Full suite complete in vanilla renminbi interest rate options

15 Sep 2007
Second-order interest rate derivatives trading in renminbi took another step forward last week with the closure of the first cap/floor straddle through the brokers. It sets another point of reference for the development of a full range of hedging tools for China risk.
Although relatively small in size at Rmb100m (US$13.3m) per leg of the trade, the cap/floor straddle represents the opening up of a new market in renminbi interest rate options. The two-year trade dealt at a strike of 3.6% with Barclays Capital buying and Deutsche Bank on the sell-side. The interbank broker was GFI.
The renminbi interest rate options market has developed steadily over the past few months with more product and tenors being transacted. In December 2006, the first swaption straddle was dealt between HSBC and Standard Chartered. That was a five-year into five-year trade for a nominal Rmb50m.
Since then there have been more than a dozen option deals traded in non-deliverable format – onshore trading has not yet been given the go-ahead by the regulators.
"It [the cap/floor straddle] completes the set of plain vanilla interest rate option trades in renminbi," said a banker. "It also helps set up the trading and documentation convention."
Setting a benchmark is undoubtedly a compelling justification for the trade as establishing convention and setting up back-office systems always comes with its challenges.
"Someone has to start the market," said Xiao Ai Lin, an associate director (emerging market Asia IRO) at Barcap in Singapore. "But the repo is a volatile instrument so it also suited us to buy the straddle." Purchase of a straddle is an effective trading strategy on the view that the underlying instrument – in this case the seven-day repo – will move a long way from the strike price in either direction.
Laying off of customer business was thought to have driven the sell-side of the trade.
There are few end users of the product at the moment, with the international banks dominating any activity in the non-deliverable offshore format.
"We get some enquiries from international companies for hedging renminbi interest rate risk, but the majority of the interest in options is coming from onshore clients looking for yield enhancement and for liability hedging," said a banker.
Much of the yield enhancement and liability hedging interest is expressed in US dollars or the other major trading currencies, according to bankers.
Liquidity in renminbi product is limited for now but moving the market onshore would help solve that issue.
"We see huge potential of rapid growth in the coming months, especially with the development of the onshore market," said a banker. "The introduction of interest rate option products onshore would give corporates an excellent alternative to managing their interest rate risk, investors the benefit of expressing their view more specifically, and banks a more liquid and deeper underlying market."
One other obstacle to overcome on the path to maximum liquidity in China’s interest rate derivatives market is the number of different indices to which end users are naturally exposed: the central bank deposits rate, lending rate, seven-day repo and the recently introduced Shibor.
"Without convergence in the market on a single index there may be some impact on liquidity and efficiency and hence an increased cost of hedging," said a banker.
So far all interbank interest rate options have been transacted using the seven-day repo curve as the underlying, but the reference rate preferred by a number of bankers – and the People’s Bank of China – is Shibor, and there should be a shift towards that benchmark.
Since its inception in January Shibor has been adopted as the standard reference rate for floating-rate note issuance by the likes of China Development Bank. Its increased acceptance throughout the financial market will benefit the development of interest rate derivatives in China. 


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