China Stock Market and Currency
Shanghai Stock Exchange (SSE) is one of the largest stock markets in the world. The market has over a thousand listed companies, over 6700 listed securities, and over 1100 stocks. Chinese stock market has witnessed sporadic growth that is fueled by the fast economic growth that has been witnessed over the last thirty years. The economic growth was driven by the adoption of various economic reforms and opening up of China to the world. China is now integrated into the global economy and plays a major role in the stabilization of the regional and as well the world economy. The fast economic growth has increased the demand for financial resources and thus the Shanghai Stock Exchange has been the central organization that has been funding expansion and operational capitals. China stock market is one of the largest markets in the world by market capitalization. SSE as at May 2015 had a market capitalization of $5.9 trillion while Shenzhen Stock Exchange had $4.4 trillion based on the World Federation of Exchanges. The figures were as a result of a sudden jump in the market that had increased the Shanghai Stock Exchange by 60% and Shenzhen Composite had increased by 120%.
On 12 June 2015, the shares prices began to decline. The decline was sharp such that a third of the stock values was lost within a month's period. Major declines were recorded on July 27th and August 24th labeled as "Black Monday." By 8-9th July, more than half of the companies listed in the market filed for a trading halt in an attempt to minimize further losses. The government responded instantly, but the efforts were fruitless as the fall continued. However, the fall did not last long. As at December 2015, the market was already on a recovery path and the performance had managed to even outperform the S&P for the year 2015. Although the market did not manage to reach the heights, it was in June. The recovery process was good and steady as the market had made began to pick and thus it was only a matter of time before it can adjust to the actual values (Riley, 2015).
Earlier in the year 2015, People’s Daily published an article calling on people to invest in the stock markets. This was in spite of the fact that the share values had soared more than 80% in the four months before the advertisement. The article targeted hardworking middle class individuals who have some saving or can access credit facilities. The article was replayed online and commentaries encouraged more people to buy stocks (Zarroli, 2015). The following day saw stock prices hit all-time highs as people streamed in to invest from cash borrowed from other financial institutions. In the subsequent two and a half months, the stock market had over 38 million new accounts. However, with the slowdown in the economic growth, the investment banks did not make much profit as the new generation anticipated. The low-profit margins drove many investors to start selling their stocks. As more and more people opted to sell, the demand of the products went down and thus drove the prices down. More people started looking forward to selling, and the shares continued to lose their values. The over-optimistic individual investors encouraged by the government publication can be termed as the main contributing factor for the decline. Small scale investors, in spite of a relatively low portfolio, when moved in large numbers had a big impact on the market. By then, 11 percent of the 443 million households were estimated to hold the stock as part of their portfolios (Osnos, 2015). The Chinese middle-class population was targeted and still is a target, if future instances are to be avoided, the government should embark on a campaign to encourage long-term investments instead of the short term speculative ones.
Hedging Strategies
Hedging refers to an advanced strategy that is used to lower the risks of volatility in the stock or other financial assets prices. It is usually considered as a sophisticated investment strategy that is aimed at cautioning against market shocks. Hedges are constructed around many financial instruments including stocks, exchange traded funds, forward contracts, insurance, swaps, options plus many other types of derivatives and over-the-counter instruments. Hedging does not prevent price volatilities, but in the events that there is a shock, one will be covered, and the overall impact will not be as high. In the stock market, the concept involves a strategic mix of financial instruments such that in the case of any adverse price movement, the investor losses will be covered by gains from another investment. In essence, one is investing in two different types of securities that have negative correlations. Thus, hedging is a reality of the risk-return-tradeoff. The interplay is that reduced risk lowers the potential income. Typically, if an asset makes a profit, hedging reduces the profits made and on the other end, if the instrument makes a loss, hedging will lower the loss incurred. Hedging unlike insurance is not guaranteed. They depend on the level of experience of the analyst who is executing the strategy. A good analyst is able to cover most of the risky assets using a combination of various hedging techniques (Figlewski, 2015).
There are various techniques that an investor can use to hedge their portfolios against shocks such as the one witnessed in Shanghai Stock Exchange. Hedging uses derivatives to caution against the future fluctuations in the prices of goods and services. The two most common techniques that could have been used by the investors include options and futures.
Put option
Shanghai Stock Exchange was marred with a lot of speculative buying. Most people expected that Historical increase will continue, and thus they expected the stock prices to continue to rise. This was in spite of the warnings that were given by various stakeholders in the industry. The stock prices increased by large margins over a very short period. The increase did not in any way correspond to the increase in the economy. Proponents of the speculative buying argued that most Chinese corporations were undervalued, and thus, they expected the market to adjust to the actual value in the near future. A smart investor should be open to any movement in the market and should be in a position to anticipate price changes like the one witnessed in the SSE. In such situations, hedging techniques such as an option should be included in the investment plan. An option can either be purchased or written. A put option is a form of derivative that gives the holder a right, but not an obligation to sell a specified amount of assets at a particular price within a specified period. The holder opines that the prices will fall below the exercise price before the date of the expiry. The investor is thus cautioned against the losses by either selling the option or exercising the option.
Consider a situation whereby an investor purchases a put option contract for a hundred shares belonging to a company X for $1. That is 100shares * $1 = $100. The exercise price for the shares is given at $10, whereas the current share price is $12. In the above arrangement, the contract gives the investor an option to sell shares at $10. If the price happens to fall below the contract price, say $8, the investor has an option to either sell the put option in an open market or sell the shares at the agreed amount $10. Thus, he will suffer less. If the option holder had already acquired the shares, the arrangement is known as "married put" and serves to caution against further losses in the share values. SSE investors would have managed to lower their losses if they had acquired put options for their portfolio. Married put are only considered when the stock and the put are purchased on the same day.
Many scholars have debated the effectiveness of these arrangements. To some, acquiring stock and then insuring them against fall in prices seems illogical. However, decades of practice and reality hit such as the declines witnessed in the SSE is an indication that the reality sometimes is different from the assumptions. Thus, an investor should brace himself for any unexpected eventuality as the price movements of the shares are not always predictable.
Future Contracts
Future contracts are the other major type of derivative that an investor can use to protect their investments from unexpected changes in the prices. Most individual and institutional investors are risk averse as they are trading with amounts that they cannot afford to lose. The stock market does not guarantee any particular changes in the price, and thus, investors are expected to make their arrangements in caring for the unexpected events. The forward contracts are within a given period and thus they should be exercised within that time limit. The investor is protected against fall in prices. The contracts are openly traded in the stock markets, and thus, the holder can opt to cut the losses by floating them on the market. The effectiveness of this method is debated because it only allows one to caution against fall over a specified period. Once the time elapses, the investor is left exposed to any further changes in the prices. The other factor that affects the effectiveness of this derivative is that in stock prices, one is not able to predict the period that the prices will change and thus to make their acquisition a form of a bet with possibilities of outcomes going either way (Rheinländer, 2011).
Forward Contracts
Forward contracts are similar to the future contracts discussed above. They function in a similar way by cautioning the investor against falling stock prices. The only limitation is that the instrument is not traded in the stock market.
In all the above methods of hedging, various techniques and strategies are applied by the individual investor to optimize on their returns and lower the risks. Examples of such strategies include:
Long/Short Equity
This is an investment strategy that is associated with mostly the hedge funds and as well applied by some asset managers. The approach involves an acquisition of long equities that are expected to gain value over time and at the same time selling the ones that are projected to lose value. The strategy involves "bottom up" and "top up" analysis of the risks and opportunities that are availed by certain industries, sectors, and macroeconomic situation. Fund managers specialize in various sectors and strive to reduce volatility by spreading their portfolio or hedging the positions across different entities. The managers may attempt to execute market neutral strategies that lower the volatility of the held stocks. In the case of Shanghai, such strategy would not have worked as the fall was not on a particular industry, but on an overall market capital (Jacobs, Levy, & Starer, 1999).
Risk reversal
This refers to a technique that involves the disposal of out of the money put and acquiring out of the money call that has similar maturity period. This investment option involves the acquisition and as well disposal of out of money option at the same time. Thus, an investor makes an investment hunch, and observes the trends, if it becomes bullish, the investor might opt to go long on the asset. Otherwise, he disposes of it and acquires another one. This trading technique would have been effective in cautioning the impacts of the market decline of 2015.
In spite of the benefits that are associated with hedging, the downside to this is the fact that there are additional costs that are involved. For investors making a long-term investment, hedging is not necessary, and thus, they are left exposed to the fluctuation in prices.
Impacts of Chinese Yuan’s Inclusion in IMF Basket of Currencies
One of a the conditions that need to be fulfilled for a currency to be included in the International Monetary Fund (IMF) currency basket is that the currency has to freely usable, widely used and widely traded. The organization announcement of its inclusion is an indication that the currency has met the above criteria. This is a significant indication of the importance of Yuan in the global market. The Yuan has already overtaken Japanese Yen as the most globally traded currency and used in the settlement all over the globe accounting for a 3% of the world transactions. This gives the Chinese market more confidence in a year that saw its stock market face two crashes forcing the government to devalue the currency. The government had pledged that it will maintain the stability of the currency in the market in spite of the slow economic growth.
The inclusion is an indication that China is on the right track towards economic liberalization. The inclusion in the SDR marks a significant milestone that will pave the way for financial liberalization. This will also improve the efficiency in the allocation of capital to the institutions and accelerate the shift from consumption to service industries. This will give China an opportunity allow market forces to drive the exchange rates. The move is expected to profile high the Yuan as a major world currency and thus boosting its use in the international transactions. There are concerns that liberalization will lead to high volatility as organizations will have the opportunity to withdraw the currency at will. However, this concern is unfounded as the market will eventually adjust to the ideal position after absorbing all the volatilities (Lopez, 2015).
The expected overall impact is that more investors will opt to include Yuan based assets in their portfolio as it will be recognized as one of the main global currencies. The demand created as central banks boost their reserves will create more demand and may result in currency appreciation. The country will attract more foreign investments and thus boost the currency value further. The impacts may not be sudden as other reforms are yet to be implemented by the Chinese government. Thus, the inclusion is a step in the right direction towards liberalization and globalization of the Chinese currency Yuan (Rao, 2015).
In conclusion, the Chinese Stock Market experienced a sharp decline in 2015 owing to an increase in the share price driven by the demand from individual investors. The purchased shares failed to make the returns they unexpected. They thus opted to sell them lowering the prices. In such an event, it is important for investors to make some arrangements to safeguard against changes in the prices. These include various hedging techniques using derivatives. Upon the recovery, IMF included Chinese Yuan in its SDR currency reserves, a move that will map Chinese currency as one of the global currencies and possibly allow further liberalization and integration.
References
Figlewski, S. (1997). Hedging performance and basis risk in stock index futures.Futures Markets / Edited by A.G. Malliaris.
Jacobs, B. I., Levy, K. N., & Starer, D. (1999). Long-Short Portfolio Management. The Journal of Portfolio Management, 25(2), 23-32. doi:10.3905/jpm.1999.319730
Osnos, E. (2015, July 15). The Real Risk Behind China’s Stock-Market Drama - The New Yorker. Retrieved from http://www.newyorker.com/news/daily-comment/the-real-risk-behind-chinas-stock-market-drama
Riley, C., & Yan, S. (2015, August 27). China's stock market crash in 2 minutes - Jul. 9, 2015. Retrieved from http://money.cnn.com/2015/07/09/investing/china-crash-in-two-minutes/
Rheinländer, T., & Sexton, J. (2011). Hedging derivatives. New Jersey, World Scientific. http://public.eblib.com/choice/publicfullrecord.aspx?p=840619.
Zarroli, J. (2015, August 27). Beijing Government Spurred Ordinary Investors To Make Risky Margin Bets : NPR. Retrieved from http://www.npr.org/2015/08/27/435113627/china-s-government-encouraged-ordinary-investors-to-make-risky-margin-bets
