Chinese Yuan (Renminbi) Derivative Products

The following sections are included:

• Contents

• Preface

• Acknowledgment

Dramatic changes have taken place in the Chinese economy and her financial system in the past quarter-century since China adopted the open-door policy in the late 1970s. It is highly necessary for readers to have a basic understanding of what major reform initiatives have been taken in the Chinese economy and what basic financial structure is in China currently before we start to address Chinese currency issues and the relating derivatives currently trading in various offshore business centers around the world. The purpose of this part is to provide readers with basic conditions of the Chinese economy and financial market so that they can grasp the Chinese currency revaluation issue easily.

The topic is too comprehensive to address in depth in a limited number of pages. We try to introduce the major reform initiatives in the Chinese economy in Chapter 2. Chapter 3 introduces the macro-economy in China. Chapter 4 gives us some background information on the Chinese monetary policies and commercial banks in China. Chapter 5 introduces the stock market, bond market, fund management, commodity futures market, and other major components of the capital market in China, and Chapter 6 focuses on the foreign currency policies and foreign exchange market in China.

The following sections are included:

• The Original “Legs” that Are Running

• The Voice of “the Congress”

• Voices Echoed “the Congress”

• Voices from Other Continents

• The Voices of Other Spheres

• Joint Voices of G7 Industrial Nations and Beyond

• From Depreciation to Appreciation

• Summary

The following sections are included:

• Household Economic Responsibility System

• Open-Door Policy and Special Economic Zones

• A Decade of Experimentation with a Market Economy

• The Beijing Olympic Games and the Shanghai World Exhibition

• World Trade Organization (WTO) Entrance

• Conclusions

The following sections are included:

• Population

• Education

• Foreign Direct Investment

• Exports and Imports
  • Development in the Past Quarter-Century
  • Trade Contribution to Economy
  • Growth of Imports
  • Contribution of Foreign Enterprises

• Foreign Reserve and Foreign Debt

• GDP and GDP per Capita
  • International Comparisons
  • Per Capita GDP
  • Energy Consumption and GDP Growth

• From Stimulating Fiscal Policy to Stimulating Consumption Policy

• Conclusions

The following sections are included:

• The PBOC

• Financial Institutions

• Chinese Banks
  • Big Four State-Owned Commercial Banks
  • Nation-Wide Joint Stock Banks
  • Local Joint Stock Banks
  • Private Commercial Banks

• Foreign Banks in China

• Non-Banking Financial Institutions

• Instruments of Banking Control in China

• Inter-Bank Money Market

• Problems in the Chinese Banking System
  • Non-Performing Loans
  • Loan-Making Procedures

• China's WTO Promises for Commercial Banking
  • Geographic Coverage
  • Clients
  • License

• Conclusions

The following sections are included:

• Stock Market
  • Brief Introduction
  • The Two Exchanges
  • Share Structure, Intermediaries, and Regulation
  • Hong Kong Stock Exchange and International Listing

• Bonds Market

• Fund Management

• Futures Market
  • Historical Development
  • Futures Contracts in China
  • The Shanghai Futures Exchange (SHFE)
  • Greater Role for China's Futures Market to Play in the World

• Insurance Industry in China

• QFIIs and Foreign Securities Companies in China

• Problems Facing China's Capital Market

• China's WTO Promises in the Securities and Insurance Market

• Measures to Accelerate Capital Market Development

• Conclusions

The following sections are included:

• The State Administration of Foreign Exchange
  • Functions and Responsibilities
  • Internal Set-up
  • Branch Offices

• Historical Development
  • Pre-Reform Era (1953–78)
  • Pre-Market Economy Era (1979–93)
  • Market Economy Era
  • RMB Exchange Rates from 1978 to 2003

• Current Foreign Exchange Administration in China
  • Managed Floating System
  • Significant Liberalizing Measures
    • New Account System is Introduced into the Banking System

• Capital Account Convertibility in China

• The Chinese Foreign Exchange Market

• Foreign Invested Enterprises and Foreign Exchange Management

• Shanghai International Financial Center

• Conclusions

Our introduction to the Chinese economy and financial markets in Part I prepared us to understand better whether the Chinese yuan (CNY) or renminbi (RMB) should revalue or not, and it is necessary for us to introduce popular foreign exchange derivatives in the international marketplace before we introduce and analyze RMB derivatives in subsequent parts of this book. Foreign exchange derivatives have been trading both over-the-counter (OTC) and at exchanges around the world for over three decades, and they have become an integral part of the foreign exchange market. Yet, most of these popular foreign exchange derivatives do not exist in China.

Part II is organized as follows. Chapter 7 briefly introduces the foreign exchange market; Chapter 8 introduces foreign exchange forward market; Chapter 9 discusses non-deliverable forward market for controlled currencies; Chapter 10 introduces foreign exchange futures trading in major futures and options exchanges in the world; and Chapter 11 introduces foreign exchange options trading in both OTC marketplaces and organized exchanges.

The following sections are included:

• Foreign Exchange Market

• Major Currencies of Foreign Exchange Market

• Uses of Foreign Exchange Market

• Foreign Exchange Centers in the World

• Singapore and Hong Kong

• Emerging Market Currencies

The following sections are included:

• Foreign Exchange Forwards

• Pricing Foreign Exchange Forwards

• Foreign Exchange Forwards in Emerging Markets

• Foreign Exchange Swaps

• Currency Swaps

• Interest Rate Swaps with Major Currencies

• Conclusions

The following sections are included:

• Non-Deliverable Forwards

• How NDFs Work

• Development of the NDF Market
  • NDF Distribution
  • Market Turnover
  • Transaction Sizes

• Examples of Uses of NDFs

• Master Agreement of ISDA

• Non-Deliverable Swaps

• Problems with NDFs and NDSs

• Impacts of NDFs and NDSs

• Institutions Trading NDFs and NDSs

• Services to NDF/NDS Market

The following sections are included:

• Introduction

• Foreign Exchange Futures

• Foreign Exchange Futures Trading Volumes

• Differences between Forwards and Futures

• Major Functions of Futures Market
  • Managing Risk
  • Price Discovery
  • Information Dissemination

• FX Futures in Developing Economies

• Conclusions

The following sections are included:

• Introduction

• Call and Put Options

• Options Premiums

• Major Differences between Futures and Options Contracts

• Currency Futures Options

• Exotic Foreign Exchange Options
  • Vanilla vs Exotic Options
  • Development of Exotic Options
  • Major FX Exotic Options
  • Turnovers of Major FX Exotic Options

• Foreign Exchange Options in Emerging Markets

• Conclusions

The Asian financial crisis that broke out in July 1997 shocked the world financial market and the East Asian economies in particular. A lot of studies have been done by various major international organizations, academic institutions and scholars around the world. There were so many aspects of the Asian financial crisis that it would take too long simply to review the major ones. Most of these studies either aim to find out factors that caused the crisis and then what policy mistakes were made by national authorities, or to find indicators that might foresee similar crises in the future…

The following sections are included:

• Thai Baht Floating and the Crisis

• Singapore and Hong Kong
  • Singapore
  • “Double Play” in Hong Kong
  • Banking Sector Performances in the Two Banking Centers

• Capital Flows and Asian Financial Crisis
  • Capital Flows to Asian Markets
  • Total Amounts Owned to US Banks

• Derivatives Associated with Capital Flows
  • Derivatives and Capital Flows
  • US Money Center Banks
  • Derivatives/Loan Ratios

• FX Market Volatility, Transactions Costs, and Liquidity

• Hedge Funds

• Institutions Involved
  • The US Money-Center Banks
  • European Financial Institutions
  • Local Investment Banks

• Summary and Conclusions

The following sections are included:

• Central Banks' Intervention in Forward Markets
  • Interventions
  • Ways to Obtain Local Currency for Delivery
  • Impacts of Forward Intervention on Foreign Reserve

• Thai Baht Forwards and the Asian Financial Crisis
  • The First Episode
  • The Second Episode
  • The Most Severe Attack
  • The Peak of Attack
  • Market Participants
  • Market Reactions

• Korean Won Forwards
  • Foreign Reserve Deposits in Domestic Banks
  • Forward Volume
  • Derivatives Trading Value
  • Profit and Loss of Various Participants

• FX Forward Market in Singapore

• Hong Kong Dollar Forwards
  • The HKMA's Intervention Activities in the Forward Market

• Brazilian Real Futures

• Summary and Conclusions

The following sections are included:

• NDFs in Asia
  • Turnovers
  • Singapore and Hong Kong
  • Tokyo

• Philippine Peso NDF

• Korea Won NDF
  • Major Policy Changes
  • Development of Offshore NDF Market
  • NDF Compared with the Spot Market
  • Onshore and Offshore NDF Markets
  • Comparison between Forward and NDFs

• Taiwan
  • Early Development of NTD NDFs
  • Turnover during the Asian Financial Crisis
  • Interventions of NTD NDF
  • Comparison between the Won NDF and NTD NDF
  • Coexistence of Offshore and Onshore NDF Markets

• Chinese Yuan NDF
  • Early Development
  • Responsibility and Diminished Pressure for Devaluation

• Russian Ruble NDF

• Summary

The following sections are included:

• Currency Swaps
  • Malaysian Ringgit Currency Swaps
  • Korean Won Currency Swaps

• Credit Default Swaps
  • Credit Derivatives
  • Credit Default Swaps
  • Geographical Differences and Notional Amount Outstanding
  • Difficulty in Pricing Credit Default Swaps

• Total Return Swaps
  • Concept of Total Return Swaps
  • Popularity in Asia
  • Korean and Indonesian Counterparties
  • J.P. Morgan and Korean Securities
  • Korean Trusts

• Swaps in Singapore and Hong Kong
  • Singapore
  • Hong Kong

• Summary and Conclusions

The following sections are included:

• “Callable” and “Put-able” Debt
  • Concepts of Embedded Options
  • Asian Debt with Embedded Options
  • Types of Embedded Put Options
  • IMF Estimation of Put-able Debts

• Currency Options in Singapore

• Options in Hong Kong during the Asian Financial Crisis
  • Foreign Exchange and Interest Rate Options
  • Stock Index Options

• Structured Notes
  • Concepts of Structured Notes
  • Structured Notes in Asia
  • Principal Exchange Rate Linked Note (PERL)
  • South Korea
  • Structured Notes with Embedded Options

• The Long Term Capital Management Episode
  • Background and Performances
  • Products Transacted
  • Portfolio Composition
  • LTCM's Near Failure

• Summary and Lessons

With all the preparations made in the previous three parts on the Chinese economy and financial markets, foreign exchange derivatives in developed markets, and the major foreign exchange derivative products involved in the Asian financial crisis, we are ready to start the main part of this book — CNY or RMB derivatives. Because the CNY is still tightly pegged to the USD, there are essentially no derivatives on the CNY in Mainland China besides a thin CNY forward market.

We will start with the CNY forward market — the only CNY derivative product onshore in China in Chapter 17; Chapter 18 introduces the CNY nondeliverable forwards (NDFs); Chapter 19 illustrates how CNY NDF contracts are used in practice; Chapter 20 introduces CNY nondeliverable swaps and forward swaps; Chapter 21 introduces and analyzes CNY nondeliverable options (NDOs) and options on the CNY NDFs and popular trading strategies using such options; Chapter 22 introduces various foreign currency deposits with embedded options; Chapter 23 introduces CNY structured notes; Chapter 24 analyzes channels to profit from the potential CNY revaluation using traditional products and how offshore CNY derivatives are related to traditional business transactions onshore.

The following sections are included:

• Brief History of CNY Forwards

• Tentative Methods of the PBOC
  • Coverage and Purpose
  • Approval for Settlement and Sales
  • Administrations

• CNY Forwards in the BOC
  • Current Account and Capital Account
  • Currencies
  • Procedures for CNY Forwards Transactions
  • Extension and Early Settlement
  • “Margin” Calls

• Turnover of CNY Forwards

• Examples of CNY Forward Hedging
  • Chinese Importer with Euro Settlement
  • Chinese Importer Importing from Germany

• Existing Problems
  • Significant Discrepancies between Implied and Actual Interest Rate Spreads
  • Little Volatility in Spot Market and Less Incentive for Hedging
  • Participation Restrictions
  • Interest Rate Mechanism

• Potentiality

• Summary

The following sections are included:

• Brief History of CNY NDF Market

• CNY NDF Contract Specifications
  • Settlement Rates
  • “Drop-Dead Date” for Unscheduled Holiday
  • Specified Rate
  • Relevant City for Business Day

• From Devaluation to Revaluation

• Factors and Events Affecting CNY NDF
  • First Stage Arguments and Events (before May 2003)
  • Second Stage Arguments and Events (June–September 2003)
  • Third Stage Arguments and Events (October–December 2003)
  • Fourth Stage Arguments and Events (January 2004–)
  • Summarizing Arguments and Events

• CNY NDF Market Participants
  • RISK Survey
  • EMTA Members
  • Hong Kong SAR
  • China-Taiwan
  • Singapore

• CNY NDF Volume Estimation
  • EMTA Survey Volume
  • Hong Kong Monetary Authority Survey Volume
  • Reconciling Results of Two Methods

• The CNY Realignment Probability

• Pricing and Other Problems with the CNY NDFs
  • Existing Theories Not Applicable
  • No Universal Formula to Price All NDFs
  • No Reliable Formula to Price Domestic CNY Forwards
  • Fundamental Data and NDF Fluctuations

• Future Development

• Summary

The following sections are included:

• Trading CNY NDFs

• Spreading with CNY NDFs
  • Premiums and Discounts
  • Spreading Strategies with CNY NDFs

• Bull Spread with CNY NDFs

• Bear Spread with CNY NDFs

• Hedging with CNY NDFs

• Arbitraging between CNY Forwards and NDFs

• Summary and Conclusions

The following sections are included:

• Cross-Currency Swaps

• Nondeliverable Swaps
  • Nondeliverable Swaps
  • Rationale of an NDS
  • Why Use an NDS?
  • How Is an NDS Settled?

• CNY NDSs
  • General Introduction to the CNY NDS Market
  • Historical CNY Swap Rates
  • Recent CNY Swap Rates

• Uses of CNY NDSs
  • Introduction to Uses of NDSs
  • Hedging with CNY NDSs

• Foreign Exchange Forward Swaps
  • Foreign Exchange Swaps
  • FX Forward Swaps
  • Nondeliverable FX Forward Swaps

• CNY FX Forward Swaps

• Summary and Conclusions

The following sections are included:

• Brief Introduction to CNY NDO Market

• CNY NDO Contract Specifications
  • Notional Amounts
  • Settlement Method
  • Exercise Style
  • Settlement Rates
  • Tenors

• Historical and Implied Volatilities of CNY Options
  • Historical Estimation
  • Implied Volatilities
  • Volatility Smile
  • Term Structure of Implied Volatilities
  • Using Implied Volatilities and Historical Volatilities Together

• Factors Affecting Implied Volatilities of CNY Options
  • Implied Volatilities and NDFs
  • Common Factors Affecting Both Markets
  • Correlation Coefficient as a Measure of General Market Sentiment

• Pricing CNY Options

• CNY Option Spreads
  • CNY Bullish Spreads
  • CNY Call Spreads
  • CNY Put Spreads

• CNY and HKD Put Spread
  • HKD as a Proxy of the CNY
  • Volatilities of the HKD
  • HKD Put Options
  • Put Spread of CNY and HKD

• Other Popular Trading Strategies
  • Time Spread
  • Other Popular Options Trading Strategies

• Options on CNY NDFs or CNY NDFOs
  • Futures Options and Forward Options
  • Historical Volatilities of CNY NDFs
  • Pricing CNY NDFOs
  • Put–Call Parity
  • CNY Bullish Spreads
    • Synthetic CNY NDFs
    • Risk Reversals Widening with Spot NDFs

• Summary

The following sections are included:

• Introduction to NDF-Linked Deposits

• How Does an NDF Currency-Linked Deposit Work?

• Currency Deposits with Embedded European Options
  • Deposit Currencies and Measured FX Rates
  • Parameters
  • Exercising Probabilities

• Currency Range Deposits
  • Range and Interest Payment Specifications
  • Exercising Probabilities
  • American Currency Range Deposits

• Dual Currency Deposits

• Currency Deposits with Embedded Exotic Options
  • Currency Deposits with “Knock-Out” Features
  • Currency Deposits with “Knock-In” Features
  • Currency Deposits with ”Double Triggers”

• CNY-Linked Deposits with Principal not Guaranteed
  • Currency Deposits with Principal not Guaranteed
  • Embedded Options
  • Currency Deposits with Partial Principal Protection

• Other Currency Deposits and Conclusions

The following sections are included:

• General Introduction

• CNY Bullish Notes
  • Face Amount
  • Issue Price
  • Redemption Value
  • Current Spot Rate and Strike Rate
  • End Rate

• CNY Bullish Notes with Caps and Floors

• Bullish Obligation on the CNY

• Structured Notes with Embedded Options

• Summary

The following sections are included:

• CNY Revaluation and Hot Money
  • Account Surpluses, Foreign Reserve, and Hot Money
  • Capital Flows to Asia Pacific
  • China' Share in the Asia/Pacific Region and Hot Money Estimation
  • Forecast of Hot Money into China in 2004

• Current and Capital Accounts
  • Current Account
  • Capital Account
  • Transfer of Deposits in Foreign Branches of Chinese Banks into China

• CNY Revaluation and Real Estates

• CNY Revaluation and Security Markets
  • H-Share Performances and the CNY Revaluation
  • QFIIs and the CNY Revaluation

• CNY Revaluation and Chinese Government Bonds

• Capital Transfer from Head Offices to China Branches and International Borrowings of Foreign Companies in China
  • Official Data and Growth of Major Components
  • FIEs and FFIs
  • Short-Term Debt
  • Composition of STD Growth

• CNY Revaluation and the HKD
  • Hong Kong Dollar Peg System
  • HKD Forwards and CNY Forwards
  • Correlation between HKD Forwards and CNY Forwards
  • Wider Band of the CNY and Its Speculative Proxy
  • Speculation on the CNY and Money Flowed into HKD
  • Convergence of the Two Highly Correlated Currencies?

• Onshore CNY Deposits and Offshore CNY NDFs
  • Onshore Transaction
  • Offshore Transaction
  • Converting CNY into USD

• Corporate Loans of Foreign Banks
  • Onshore CNY Loans
  • Loans in USD
  • Synthetic CNY Loans with Swaps

• Summary and Conclusions

We have introduced major derivative products on the Chinese yuan in Part IV based on the introduction of the underlying Chinese Economy, banking system, capital market and foreign exchange system introduced in Part I. We previously planned to write one whole chapter on the Chinese foreign exchange rate formation mechanism which has been so important and relevant to the future development of Chinese yuan derivatives markets both onshore and offshore because the rate formation mechanism will answer all the three questions we raised at the beginning of the preface. Yet, published materials on this topic are currently so limited that it is rather impossible to have one concrete chapter prior to the publication of this book because it takes time to research and design an appropriate rate formation mechanism that can reflect market forces and at the same time maintain somewhat the relative foreign exchange stability in China. We are working on this topic and plan to add that as a chapter in the subsequent edition of this book.

The following sections are included:

• Trade Growth in China

• FDI, QFIIs, and QDIIs in China

• Economic Growth in China

• OTC Derivatives
  • CBRC
  • OTC Derivatives Onshore
  • OTC Derivatives with US Banks

• WTO and CNY Derivative Business

• Further Development of the CNY Forward Market

• Coexistence of Onshore and Offshore Markets
  • Onshore and Offshore NDFs for the Korean Won
  • Onshore and Offshore NDFs for the New Taiwan Dollar and other Currencies
  • Onshore Forwards and Offshore NDF for the CNY

• OTC and Exchange Traded Derivatives

• Potentiality of Derivatives Trading in China
  • Foreign Exchange Derivatives
  • Exchange Traded Derivatives
  • OTC Derivatives

• Summary and Conclusions

The following sections are included:

• Major Websites in the Chinese Financial Market

• Further Readings

• Index