Hedging And Synthetic Funds Creation In The China Market
By Ronald Slivka and Xin Li

Following a meeting of the U.S.-China Strategic & Economic Dialogue in Beijing on May 25, 2010, China reported that it will permit QFIIs (qualified foreign institutional investors) to use the newly created CSI 300 Stock Index futures that began trading on the CFFEX (China Financial Futures Exchange) on April 16 of this year. To accommodate expanded usage by QFIIs, the quota assigned for use by these institutions was raised to $30 billion, which may seem like a large sum but in fact is a very small part of the $2.7 trillion in China stock market capitalization. Nevertheless, this announcement, which further opens capital markets in the world’s third-largest stock market, will allow foreign investors to expand their use of derivatives to hedge their investment risks and to create new investment products. Martin Currie, Aviva Investors and AMP Capital, all QFIIs, agree that the use of stock index futures will enable them to hedge country risks and compete with China’s domestic money managers as investments in China’s markets expand. Following the pattern of development in other new futures markets, the primary uses by such institutional investors for these derivative instruments will be to hedge assets under management and to develop new investment products. This article focuses on professional uses for CSI 300 futures that are likely to emerge in the very near future.

During 2008 when the Chinese stock market suffered large swings, including a 65 percent decline, hedging institutional portfolios at that time by selling CSI 300 futures was not permitted for QFIIs but would have been most welcomed by them. The use of stock index futures for such short hedging is common outside of China and will no doubt be increasingly common within China as the domestic futures market grows. What makes CSI 300 futures particularly relevant to institutional investors is the composition of their portfolios. Overseas investors are permitted by Chinese regulators to purchase B shares, trading on the Shanghai exchange in U.S. dollars. However, A shares, denominated in yuan, are permissible for purchase only by QFIIs and Chinese citizens. The CSI 300 futures are based on an index of 300 A shares traded on the Shanghai and Shenzhen exchanges. For QFIIs then, futures based upon such an index construction are quite sensible to sell as a hedge. Since institutional investors typically have large fractions of their portfolios in A shares, the CSI 300 futures will be increasingly welcomed as a means for managing risks by selling futures to offset declines in the broader market.

The Long And The Short Of Hedging With Futures
Types of Short Hedges
Until China’s regulators actually set a start date that permits QFIIs to employ CSI 300 futures to hedge their stock exposure, institutions holding diversified portfolios of China’s A shares have very few methods from which to choose as they seek to manage market risks. Domestic stocks in China cannot be shorted, and single stock futures and options markets do not exist. Accordingly, QFIIs must seek to construct short hedges arising from the use of other assets that are correlated with portfolios requiring a hedge. And although these proxy hedges are less effective than the futures, they nevertheless afford some measure of protection in a bear market such as the one that began in 2008. Examples of such proxy assets for hedging include ETFs linked to indexes, commodities tied to China’s growth (copper, oil, soybeans) and credit default swaps on single stock issues. China stocks that trade on exchanges other than those in mainland China generally display weaker correlations, which makes hedge construction with them more complex.

With CSI 300 futures available, however, more direct and effective hedges can be constructed including beta-adjusted, minimum-variance and simple short hedges. Implementing hedges on passive or actively managed portfolios will be feasible once QFIIs are permitted to utilize them. For example, suppose a fund manager owns an RMB 84 million actively managed portfolio of A shares with a beta of 1.2 and the CSI 300 Index at 2800. Then hedging the market risk for the entire portfolio only requires selling 120 futures contracts calculated as follows:

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