An unhealthy obsession

The extreme swings in equity and foreign exchange prices seen in the past three months are not all about problems with home loans and the latest economic statistics from the US, despite all the media attention on them.

Certainly, a pronounced downturn in the US economy would cause problems for Asia, so the release of US car and home sales, productivity and inflation statistics is having a bearing on the region's financial markets. But it's Asia's love affair with structured products that is exacerbating market moves. Even before the subprime debacle, academics were observing how the sheer scale of structured products sold in the region was skewing Asia's cash markets due to associated hedging activity.

One of the underlying assumptions of the Black-Scholes model is there is sufficient liquidity in the underlying stock or index to ensure that delta hedging has no impact on its price. But David Samuel, London-based head of equity derivatives for the global markets division at the Royal Bank of Scotland (RBS), demonstrated to private banking delegates attending an RBS Academy seminar in Kota Kinabalu, Malaysia, in August that this is not the case with Asia's largest structured product market, Hong Kong. According to Samuel's study, Hong Kong underlyings were demonstrably affected by delta hedging compared with the US equity market, where there is proportionally far less structured product business.

The same seems to be true in other markets such as South Korea and even Japan, say senior bankers. And they agree that some of the big market swings in the past few months are linked to structured product hedging, particularly due to the large increase in short-term correlation between equity markets in the region, as well as big increases in equity-forex correlation.

Banks can 'tough out' short-term correlation increases, but it's unclear how long hedge funds can hold their positions. Even the biggest dealers would lose billions of dollars if correlation levels were to remain significantly high for, say, six months.

Problems may also be looming due to prime brokers pulling credit lines to hedge funds. These funds often take the book axes of dealers that have built up concentration risks from their structured product businesses. If the funds are concerned about credit lines, they may be less willing to take the positions.

But it's not all doom and gloom. Increased market uncertainty should lead to more market participation by institutional money and corporates. And that may end up helping to provide a healthier balance to Asia's skewed financial markets.

Christopher Jeffery.