South Korean exotic notes face margin-call risk

SEOUL: South Korean investors and bankers, who have bet on low volatility in global stocks over the recent years, now face increasing risks of losses from complex equity-linked notes.

About 9.6 trillion won (US$8bil) of outstanding equity-linked securities sold by Korean issuers will incur a loss if the underlying Kospi 200 Index falls between 40% and 60%, according to data from Korea Securities Depository (KSD). Issuers that intended to receive a premium by selling put options could also suffer losses from their bets given the market slump.

Both the benchmark Kospi index and the Kospi 200 fell as much as 5.2% Thursday, triggering a halt on program trading in Kospi shares. The two indexes have both declined about 19% from a peak in late January.

South Korean investors are known for their appetite of esoteric financial products fuelled by a hunt for yield amid record-low domestic interest rates.

The nation’s regulators have stepped up scrutiny over the improper sale of derivative products at local brokerages to retail investors, many of whom were elderly people seeking a stable yield for retirement.

“The bad thing is they are complicated products and retail investors probably don’t understand them,” Benn Eifert, chief investment officer at Qvr LLC, said. “I think those markets developed historically because Korea became a very wealthy country very fast and didn’t have as many as domestic investment opportunities.”

The complicated notes linked to assets including equity indexes, commodities, bond yields and single stocks have a total outstanding balance of 104 trillion won, according to KSD. Products linked to the Euro Stoxx 50 Index were the most popular in South Korea in the past year, it said. The gauge has lost 25% from a high last month.

“I expect many hedge funds and brokerages will get margin calls soon on their hedges for the notes,” said Hyo Seob Lee, research fellow at Korea Capital Market Institute.

“The issuers will feel they need to reverse their current positions – selling put options – before the notes hit the loss-making barriers. So they will eventually buy put options if the sell-off continues, resulting in a further outflow in the cash market.” — Bloomberg
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