QDII managers cautious about using RMB options

Qualified domestic institutional investor (QDII) fund managers are weighing the costs and benefits of using soon-to-be available RMB options to hedge against foreign exchange risk.

China is set to launch the tool on its interbank market in April, the State Administration of Foreign Exchange (Safe) announced this week.

A circular on its website reads: “As China’s yuan exchange rate is becoming more flexible, enterprises’ and banks’ demands for hedging tools are on the rise, which boosts the development of the foreign exchange derivatives market.”

The move to introduce RMB options is regarded as a major step in the development of the country’s financial markets. But QDII managers are adopting a cautious approach.

“What an option can do is to ‘hedge risk with a cost’, and theoretically the cost is expected RMB appreciation in a risk-neutral world,” says Tony Liu, deputy director of the product department at China Merchants Fund.

“Plus options will impose additional costs on our operating team. If I cannot see an immediate and reliable benefit from RMB options, I will not jump into the pool so soon.”

Rico Cheung, prospective fund manager of Da Cheng’s S&P 500 Equal Weight Index Fund, suggests he too will wait before deciding whether to use this tool depending on the “activeness of the market and the spread priced-in by the options”.

“Since RMB appreciation can be predicated within a relatively stable range of 3% to 5% per year, if the cost of hedging tools is higher than that, then we will probably choose not to hedge,” he adds.

These European-style options being introduced by Safe can only be exercised at maturity, and buyers need to deliver the full amount at the strike price. Safe also notes in its circular that banks and other participants can only buy call and put options but not sell them, except for the purpose of closing their positions.

David Chang, head of international business at Guotai Asset Management, expressed concerns that restrictions will limit the activeness of the market, at least initially.

For QDII managers, foreign exchange risk has long been a concern against the backdrop of RMB appreciation. Chang notes that the question is about how to offer a mature-market focused product to Chinese investors and alleviate foreign exchange risk at the same time.

Tom Duan, head of institutional services at Haitong Futures, says: “Nowadays, QDII managers mitigate risks primarily through diversifying their asset allocation. But, in fact, if they exploited derivatives, their portfolio would have suffered less during the market downturn in 2008.”

He sees RMB options as “a very good hedging tool against foreign exchange risk”, which should be adopted by QDII managers at the product development stage.

Currently, RMB options are tradable offshore, mostly in Hong Kong, while RMB futures are traded on Chicago Mercantile Exchange (CME) on a very limited scale.

Most market participants use offshore RMB non-deliverable forwards (NDFs) to hedge foreign exchange exposure.

NDFs are contracts with defined tenors and value, whereas QDII funds are open for subscription and redemption and subject to changes in market conditions which cause their AUM to fluctuate from time to time.

Therefore the tenors and value of the NDF and QDII funds often do not match, limiting NDFs role as a hedging tool. Some QDII managers have avoided NDFs precisely because they cannot hedge their FX risks sufficiently.

Unlike NDFs, which are standard contracts, the pricing and terms of the European-style options can be negotiated with banks. Cheung believes these offer greater flexibility in line with funds’ asset allocation and AUM.

Moreover, given that RMB options will be traded onshore and the option fees are in RMB, Cheung expects it to be a more efficient hedging tool than offshore RMB NDFs.