Korea Capital Market Institute

In this report we introduce a variety of financial instruments which can be used by financial investment companies in their proprietary trading. For each instrument we investigate the concept and trading structure, current market conditions both in Korea and abroad, and trading examples or strategies, and then propose innovative approaches to improve current regulatory schemes or trading practices together with some important implications. Ⅰ. Commodities In alternative investment field, the term ‘commodities` mean valuable physical resources such as crude oil, gold, wheat, etc. The commodity exchange where a number of derivatives such as futures and options are traded among investors with high liquidity is the major infrastructure in the commodity markets. The basic and simple exposure to commodities is to purchase and hold those. The other way to take a exposure to the commodities includes (i) the purchase of the stocks of natural resources companies, (ii) commodity (index) futures and option trading in commodity exchange, (iii) commodities forwards and swaps trading in OTC market, and (iv) the issue or purchase of commodities linked notes(CLN). Among many commodity exchanges, CME group including CME CBOT, and Nymex is regarded as the top exchange. Its commodity products encompass energies, precious metals, non-ferrous metals, grains, dairy products, ets. In contrast, Korea Exchange is listing only two commodity futures, i.e. gold and lean hog, whose trading volumes have been very trivial. The CLN is the structured bond with the payment related to commodity price. It can be a good external financing instrument for the firm to excavate, develop, produce, process or sell commodities. And it provides the relatively safe alternative to investors who can not access directly the commodity market. The so-called Managed Futures which represents the U.S. futures industry means active investment strategies using futures and options with highly short-term long or short exposures. Sometimes it also refers to the private investment vehicle with those strategies. The total AUM managed by Managed Futures in U.S. was as much as 200 billion U.S. dollars in 2009. The CTAs/CPOs invest and trade the derivatives underlain by financial assets/indices and currencies as well as the commodity futures and options. Korea is the one of the poorest countries in terms of natural resources. So the sudden rise of the commodity price has threatened the Korean economy. Moreover recently the investors in Korea begin to be interested in the commodity investment. So, it is necessary that the policy change of Korean financial authority and the effort of the investment industry to develop commodity investment environment to meet the national necessity and investors` need. First, further development of commodity derivative market in KRX should be promoted because the commodity exchange is the core in the commodity market and industry. Second, The Capital Market Law in Korea should define explicitly the issuer of CLN. Although there is no prohibition code for corporations to write CLN, no corporations with natural resource business have issued CLNs or securities linked the commodity price. Third, the codes of fund regulations in the Capital Markets Act are needed to be revised. While the CTAs and CPOs have managed the hedge fund type private investment pools so they can avoid the SEC regulations, the shape and management of private funds are restrictive in the Korean capital market. Lastly, the experts for commodity and derivative trading should be nurtured since the expertises in the commodity markets are crucial. The license or certificate system of financial authority can be recommended. Ⅱ. Real Estates Real estate investments are seen as an integral part of the asset allocation for many institutional investors. Increasing sophistication of private investors and their appreciation of diversification benefits has also led to broader asset allocations. The reasons typically mentioned why some should invest in real estate are as follow: favorable risk return characteristics, diversification benefits due to low correlation with other asset classes, stability, and consistency. There are three ways to gain exposure in real estate: buying physical assets(i.e. investing directly), investing through funds (i.e. investing indirectly), and investing on property derivatives. Direct investments are illiquid, difficult to manage, and out of reach for most of small investors. Indirect investment, on the other hand, are typically traded conventionally than direct investments. Besides the eased trading and handling, their main advantage compared to direct investments is the diversification of specific risk to multiple properties. In Korea, there are two main indirect investment vehicles. One is real estate investment trust(so called K-REIT) which is legal corporate to hold and manage properties. The first K-REIT permitted their establishment in 2001. There are 30 currently operating REITs and 4 of them are listed on Korea Exchange. The other is real estate fund which is a collective investment vehicle to invest in properties or to lend money to project finance vehicles(PFV). Property derivatives are financial instruments that are valued in relation to an underlying asset or price index. With property derivatives, investors have an efficient opportunity for protection in down markets. Derivatives only make sense if the underlying asset exhibits sufficient market risk that many participants are willing to transfer, hedge against, and speculate on. The three fundamental requirements for an asset class to be a suitable underlying asset for derivatives seem to be fulfilled by the real estate markets. First, the size of the market is sufficiently large to make a derivatives market desirable. Second, risk in terms of volatile returns is present, meaning that it makes sense to invest or hedge. Third, a credible index that is accepted as a common benchmark must exist in order to have a reference for payoffs. Property derivatives are not introduced in Korea so far. However, environments in Korea real estate market have been changed enough to meet the qualifications for developing property derivatives. The property market is large enough for a derivatives market to face sufficient demand and supply. Several indices measuring property prices have been announced regularly. It is expected to be introduced property derivatives in the near future. Ⅲ. Credit 1. Credit Default Swaps(CDS) A credit default swap(CDS) is a kind of insurance that can be used to hedge against credit risk. Using the swap a protection buyer and seller can separate credit risk from the financial product such as bonds or loans, and trade that risk. Since U.S. investment banks introduced credit derivatives in the early 1990s, they have been widely used for the purposes of credit risk management and investment in global financial markets. Although the global CDS market has grown tremendously, the Korean CDS market is not fully activated yet. To boost the domestic CDS market further, width and depth of the market need to be increased through attracting more market participants and nurturing dealer institutions. Revitalizing the primary and secondary markets for corporate bonds is another prerequisite for activating CDS trades that reference won-denominated bonds and loans. Continuous improvements to the market infrastructure including the standardization of contract types are necessary in order to help market participants evaluate credit derivatives appropriately. Establishing a CCP for clearing OTC derivatives will contribute to the improvement of market infrastructure, although it may also result in higher transaction costs. Regulators, therefore, must be cautious in choosing the right time to introduce a CCP. Finally, financial investment companies need to improve their credit ratings not only to facilitate the development of various CDS-related investment products but also to achieve better profit margins. Ⅳ. Interest Rates 1. Interest Rate Swaps(IRS) Interest rate swaps are contracts under which the counterparties agree to exchange interest payments of each other for a specific period of time. While initially developed to manage interest rate risks, interest rate swaps have become important financial tools and the trades of interest rate swaps have increased dramatically as the awareness of the interest rate risk has increased. Most of the interest rate related OTC derivate transactions are interest rate swaps. In the domestic market, the trades of interest rate swaps increased greatly due to the increase in the interest rate volatility and the increase of the issuance of structured notes. Examples of the applications of the interest rate swaps are in interest rate arbitrage trades, the design of structured notes, the asset liability management of banks and the government floating rate notes program. In order to further improve the interest rate swap markets, swap banks must play the role of liquidity providers to the market by taking the counterparty positions against the client trades. In view of the fact that the interest rate swap markets are serviced exclusively by the commercial banks, it is recommended that investment banks enter into the interest rate swap markets as swap banks in order to provide trade positions opposite to those of swap banks which are the commercial banks. 2. Structured Notes Structured notes are bonds with embedded derivatives and as such principals and interests are linked to market interest rates, currencies and stocks among others. Typically options such as calls, puts, caps and floors are embedded and investors tend to be option-sellers and issuers, option-buyers. The largest structured notes market is Europe and the structured notes market is growing rapidly in Asia. As in the US, the development of the structured notes market in Korea is stimulated by the convergence of the issuance of structured notes by the government owned companies and financial institutions and the demand of institutional investors for high-yield notes. The rapid development of the structured note markets in recent years in Korea is facilitated by the demand for high-yield notes due to the low interest rate environment, the ease of designing structured securities, the customization of structured notes to the needs of the investors, etc. Since structures notes link bond markets, swap markets, currency markets and Repo markets at the same time, investment banks have a clear comparative advantages in this market. Innovative structured notes are expected to provide investment banks with new growth. However, in view of the fact that even institutional investors can take speculative positions using structured notes without proper understanding of the product or taking proper risk management measures as shown in the Orange County fiasco, it is important that the industry makes a concerted effort to protect the investors through adequate investor education and product explanation. Ⅴ. Foreign Exchanges 1. FX Margin Trading Unlike in the U.S. and Japan, financial investment companies(FICs) in Korea cannot become a counterparty to retail customers in FX margin trading as leveraged retail FX transactions are classified into ‘exchange-traded` derivatives in the Financial Investment Services and Capital Markets Act. As FICs are only allowed to conduct brokerage businesses through the foreign dealers, retail investors pay unreasonably high transaction costs with regard to bid-ask spreads. There is also an urgent need to improve the current situation in which domestic securities companies with more capital play as only an introducing broker for overseas retail FX dealers. Meanwhile, Korean retail investors are not allowed to trade the Korean won(KRW)?denominated currency pairs but cross-currency pairs only. This may adversely affect investors` profitability and trading volume because they generally have difficulties in predicting FX　cross rates with limited information. Therefore, trading KRW?denominated currency pairs should be allowed together with flexible minimum trading units such as a 10,000 unit. In order to vitalize the retail FX market in a long-term perspective, FICs need to make efforts to establish sound investment practices through enhanced investor education, public relations and customer services. 2. Currency Swaps(CRS) Currency swap is a contract under which the counterparties agree to exchange a stream of cash flows, which can be calculated on a similar or different basis. Typically, domestic financial institutions enter into currency swaps with foreign financial institutions when they invest in foreign currency denominated securities or when they issue asset backed securities in international financial markets. For the further development of the currency swap markets in Korea, there is a need for the standardization of financial derivatives along with the modernization of transactions and settlement process. Swap banks must play the role of liquidity providers to the market to a greater extent than now by taking the counterparty positions against the client trades. In view of the fact that there is only one type of swap banks which is the commercial banks, investment banks must be able to enter into the currency swap markets as swap banks in order to provide trade positions opposite to those of swap banks.