Hedging China's Stock Market Decline - Case Study Example

Hedging China’s Stock Market Decline

Factor behind the Several China Stock Market Decline

The main reason for the decline in the Chinese stock market from 12 June to 26 August is basically because of panic by the investors. The panic experienced in the country due to several factors drove the investors to sell their stocks at the same time causing a decline in the stock market.

In most of the stock markets in the world, investors are always institutional; however, this is not the case with China. In the Chinese stock market, most of the investors are small retailers. The small retailer investors contribute to 80% of the Chinese stock market. Apart from the small investors dominating the market, they are also close to the foreigners which make them prone to volatile behavior. Just as in other financial markets, small retailer investors are likely to act in groups. When I say “acting in groups” I mean that when one retailer investor pulls money out to make some profit from a given market, the remaining retailers will follow believing that the first movers are more informed. However, this is worse in China. In most of the developed countries markets, information is always transparent. In China, information is less transparent and the fact that the market is dominated by state firms’ means that checking of the books is not always easy (Yueh, L., 2016).

Shmuel, (2016), confirms that Shanghai stock market crashed by 7% before a circuit breaker was triggered. However, he links this to the biggest downwards adjustments to the yuan since August. Yuan is fixed to the U.S. dollar and the People’s Bank of China has been gradually lowering the value of yuan currency against the greenback for the past years. Most of the economists see this kind of move as an effort at competitive devaluation as the Chinese economy continue to experience signs of slowing growth. Most economists have also associated the Thursday market crash as a result of currency panic. Even though for the past years yuan has been gradually lowering, there has been no explanation for the currency devaluation and this has shaken the confidence of the investors. The move has also created fear that the Chinese neighbors will be forced to engage in devaluation competition with the aim of keeping their exports competitive thus worsening the instability of the region. The selloff being experienced in the Chinese stock market is a move by the investors to shift their money into assets that are not tied to the yuan with the aim of protecting the value of their investment.

The Hedging Techniques

A hedging trade entails buying a security that will gain value if the stock price being hedged experience a decline in its value. It is important not to confuse hedging strategies as a trade for profit. Hedging are strategies applied in the stock market to reduce the risk for loses. In any hedging strategy taken, there will be a cost incurred. Some of the cost incurred will include the cost of the hedged product to lost profit in case there is an increment in the value of the stock, in such a case, the hedge produces offsetting loses. The hedge can be utilized to cover some of the portion of a person’s portfolio value with the aim of having the hedge produce profit that will counter some of the losses in case of a market decline (Plaehn and Media, 2016). Some of the hedging techniques that could be used include stock index futures, put option, and inverse ETFs.

Stock Index Futures

One of the most competent hedges against a declining stock market would be future contract trading against stock indexes. Futures can be refereed as consistent derivatives that provide the buyers and sellers with a chance to contract for the future delivery of a given commodity. However it is important to understand that trading future is very complicated but if a person need to hedge a large stock portfolio, then he or she learning about future would be very important. One of the widely traded index future contracts used in the U.S. is the S&P 500 index. Most of the portfolio managers with the aim of hedging risk over a given period of time always use S&P 500 future to do so. By shorting the contract, the stock portfolio managers can protect themselves from the risk of falling prices as a result of declining market. To successfully implement a hedge, there must be a similar price movement of the instruments in the cash and future market. Furthermore, the amount of money invested in cash and future must be the same. For the investors to reduce the exposure from the systematic risk they usually hedge with stoke index future. Hedging transfers the price risk of owning a stock from a person reluctant to admit systematic risk to a person willing to accept systematic risks. An instant is investors who possess a portfolio of security that is valued at $ 1.2 million with a 4% dividend (Hull et al, 2013).

The investor has been flourishing with his or her stock pick. As the return of the portfolio fluctuates with the market, the investor outperforms the market by 6% consistently. Hence the portfolio will have an alpha of 6% and a beta of 1.00. Assume that an investor thinks that the market is going to experience a decline of 15% that will be compensated by the 1% obtained from the dividends. The net broad market return would be negative 14%; since they outperform the market by 6% consistently the investor’s estimated returns will be negative 8%. In this scenario, the investor is likely to cut their beta in halving their alpha. This can only be achieved by selling stock index futures. In this instant, the S&P 500 index is at 240. Each contract is $ 120,000 and the contract multiplier is $ 500. Since the investor is interested in simulating a sale of $600, 000 which is half of his or her portfolio, the investor needs to sell five contracts (5 × $120,000). Hence, the fluctuation in the market will only affect half of the investor’s portfolios (Referenceforbusiness.com, 2016).

Put Option

The put option contract increases the value if the original stock declines below the level that was pre-set by a given put option parameters. Put can be utilized to hedge the whole stock market or to hedge against decline in a person’s stock. The only money that is at risk is that paid for option contracts; buy this, put options allow a person to gain some profits, instead of the portfolio going down, it goes up by more than what a person paid for the puts (Plaehn and Media, 2016).

An instant of a put option on a stock market is where a put buyer purchases a put contract to sell 100 shares of a given company to put writer at $ 50/share. Each share currently sells at $ 50 and put buyer pays a premium of $5 per share. If the company’s stock deprecates to $ 40 per share before expiration date, the put buyer can buy 100 shares at $ 40 per share at the stock market then sell them to put writer at $ 50 per share. In such a case, the total earning of the put buyer would be $ 500. However, if the share price did not drop below $ 50 per share, then put buyer will not exercise the option. The option of the put buyer would be worthless because he or she would have lost the investment (Chan, Chung and Fong, 2002).

Inverse ETFs

Inverse exchange trade funds are prepared to change the value of a specific index in the opposite direction. Leveraged, inverse ETFs produce a value change that is of two or three times the index but again in the opposite direction (Hull et al, 2013). A person will realize gains if the stock market experiences a decline if he or she purchases a leveraged, inverse ETF in his or her stock portfolio as it will hedge the decline. However, in case of a rise in the market, ETF will drop (Plaehn and Media, 2016). The result provided by inverse ETFs is similar to that of short selling the stocks in the index. For an instant, if there is an increase in S&P 500 by 1% the inverse ETFs is designed to fall by 1%. On the other hand, if there is a fall S&P by 1%, then the inverse ETF should rise by 1%. Because the value of inverse ETFs rises in declining markets, they are popular in the bear market (Baker, 2007).

The panic experienced by the investors in the Chinese stock market is due to the fear of the devaluation of yuan which has made investors to sell their stocks bat the same time causing a decline in the stock market. However, with the stock market experiencing some decline it would be important for the investors to reduce the risk involved through hedging. The best hedging technique that the investors can use is inverse ETFs. Because Inverse ETFs increases with the declining stock market it seems to be the best choice because there is a higher possibility of Chinese stock market continuing to decline. If this trend continues, investors using inverse ETFs as their hedging strategy will benefit from the declining market as the value of ETFs will rise. Because China is still experiencing a slow growth, it is more likely to continue devaluing yuan to improve its export competitive. It competitors are also likely to engage in the devaluation competition to also improve their export competitive advantage. As this yuan devaluation competitive strategy continues most of the investors will continue selling their stock to shift their money to stronger currency than yuan. The continuous selling of the stocks is likely to cause the Chinese stock market to decline therefore contributing to the rise of the inverse ETFs value which in turn will benefit the investors. However, it is important for the investors to study the market keenly because any growth in the Chinese stock market means devaluation to the inverse ETFs.

Impact of the Chinese Yuan’s Inclusion in IMF’s Basket of Currencies

The inclusion of China in International Monetary Fund's (IMF’s) basket currency will force the country to open its financial market to the foreign investors. This is the only way that that China will be easily added to the reserve holdings. China would be required to give the central bank yuan worth between $ 750 billion to $ 1.2 trillion. The Chinese government will have no choice but to provide good regulations and rules and provide effective supervisions that will contribute to opening the market for the foreign investment. In addition to opening the market for the foreign investors, the new laws and effective supervision will greatly contribute to the yuan being more attractive globally(Ramage, 2015).

The inclusion of yuan in the IMF’s basket currency is a clear indication that IMF has come to accept that Chinese currency is in the same global standing as the other four currencies that are currently baskets which include the euro, the yen, the dollar, and the sterling. This move is of great importance to the Chinese government as it contributes in integrating the Chinese economy into a global financial system. The inclusion is also a sign that the world has acknowledged the progress made by the Chinese authorities for the past years in reforming the Chinese’s financial and the monetary system. For any currency to be included in the SDR baskets, one of the most vital conditions is that the currency must be freely usable. To ensure that yuan is freely usable, the People’ Bank of China confirmed after the announcement that it would the Chinese currency to be increasingly determined by the market force.

The inclusion of the Chinese currency in the SDR basket is enabling yuan to become recognized internationally. By the currency being recognized internationally, most of the central banks around the world will start to increase their holding of the yuan. Currently there are plans by the central banks of some countries like Indonesia, Korea, and Philippines to increase yuan reserves. Because yuan is now recognized as a global reserve currency, the country may now attract more inflows from various foreign investors such as sovereign wealth funds, mainly because of the monetary policies that are accommodative in Japan and Europe. Because the country is going to experience higher foreign inflow, there is a possibility that the high foreign inflows will also lead to currency appreciation. China being included in the SDR basket is not enough; the country still needs to implement some reforms for it to increase its link with the world market. Even though Peoples Bank of China has accepted that it will surrender its control yuan gradually, the Chinese government must also be ready to apply measures that will lead to the relaxation of the capital market (Rao, N., 2015).

The move by the IMF to include yuan in the SDR basket has built the confidence of the policymakers and they strongly believe that the move will build the credibility of China (the country with the world’s second largest economy) on the international stage. The reason for the Chinese revaluing of yuan in August was basically to pursue SDR status. Various bank analysts have confirmed that the move by the IMF will lead to the use of yuan in both the trade and financial transaction globally (Spence, 2015).

Various economists are expecting China to experience an inflow of as much as $3 trillion into yuan assets over the medium and the long term period. This is so because of the International Monetary Fund's (IMF) announcement of the inclusion of yuan in the SDR currency basket which also provides an opportunity for the further opening of the Chinese financial market. Even though Chinese have been in the move to internationalize yuan, the inclusion in the SDR currency basket has helped strengthen their continuing fight of globalizing their currency and its capital account (Chandran, 2015).

The changes in the currency dynamics cause new political concerns. The new status of yuan will possibly improve the International monetary system and defend the global financial stability. As yuan becomes used globally, it is likely to undermine the financial sanctions that are imposed by the West on some countries like Sudan and North Korea that are linked with human right violation. These countries that are sanctioned are likely to carry out transactions with yuan. China always argues that it is vital to respect the power of a given nation and leaders need to set policies without fear of international interference. Up to date China has been a close financial and business partners with both North Korea and Sudan who have been sanctioned by the West for human right violation. As yuan rises, more options will prevail, and countries will have several choices where they can do their banking. This will definitely increase the human right crimes as countries have various ways of avoiding the West sanction (Bradsher, 2015).

Referencing

Top of Form

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Bottom of Form

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