Reasons for the severe decline in Chinese Stock market in 2015
Between June 2014 and June 2015, the CSI 300 Index rose by 150%, reaching the peak at 5,166.3 on 12th June 2015. What follows was a severe decline in the stock index. Within just one month, the CSI 300 index had lost 30% to 3,507 on July 8. Several factors caused the fall.
Short selling
In the run-up to the stock market decline, investors were aggressively involved in short selling and margin trading. Short-selling and margin trading allowed investors to purchase shares using borrowed money thereby increasing the demand for stocks. Investors engaged in short-selling sell stocks borrowed from a broker and the seller later rebuys the stock and returns it to the broker. Short-selling is common when stock prices are expected to fall. The Chinese government blamed the stock market slump on the activities of short-sellers. As one of its measures to prevent further decline, the government banned short-selling.
Aggressive demand coupled with a slowdown in the economy
The economy of China experienced a slowdown from late 2014 and company profits declined. However, this was not reflected in the stock prices. The state of the economy directly affects the stock market. If the economy is slowing down and companies’ profits are falling, the stock market index should fall. The Chinese government implemented a loose monetary policy among other measures to encourage regular investors to invest in the stock market. The increased demand for stocks led to the rise in stock prices and the stock market index. Therefore, the rise in the index was not due to the increase in the real value of stocks but was only demand-driven. This created an economic bubble that was waiting to be popped. When it was finally exploded, the stock index declined. Panic sales by investors worsened the decline as it increased the supply of stocks in the market, thereby causing a reduction in stock prices.
iii) Nature of investors in Chinese stock market
A large percentage of Chinese investors in the stock exchange are retail investors, unlike in markets like the US that are dominated by institutional investors. The government encouraged ordinary people to invest in the stock exchange. Before the decline, there were about 90 million shareholders, of which 80% were regular investors. Institutional investors are more experienced in handling stock market slumps than individual retail investors.
Hedging techniques
Investors in China can use different hedging techniques to prevent losses occurring from the decline in the stock market index. The methods include stock options, stock index future, and Equity Exchange Traded Funds, among other techniques.
Stock-index options
Stock-index options give the holder a right but not an obligation to buy or sell a basket of stocks at an agreed price at a future date. The agreed price is known as the strike or exercise price (Brigham and Daves, 2014). The holder of an option has the right to exercise the option of the maturity date but is under no obligation to do so. An option giving the holder an option to buy an asset is known as the call option while that giving the holder the option to sell an asset is known as the put option (Moyer, McGuigan and Kretlow, 2014). The difference between a stock-index option and a stock option is that under a stock option, the underlying instrument is the individual stock prices while the underlying instruments in stock-index options are the stock market indexes.
A portfolio manager can use stock-index options to mitigate the risk of fluctuations in the stock market index (Moyer, McGuigan and Kretlow, 2014). When the investor decides to exercise a call option, he/she will buy a basket of stocks at the strike price irrespective of the prevailing stock market index. For instance, if an investor buys a three-month stock-index option with a strike price of 3,070 and after three months the stock market index increases to 3,100 the investor will acquire the stock at the strike price. If the index falls to 3050, the investor will not exercise the option. Instead, he will buy the basket of stocks in the stock market at 3050. Therefore, a call stock-index option protects an investor planning to buy stocks from a rise in stock prices. On the other hand, an investor can buy a put stock-index option which gives him the right to sell to the basket of stocks to the options trader. If the stock market index is 3,080 and the stock market price increases to 3,150, the investor will not exercise the option and will sell the basket of stocks at the prevailing stock market index. However, if the index falls to 3040, the investor will exercise the option and sell it to the options trader. Therefore, a put option protects an investor planning to sell his stocks from downward movements in the stock market index while giving him an opportunity to gain. Therefore, portfolio managers can also use stock options to mitigate the risk of loss resulting from unfavourable movements in the stock market index (Madura, 2014). Besides, the manager uses the strategy for speculative purposes to earn arbitrage profits.
Besides, traders globally can use options to mitigate risk. Besides the stock options, foreign traders investing in the Chinese stock market can use currency options to mitigate foreign exchange risk (Madura, 2014). This protects them from unfavourable movements in the exchange rate between the Chinese Renminbi and the US Dollar, the Euro, the UK pound, among other currencies.
Effectiveness of options
Option contracts are effective in mitigating stock market risks. While they protect the investor from unfavorable movements in stock prices and the exchange rate, it allows them to gain from favorable movements (Madura, 2014). The investor can only exercise the option if the strike price is more favorable than the prevailing market price, stock index or exchange rate. Besides, option premiums are inexpensive thus the cost of using options is low. Portfolio managers can use options to enhance portfolio’s return.
Limitations of options
Options may expire out of the money or worthless. If the strike price is less favourable than the prevailing price at the expiry of the option, the investor will not exercise. Thus, the option expires worthless, and the investor loses the option premium. It may lead to losses if the investor or portfolio manager wrongly predicts the direction of movement of stock prices.
Availability of options in China
Options are available in the Chinese market but with certain restrictions. The Chinese market for options is an emerging market. Equity options started trading on the Shanghai Stock Exchange on 9th February 2015 (Reuters India, 2016). Individuals wishing to trade n options must have at least 500,000 Yuan in their accounts while institutions are required to have at least 1 million Yuan. Since the market for options in China is not well-developed, hedging through stock options may not be as effective as in other markets where the options market is well-developed (Hintze, 2016).
The Chinese government still has restrictions on using options for speculative purposes. In 2015, it banned speculators in an attempt to make the Yuan less predictable. When it introduced currency options in 2011, only call options were allowed. Besides, it required that investors use options only for hedging and not speculation.
Stock-index futures
Stock-index futures are contracts to buy or sell a portfolio of stocks at an agreed stock index at a future date (Tarantino and Cernauskas, 2011). If a portfolio manager expects the stock market index to change, he can purchase a stock-index futures to mitigate the risk of changes in the stock market index. For instance, if the portfolio manager plans to sell a portfolio of stocks, a decline in the stock index would lead to losses. If he purchases a stock-index futures contract, the portfolio of stocks will be exchange at the agreed index or prices irrespective of the current market index. Unlike stock-index options, futures contracts do not give the portfolio manager the option to exercise. Once the manager has entered into the contract, he will be required to buy or sell the underlying stocks even when it is less profitable. Assume a portfolio manager acquired a three-month stock-index futures contract with to sell a portfolio of shares at an index of 1,425 and that the market index at the date of the transaction is 1,415. If the market index increases to 1430 after three months, the portfolio manager can increase the portfolio return by selling the stocks at the prevailing index or prices (Tarantino and Cernauskas, 2011). However, the futures contract binds the portfolio manager, and he has to sell the stocks at the agreed index or prices hence, there will be a loss on the portfolio.
Effectiveness of stock-index futures
Stock index futures are effective in protecting a portfolio manager planning to sell a basket of stocks from downward movements in the stock market index. They guarantee a price or index for the portfolio of stocks. On the other, stock-index futures protects a portfolio, whose manager is planning to buy stocks, from increases in the stock market index. However, the strategy is only effective if the portfolio manager accurately predicts the nature of the future movement in the stock index. If there are unfavourable movements in the stock market index, the portfolio manager suffers a loss, unlike stock-index options where the manager only exercises the option when the movements are favourable.
Availability in the Chinese market
Stock-index futures are available in the Chinese market. Before the start of the stock index decline, the Chinese stock-index futures market was the biggest in the world. However, the stock market decline prompted the Chinese government to impose restrictions on the market thus making its application difficult (Hintze, 2016).
Impact of inclusion of the Chinese Yuan in the IMF basket of currency on the longer term risk management of Chinese firms
The inclusion of the Chinese Yuan in the IMF’s basket of currencies implies that the Chinese government will be forced to adopt a flexible exchange regime (endorsement, 2016). The Chinese government has been operating a pegged exchange regime. It did not allow the Chinese Yuan to trade freely in the foreign exchange market. Monetary policy reforms were initiated in Chine in 2005. Before the reforms, the Chinese Yuan was pegged to the US dollar, but the government removed the peg and attached its value to the basket of currencies. The reforms saw an appreciation of the Chinese Yuan against the US Dollar by 21% between 2005 and 2008. Controls were also imposed in 2012 where the Chinese Yuan was only allowed to fluctuate by 1% daily. Pegging the currency was a way the government used to protect the economy from the effects of volatility in the exchange rates.
The Chinese economy has a surplus balance of trade hence the value of its currency should have appreciate against other currencies like the US Dollar. However, this did not happen due to the controls exercised by the government (Financial Times, 2016). Yuan’s inclusion implies the Chinese Yuan would be traded freely in the exchange market. Its value will be determined by the market forces of demand and supply. The IMF advocates for a free and flexible exchange rate policy hence the Chinese government would not be able to control the exchange rate.
The demand and supply for global currencies like the US is influenced by factors, both domestic and international. Some of these variables are beyond the control of any government hence, it is almost impossible to avoid exchange rate volatility. For instance, an increase in inflation rate in China will cause a fall in the value of the Yuan thus changing the exchange rate. This implies that Chinese firms that were not exposed to foreign exchange rate risk will be affected by the fluctuations in the exchange rate. This will directly affect Chinese firms operating in the international market although domestic firms will also be affected by competition from foreign firms. The Chinese firms will, therefore, have to include foreign exchange risk in their risk management policies.
They must establish appropriate policies for hedging foreign currency risk since their earnings and obligations will be exposed to foreign exchange risk once the government allows the Yuan to trade freely and desist from any interventions in the foreign exchange market (Baker and Powell, 2011). A Chinese a firm whose revenues are derived from international markets and received in foreign currency will have to employ strategies such as using options, futures, and forward contracts, among other hedging strategies.
The inclusion may also have positive implications on the long-term risk management of Chinese firms. The IMF’s basket of currencies consists of currencies that are used globally. Currently, the US Dollar is widely used in international transactions including transactions where both parties are non-US firms. Before the IMF added the Yuan to its basket of currencies, it had to determine that it is freely tradable (Bloomberg.com, 2015). The SDR status also implies that the IMF has determined the Yuan as a safe currency where governments can store their foreign exchange reserves. This boosts the confidence of investors globally. When investors will be fully confident in the Yuan and after the Chinese government has liberalized its market, investors will freely use the Yuan for international transactions. This may reduce the foreign exchange risk facing Chinese firms in the international market. This is because they will be able to invoice their sales derived from foreign markets in Yuan as well pay its international expenses in Yuan. If a single currency is used for both domestic and international revenues and expenses, the foreign exchange risks will decline.
Besides, the world’s economy, including the Chinese economy, is significantly affected by the actions of the Fed. Since the US dollar is widely used in international trade, macroeconomic and other fiscal policy actions taken by the Fed affect the entire global economy. For instance, the 2008 financial crisis spread quickly to other economies since there were so many US dollar-backed securities traded in the international market. The US dollar is still the most important currency in the IMF basket of currencies. If China opens up its borders to international trade and allows the Yuan to freely trade in the market, the Yuan will gain importance in the IMF basket of currencies. Therefore, China will gain more influence on the global economy. In the long-term, it will reduce the foreign exchange, among other international risks facing Chinese firms.
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