allocation of RMB assets and the related cross-border capital flows. In developed countries such as Japan, the UK and the US, the size of their credit, equity and bond markets is more than 5 times of their GDP, whereas the corresponding figureis around 2.1 times in China. This indicates substantial room for further development in China in terms of financial market deepening and financial product diversification. Together with the inclusion of RMB in the International Monetary Fund’s Special Drawing Right (SDR) basket of currencies, two-way volatility is expected to become the new norm. More and more investors have become increasingly aware of this market change and have started to manage their exchange rate risk exposure.
Through further developing and enriching its range of multi-facet financial products and related financial services, Hong Kong can continue to well position its offshore RMB market as a major venue for cross-border investments (especially overseas investments from the Mainland) and related risk management. Now is a good time for Hong Kong to further build up the market depth and effectiveness of its offshore RMB market. Through more effective and sensible pricing benchmarks for onshore and offshore RMB markets, segregation in the RMB pricing structure could be improved and a reasonable price difference between the onshore and offshore RMB markets could be maintained. This would require further connectivity between the onshore and offshore RMB bond markets, foreign exchange (FX) markets and derivatives markets, enhanced market liquidity and an increased number and diversity of market participants.
(2) Hong Kong is well positioned to become a risk management centre to facilitate the current transformation and adjustment process of the Mainland economic and financial system. For example, greater flexibility in the RMB exchange rate is broadly expected in the next stage of the currency’s path towards internationalisation, and in such process the demand for exchange rate risk management is bound to be substantial. Meanwhile, Mainland companies are expanding their global reach and their participation in projects in countries along the Belt and Road. In this process, Hong Kong is also well positioned to serve the demand from these companies for overseas investment risk management and their global presence.
(3) Following the gradual opening of China’s financial market, Hong Kong will not only be an active destination market for investment purposes by Mainland entities, but is also becoming the gateway market for Mainland entities to invest in other markets. This is becoming more evident after the launch of the Mainland-Hong Kong Mutual Market Access pilot programme. The launch of Shanghai-Hong Kong Stock Connect (Shanghai Connect) in November 2014, the Shenzhen-Hong Kong Stock Connect (Shenzhen Connect) in December 2016, and the mutual bond market access on bond markets (Bond Connect) in July 2017, has linked up Hong Kong, Shenzhen and Shanghai into a sizeable mutual market. With Hong Kong as the gateway, such a mutual market will support the global asset allocation of Mainland funds and provide sound infrastructure and platforms for international funds to invest in the Mainland capital market. Foreseeably, if such a framework of connectivity is expanded to other product types, Hong Kong’s key role as a gateway market will be further strengthened. With the increasing cross-border investment activities, the demand for risk management is expected to increase, possibly multi-fold.
1.2 The support offered by HKEX’s RMB products and platforms
Against the macro backdrop analysed above, the overseas market saw growing interest in China’s fixed income and currency (FIC) market and greater demand for risk management and investment. HKEX has been devoting efforts in multiple dimensions with an aim to be an offshore RMB product trading and risk management centre. HKEX’s platforms now have a variety of RMB products including bonds, exchange traded funds (ETFs), real estate investment trust (REIT), equities, RMB fixed income and currency (FIC) derivatives and commodity derivatives. The HKEX RMB product suite is provided with an aim to match market demands.
HKEX launched its USD/CNH Futures contract in 2012, which has seen turnover take off since 2015 and is now one of the most actively traded RMB futures contract in the world7. HKEX then moved to diversify its product offerings by launching new CNH currency pairs against the Japanese yen, Euro, and Australian dollar, which began trading on 30 May 2016 to facilitate cross-currency hedging. In addition to RMB currency risk management tools, RMB interest rate risk management tools on HKEX were also enriched upon the introduction of HKEX’s Five-Year China Ministry of Finance Treasury Bond Futures (Bond Futures) on 10 April 2017. The Bond Futures would be useful tools for interest rate hedging, especially upon the launch of the connectivity scheme between the bond markets in Mainland and Hong Kong (Bond Connect) on 3 July 2017. Bond Connect is a pilot scheme that connects China’s interbank bond market with the world, giving international investors “Northbound” access to trade bonds directly on the China Foreign Exchange Trading System (CFETS), the Mainland interbank bond market trading platform, for the first time.
There is also tremendous potential market demand for an RMB Currency Index benchmark as the RMB becomes a reserve currency and the market focuses on the relationship between the RMB and global currencies. In June 2016, HKEX launched the TR/HKEX RMB Currency Index series (RXY Indices or RXY Index series) which is jointly developed with Thomson Reuters, allowing market participants to conveniently monitor the RMB’s movements. HKEX also plan to introduce futures and options on the index in the future to provide the market with effective RMB risk management tools.
In addition, HKEX plans to launch a full suite of different RMB products. As a start in the commodities segment, HKEX launched dual-currency (USD and RMB pricing and settlement) physical delivery Gold Futures Contracts on 10 July 2017. This new product offers gold producers, users and investors a practical solution to manage risks arising from the gaps between the gold spot and futures markets, as well as the price difference between the RMB and USD.
Furthermore, enhancements in HKEX’s infrastructural platforms add to a solid foundation for further development of RMB derivatives in Hong Kong. HKEX’s subsidiary, OTC Clearing Hong Kong Ltd (OTC Clear), commenced business in 2013. This is a key piece of infrastructure to serve clearing service needs of FIC market participants, especially in regionally-traded products and in particular RMB-based derivatives.
1.3 HKEX USD/CNH Futures: one of the world’s most liquid USD/CNH contracts
There is an increased market awareness of the merits or even necessity of hedging RMB exchange rates. The first RMB derivative product traded on HKEX was the USD/CNH Futures launched in September 2012. Investors, both individuals and institutions, have started to realise how the RMB FX volatility can have an impact on their investment portfolios in terms of RMB assets, liabilities and cash flow. The RMB’s two-way movement has become accepted as a metric in investors’ risk management framework.
In 2016, the HKEX USD/CNH Futures recorded historical highs of annual contract volume and year-end open interest8. The record-breaking total trading volume of the product in 2016 was 538,594 contracts, an annual increase of 105%; and the record high year-end open interest was 45,635 contracts, a year-on-year increase of 98%. Its average daily volume climbed to 4,325 contracts in December 2016. The cash-settled CNH/USD futures also showed a growing contract volume in 2016H2 and its open interest has been continuously building up since launch. Its average daily volume achieved 95 contracts in December 2016; and its open interest reached the highest of 1,494 contracts at year-end.
Entering into 2017, new records of performance were seen in this product:
Record single-day turnover of 20,338 contracts (notional value of US$2 billion) on 5 January 2017; followed by the second and third record turnovers of over 8,600 contracts(notional value of more than US$860 million) on 31 May and 1 June 2017
Open interest record of 46,711 contracts (notional value of US$4.7 billion) on 4 January 2017
Night-session record of 3,642 contracts (notional value of US$360 million) on 4 January 2017
Increased market participation, bringing the total number of exchange participants (EPs) having traded the product to 112.
2.HKEX USD/CNH OPTIONS: THE RISK MANAGEMENT TOOL MADE AVAILABLE ON EXCHANGE MARKET
Currently, a sizeable OTC RMB options market already exists, with an average daily trading volume of US$18 billion9 and an average transaction size US$150 million10 (see Figure 3). Unlike two to three years ago when CNH structured forward positions dominated the market risk profile in the OTC CNH derivatives market, almost all new volatility risks are now hedged by vanilla options which are standardised calls / puts with no special features. This demonstrates an increasing market demand to hedge currency risk using vanilla options instead of exotic-style options.
Compared to the OTC RMB currency options market, HKEX’s currency options market has several characteristics, explained in sub-sections below.
2.1 Continuous quotation
Traditionally, OTC RMB currency options market is operated on a bilateral dealing, requestfor- quote (RFQ) basis. Investors have to source, contact and negotiate with price providers individually to get a quote on options price and compare the prices among themselves, which might not be the most efficient way for price discovery.
In this regard, HKEX’s USD/CNH Options offer a different role on trade execution and price discovery. Typically, continuous quotations on around 150 option series are available provided by dedicated liquidity providers, with the average spreads of 12-40 pips for short tenors and 80-160 pips for long tenors11. Such streaming of bid/ask quotations allows investors to freely execute trades at their desired strike and tenor, facilitating liquidity development. In addition to continuous quotation, investors can also submit quote requests to dedicated liquidity providers on specific strike and tenor.
One of the special characteristics of an exchange-traded market for RMB derivatives traditionally traded OTC is that it acts as a liquidity aggregator offering continuous and tight bid/ask liquidity. The regulatory and capital benefits (see Section 2.2 below) of trading listed products have become more pronounced. The exchange market offers a marketplace for orderly and transparent trading on an equal basis.
2.2 Capital efficiency
New rules in Europe (EMIR) and the United States (CFTC) are affecting existing OTC participants. From 1 March 2017, all in-scope counterparties (primarily financial entities and systemically important non-financial entities) with uncleared OTC portfolios must exchange variation margin daily. This requirement is relatively new for many users of OTC products, and the requirement to exchange initial margin is being made mandatory in stages over time towards full implementation by September 2020. RMB exchange-traded derivatives provide capital efficiency to investors as a result of their comparative advantages in various aspects vis-à-vis the OTC market. Table 1 presents a table of comparison between exchange-traded RMB derivative products and OTC products.
2.3 Versatile hedging tool due to unique risk and reward profile
HKEX’s USD/CNH Options contract is designed to mirror the characteristics of the USD/CNH futures contract to allow for cross-product hedging and cross-margining benefits, as well as to provide alternative product payoff structures for the same notional contract size.
(i) Cross-product hedging
USD/CNH options are directly complementary to the existing HKEX USD/CNH Futures, which together could allow investors to deploy trading and hedging strategies under various market conditions with relatively low counterparty risk in comparison to OTC derivatives. They provide investors a hedging tool against RMB volatility amid the ongoing (See Table 2 for a comparison between options and futures.)
(ii) Cross-margining benefits
HKEX’s USD/CNH Options contract is traded on a margin-basis under the SPAN methodology15 adopted by HKCC, where net delta is a key determinant of margin requirement for futures and options of the same underlying. A client can therefore enjoy cross-margining benefits when holding USD/CNH Futures and Options positions at the same time, paying less margin compared to those required for separate outrights.
From a risk management perspective, Options contract is a versatile tool due to options’ unique risk and reward profile. With a variety of options/futures strategies deployable, Options contracts provide exposure to multiple market parameters, e.g. spot rate, volatility and time.
Options contract is suitable for various RMB market conditions, providing flexibility of strategies to cater for various market conditions — they can be utilised in bullish, bearish, range-bound or volatile markets. (See section 3.2 on the basic applications of the product.)
2.4 Other characteristics of exchange trading
Cost effectiveness: In general options contract traded on exchange provides leverage16 and cost effectiveness as it is traded on an option premium and margin basis, and requires upfront payment of only a fraction of the notional value. For the HKEX USD/CNH Options, related transaction cost is further reduced as the trading fee is waived for the first six months (20 March 2017 – 29 September 2017) and the SFC levy is not applied.
Transparency: Being exchange-traded options, options contract is standardised, trading of which is orderly and transparent. Investors can access real-time exchange-traded options prices via, information vendors (see Appendix 3 for list of source of market information for USD/CNH options) and the trading platforms of brokers.
Ease-of-Access: In general, exchange is available to different investor types, including but not limited to retail investors, corporate users, asset managers and hedge fund managers. For example, in HKEX, investors can access the product through the existing distribution with over 120 RMB-enabled EPs. In comparison, OTC RMB currency options market is restricted to institutional users only.
Supported by the aforementioned characteristics, the trading volume and open interest of HKEX’s USD/CNH Options continue to accumulate. Up to 31 July 2017, the total trading volume since launch was 4,914 contracts (i.e. US$491 million in notional amount) and the open interest continues to hit record high. As of 31 July 2017, the open interest across all contract months reached 1,727 contracts (i.e. US$173 million in notional amount).
3.HKEX USD/CNH OPTIONS: PRODUCT DESIGN AND APPLICATIONS
HKEX’s USD/CNH Options contract is a European-style option on spot, exercisable only at expiration date but not before. This is designed based on the prevailing OTC market practice (where the majority of FX options exist in European-style forms). Exercise at expiry results in the delivery of USD against RMB with full principal amount at the strike price, which meets the demand for principal exchange from options users.
3.1 Pricing behaviours and risk factors to monitor
The option premium, i.e. the option price, is a function of a certain number of factors including the underlying asset’s strike price and spot price, interest rates (of the two underlying currencies), tenor and volatility. The Black-Scholes pricing model, commonly used for equity options, was extended by Garman and Kohlhagen17 to price currency options.
Currency options are multi-dimensional instruments and their prices in the secondary market respond to various market parameters. Due to the diversity in the terms of options, i.e. tenor, strike, etc., it is impractical for a market participant to hedge with exactly the same options in the market. As such, option traders act as risk managers and manage their risks by closely monitoring various market parameters. There are specific measurements of the sensitivity of the option value with respect to different market parameters. These measurements are collectively known as the “Greeks”. Analysis of Greeks is crucial to option valuation and risk management.
The Greeks decompose the risks contained in an option price or a portfolio of options into their various constituent parts, which in turn allows traders to decide which risks to retain and which to hedge. The different risk measures in the Greeks include:
Delta: Change in price of the option for a change in the spot price of the underlying
Gamma: Change in delta for a change in the spot price of the underlying
Theta: Time decay of the option, i.e. change in price of the option for the passage of time
Vega: Change in price of the option for a change in volatility of the underlying
Phi: Change in the base currency’s risk-free interest rate
Rho: Change in the pricing currency’s risk-free interest rate
3.2 Product applications of HKEX USD/CNH options
Main users of RMB currency options and futures would include corporates, asset management firms and fund houses, proprietary trading firms, brokerage firms and professional investors. These different user types could use the RMB currency products for various purposes.
Listed below are hypothetical illustrations of product applications of the RMB currency options (analysis do not include transaction costs and past performance is not an indicator for future performance).
3.2.1 Basic applications
(a) Protection on RMB depreciation
Situation
An investor worries about RMB depreciation. He needs to sell his RMB assets and convert back to USD after 3 months.
Possible application
Buying a 3-month call options (i.e. buy USD, sell RMB) with strike 6.8500 as an example.
Scenario
At expiry, if USD/CNH fixing rate appreciates to 6.7000, the option expires and is not exercised. The investor can sell his RMB assets and covert RMB to USD at a better level at 6.7000. If USD/CNH fixing rate depreciates to 7.0000, the option is exercised and the investor can sell his RMB assets and covert RMB to USD at the original strike rate (i.e. 6.8500).
Potential Risks and Returns
Potential returns: The investor is able to covert RMB to USD at a better price if the RMB depreciates.
Potential risks: The investor has to pay options premium to buy the protection.
(b) Protection on RMB appreciation
Situation
An investor worries about RMB appreciation. He needs to sell his USD assets and convert back to RMB after 3 months.
Possible application
Buying a 3-month put options (i.e. sell USD, buy RMB) with strike 6.8500 as an example
Scenario
At expiry, if USD/CNH fixing rate depreciates to 7.0000, the option expires and is not exercised. The investor can sell his USD assets and covert USD to RMB at a better level at 7.0000. If USD/CNH fixing rate appreciates to 6.7000, the option is exercised and the investor can sell his USD assets and convert USD to RMB at the original strike rate (i.e. 6.8500).
Potential Risks and Returns
Potential Returns: The investor is able to covert USD to RMB at a better price if the RMB
appreciates.
Potential risks: The investor has to pay options premium to buy the protection
3.2.2 Advanced applications
(a) Yield enhancement — sell covered call
Situation
An exporter has USD receivables due in three months and targets to convert the USD into the CNH at a better rate than futures price. The exporter does not need to sell the USD upon receipt so he would rather sell it at a better rate. The exporter also wants to make some extra yield from this expected cash inflow.
Possible application
The exporter sells a Mar 2017 expiry USD/CNH call option with strike 7.1000 and receives the CNH premium of 775 pips. USD/CNH spot rate: 6.9300, Mar 2017 futures price: 7.0450,Volatility: 7.40 bid.
Scenario
At expiry, if USD/CNH fixing rate is less than 7.1000, the option expires out-of-the-money and is not exercised. The exporter keeps the CNH premium as an extra return from taking the position. If USD/CNH fixing rate is greater than 7.1000, the option is exercised and the exporter sells USD against CNH at 7.1000 which is still better than the futures price if he had hedged three months ago. The exporter keeps the CNH premium which makes his effective selling rate 7.1775.
Potential Risks and Returns
Potential returns: The exporter makes an extra return on the usage of idle cash by selling options. The exporter sells at an effectively better rate even if the option is exercised by the buyer.
Potential risks: Should the USD appreciate significantly against the CNH, the exporter may incur opportunity cost compared to selling at the prevailing market rate.
(b) Cost Reduction — Buy call spread
Situation
A portfolio manager, who has exposure to RMB-denominated assets, plans to hedge CNH depreciation by buying USD/CNH call options. The portfolio manager’s hedging horizon is one year. However the long-tenor USD/CNH call option is very costly due to the time value, upward sloping volatility curve and futures curve. For example, Dec 2017 expiry USD/CNH call option with strike 7.2500 is priced at 2,515 pips.(USD/CNH spot rate: 6.9300, Dec 2017 futures price: 7.2650, volatility: 8.85 offer)
Possible application
The portfolio manager can sell Dec 2017 expiry USD/CNH call option with strike 7.5000 and receives a premium of 1,585 pips with the view that USD/CNH may depreciate, but not to the level of 7.5000. (7.5000 strike volatility 9.06 bid). The premium from the 7.5000 strike call reduces the net cost of the hedging strategy of buying USD/CNH call options with a lower strike of 7.2500. The portfolio now pays a net premium of 930 pips.
Scenario
At expiry, if USD/CNH fixing rate is less than 7.2500, both options expire out-of-the-money and are not exercised. The portfolio manager bears the net option premium as hedging cost, but it is cheaper than not having adopting the strategy. If USD/CNH fixing rate is greater than 7.2500, but less than 7.5000, the portfolio manager exercises the option he has bought and let the option he sells to expire. This is the best scenario because he keeps the hedge and has reduced the hedging cost. If USD/CNH fixing rate is greater than 7.5000, both options are exercised. The portfolio manager loses the hedge, however he makes a net cash flow of 2500 pips in the CNH, which helps compensate his hedge in the spot market.
Potential Risks and Returns
Potential returns: The strategy reduces the hedging cost by taking a view on the movement of the USD/CNH exchange rate.
Potential risks: The strategy may become a partial hedge under some circumstances.
3.3 Physical delivery on exercise
3.3.1 Call options
Assumptions:
Strike price (k) = 6.90; Official settlement price (s) = 6.95
If the settlement price > strike price, the option is exercised, if the settlement price ≤ strike price, the option expires worthless.
Physical delivery process (see Figure 5):
If the call option is exercised, on physical delivery, the buyer pays the final settlement value, i.e. contract size (100,000 USD) x k (6.90) = 690,000 CNH, to the clearing house and receives the underlying currency value equalled to the contract size (100,000 USD) from the clearing house.
On the other hand, the seller delivers the underlying currency value equalled to the contract size (100,000 USD) to the clearing house and receives the final settlement value, i.e. contract size (100,000 USD) x k (6.90) = 690,000 CNH, from the clearing house.
3.3.2 Put options
Assumptions:
Strike price (k) = 6.90; Official settlement price (s) = 6.85
If the settlement price < strike price, the option is exercised, if the settlement price ≥ strike price, the option expires worthless.
Physical delivery process (see Figure 6):
If the put option is exercised, on physical delivery, the buyer receives the final settlement value, i.e. contract size (100,000 USD) x k (6.90) = 690,000 CNH, from the clearing house and delivers the underlying currency value equalled to the contract size (100,000 USD) to the clearing house.
On the other hand, the seller receives the underlying currency value equalled to the contract size (100,000 USD) from the clearing house and pays the final settlement value, i.e. contract size (100,000 USD) x k (6.90) = 690,000 CNH, to the clearing house.
