Chinese Investors Hit By “Snowball” Derivative Losses ❄️

🐺 Hi pack-mates,

This is Howling Markets, the newsletter that snowballs your financial knowledge!

Today we will be covering:

• Education: What Are The Chinese Snowball Derivatives? ⚪

• US Economy Grew Better Than Expected In The Fourth Quarter 📈

• Chinese Investors Hit By “Snowball” Derivative Losses ❄️

• Equity and Debt Markets Daily Update ⚖️

• And more!

Market Watch 👀

What Are The Chinese Snowball Derivatives?

Snowballs are structured derivatives introduced in 2018 to bet on the stability of the market. In recent newsletters we have discussed how in China the investors’ sentiment has really reached the all-time low after a decade-long bear market.

In this environment, financial institutions have created this new derivative that promised a periodic interest payment as long as the price remained within a specified price range, determined at the moment of the purchase.

These derivatives were marketed as a safe alternative to both stocks and bonds. Compared to stocks, snowballs can generate profits regardless of the market direction, as long as the price remains within a relatively wide range. Compared to bonds, these derivatives pay a higher yield and do not suffer from liquidity and bankruptcy risks, as opposed to both corporate and government bonds.

However, these derivatives were much riskier than people realized.

Usually, these contracts are either written on the CSI 500 or the CSI 1000 and pay an annualized yield between 12% and 20% as long as the price remained between +3% and -20% from the price of the day on which the investor purchased the snowball.

If the price of the index surges above the upper margin, a “knock-out” is initiated. The contract is closed, and the investor receives the amount invested plus the interest payment up to the termination of the contract.

If the price falls below the lower margin, a “knock-in” is performed. The contract is closed, the investor is not paid any interest and they will lose 20% of the original capital invested.

US Economy Grew Better Than Expected In The Fourth Quarter

The health and growth of the United States has been the central topic of any economic discussion over the past two years as they are extremely closely correlated to the Fed’s monetary policy.

A sudden and premature rate cut would simply help inflation speed up again, nullifying the sacrifices of the long tightening cycle. On the other hand, keeping interest rates extremely high for just to be “safe” can be even more damaging.

A period of high interest rates restricts the economy, slowing down investments and reducing the national GDP. If this enviroment is prolonged more than the economy can sustain, the country might enter a recession, which a period of negative GDP growth.

On Thursday, the US GDP reading for the fourth quarter of 2023 was released, and it was much better than what the market expected. The United States’ GDP grew 3.3% QoQ, meaning with respect to the previous quarter.

Even though this increase is significantly less than the 4.9% QoQ registered at the end of the third quarter, it substantially exceeded the markets’ expectations, which averaged around 2.3% according to TradingEconomics.

Today’s Howling Question

And now, it is time for our howling question!

So, we have seen how the American economy is still showing some signs of strength according to its GDP reading, but can we say the same about Europe? Which was the QoQ GDP reading measured by the European Central Bank at the end of the third quarter?

a) -0.1%

b)  +0.3%

c)  +1.2%

d)  +2.5%

e)  +3.7%

Note: We are considering the third quarter’s GDP reading because the fourth quarter one will be released next Tuesday.

Try to answer the question by yourself, and then check the correct answer after the last interesting news!

Chinese Investors Hit By “Snowball” Derivative Losses

As we have briefly mentioned, the Chinese stock market has been on a severe downtrend that has lasted multiple years. As a result, even a -20% margin on snowball derivatives has started to feel tight.

In recent years, the relatively new “snowball market” has grown to more than $45 billion with investors hoping to generate some relatively safe returns, even when the market continues to go down.

However, between the beginning of the year and last Monday, the CSI 500 index lost an additional -11.18%, which after a poor 2023 performance, caused a wave of knock-ins costing million of dollars to many Chinese investors.

Additionally, when financial institutions expose themselves to the potential risk of paying high yield for a long period of time, they often seek insurance against this risk.

In this case the insurance came in the form of futures contracts which can be used to speculate about the future price of an asset. So, a wave of knock-ins caused a wave of futures contract sales which in turn helped the price fall even further.

Equity and Debt Markets Update ⚖️

And now, our daily markets update!

Thursday was a very strange day for the market. Once the great news about the GDP came in, the price jumped up around +0.50% and continued to move higher for a short while before coming back down. During the last few hours of the trading session the price picked back up and closed +0.58% higher.

However, the volatility index of the SPX, called VIX, moved higher for a second day in a row, showing a strong contrast with the market and the indication that if the news would have been in line with the expectations the price would have most likely fallen.

On the other hand, the 10 year US government bond yield fell quite significantly on Thursday, closing -1,44% lower.

Answer

The correct answer is a) -0.1%.

During the third quarter the Eurozone economy contracted by -0.1%, a downward surprise with respect to the +0.1% forecast. Despite this contraction, this does not classify yet as a recession as economist usually define this phenomenon as three consecutive quarters of negative GDP growth.

Howl-Worthy Memes 😂

🐺 See you next time!

Enjoy reading this newsletter? Forward it to a friend.

Was this newsletter forwarded to you? Sign up here.

Want to get your product or job listing for business-related readers? Please email us.