Few issues have attracted as much attention worldwide as the Chinese yuan (CNY) or renminbi (RMB) has done in the past two years. We have heard so many talks, arguments, discussions and debates on such questions as whether the yuan should revaluate, when and how much it would appreciate and if it should appreciate at all. Hundreds of billions of U.S. dollars have been traded in yuan derivatives in the past two years in the offshore market with the yuan revaluation perspective since late 2002.
Offshore Yuan Derivatives
Because the domestic yuan forward market is still in the experimentation stage, despite over seven years of moderate turnover (the total turnover was just over 1% of total Chinese exports and imports of USD852 billion last year), international players with increasing export-import businesses with China, higher foreign direct investment (FDI), greater participation of qualified foreign institutional investors (QFII) in the Chinese securities market, users can only choose to participate in the offshore market for yuan derivatives because the domestic derivatives market is not well developed.
There are many types of derivatives referenced to the yuan in the offshore market, including non-deliverable forwards (NDFs), non-deliverable options (NDOs), non-deliverable swaps (NDSs), structured notes and deposits on hard currency linked with yuan NDFs.
Yuan Non-Deliverable Forwards
Non-deliverable forwards are the most actively traded products. An NDF contract, as its name implies, is a forward contract trading in the inter-bank market without delivery of the yuan, but rather settled with a major currency such as the U.S. dollar. The yuan NDF changed from premiums to discounts in late 2002 when yuan revaluation pressure began to accumulate. The premium or discount is measured in the number of pips. For example, the current one-year yuan/dollar contract is trading at a 3000 pips discount and the official exchange rate is CNY8.275, so the implied one-year yuan/dollar exchange rate would be CNY8.277 3000/10000 = CNY7.977.
Despite its early existence in 1996 even before the Asian financial crisis when NDFs on other Asian currencies came into being, liquidity was rather low in the yuan NDF market before late 2002. Daily turnover was about USD200 million late in 2002, however, when yuan revaluation pressure began to accumulate worldwide to around USD300 million in the first half of last year and to around USD1 billion late in the year. The increased liquidity in the yuan NDF market makes it easier for market players to hedge their yuan related positions or speculate.
Figure 1 depicts daily 12-month yuan NDF rates from late 2002 to March. It clearly demonstrates significant changes in the yuan NDF rates from early November 2002 when the NDF was at about the same level as the official exchange rate of CNY8.277, yet it began to change significantly. We can divide the yuan revaluation pressure implied from NDF market into four major stages.
Trading Yuan NDFs
According to the Hong Kong Monetary Authority (HKMA), calendar spread trading is the most popular strategy. As its name implies, it involves buying and selling futures or NDF contracts with different tenors. Figure 2 depicts the spreads between six-month and three-month NDFs and between 12-month and six-month CNY NDFs from January 2003 to September 2003.
Bull spreading is the most popular trading strategy with NDFs. A bull spread involves selling a nearby NDF contract and buying a distant NDF contract. Spreaders who believe the distant month contacts will rise faster than the nearby contract or believe the nearby contract will fall faster than the distant month contract would arrange a bull spread. When the yuan is believed to be in an up-trend, prices of the more deferred contacts tend to rise faster than the nearby contracts. Let's show bull spreading with specific examples.
Example 1: What is the spreading result if the bull spreader sells a three-month yuan NDF contract with a notional principle of USD10 million and buys a six-month yuan NDF contract with the same principle, given the three-month and six-month NDF trade at discounts of 135 and 385 pips respectively, when the spreading position was taken on June 26, 2003; and the discounts changed to 597 and 1447 pips respectively on Sept. 26, 2003.
This week's Learning Curve was written by Peter G. Zhang, chief financial engineering advisor and senior director of research and development at the Shanghai Futures Exchange.
