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 But when it comes to China, the world's second-largest economy, the
probability of a full-blown crisis is apparently so remote that
hardly anyone will buy an insurance policy against it, no matter how
cheap.
Financial wizards have been trying to sell peace of mind to
investors in China for years, but fewer and fewer of those investors
are interested, despite some worrying headlines.
In the past few months alone, China has seen its first domestic bond
default, a small bank run, its weakest export performance since the
global financial crisis, a marked slowdown in its property market
and a rise in labor unrest.
Steve Diggle, a Singapore-based hedge fund manager who crafts
strategies to protect investors against financial catastrophes, says
investors have faith that the Chinese government, armed with almost
$4 trillion in foreign exchange reserves, will simply not allow
things to get out of hand.
He had to close down a fund that used to bet on doomsday outcomes in
Asia last year.
"There's a sense you are playing poker against a guy who makes his
own chips," Diggle said.
Before the 2008-09 global financial crisis, he had run a successful
fund, Artradis, which thrived on volatility in financial markets.
Now, he says, hedging against a catastrophe seems to be passe — and
not just for China.
Governments and central banks around the world have shown themselves
willing to deploy vast sums of money — China alone launched a 4
trillion yuan ($643 billion) stimulus package in late 2008 — to
avert a financial meltdown.
"You are no longer in an environment where market forces will play
themselves out because you have an extraordinarily powerful and
motivated intervention in the market process from someone, such as a
central bank or government, who has a strong ability to influence
those processes," said Diggle.
BETTING ON A BLACK SWAN
There are still some hedge funds that take out insurance against
extreme, improbable events — such as the notion that China's
economic miracle will end in tears.
Andrew Wong, co-chief investment officer of Fortress Convex
Strategies Group, runs a fund that aims to make money from these
so-called "black swan" events.
"A pattern we've seen through long cycles is that in the period
leading up to a systemic crisis, people buy hedges, lose money and
unwind those hedges. Because it hasn't been efficient and has lost
money, by the time the real thing happens they may end up being
completely unhedged," said Wong.
"It's very hard to time the market precisely, so in general you need
to have the insurance before the house is on fire."
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For cautious or contrarian investors, taking out insurance on such
apparently unlikely events as a China crisis has to be cheap. It is
futile to spend large sums of capital on so-called tail-risk bets,
waiting for such long odds to pay off.
Hedges can be expensive, though one relatively cheap method is to
buy put options on the yuan or on Chinese stocks at strike prices
well below current market levels.
Typically, though, the cheapest hedging strategies can also be the
most complex. One such strategy involves variance swaps, a financial
instrument that tends to pay the investor when volatility of an
underlying bond or stock spikes.
In hedging against the risk of a major outbreak of defaults, a
straight-forward approach such as buying credit default swaps (CDS)
is not the most cost-effective. Instead, funds will offset the cost
of buying CDS insurance against a distressed company by also selling
CDS protection against a more creditworthy one.
"If they want to hedge, it is relatively cheap," said Camiel Houwen,
head of equity derivatives trading at ING Asia. "But not too many
people are setting up the trade."
In China's case, some fund managers think investors may be
overestimating the hold Chinese authorities have on markets.
"A China hard landing is not our base-case scenario, but if it were
to happen, it is one of these events that would have significant
implications for a wide number of assets," said Viktor Hjort, head
of Asian fixed-income strategy at Morgan Stanley.
"So it is a low-probability, high-impact type of scenario, and
against those it always makes sense to consider hedges."
(Additional reporting by Nishant Kumar in Hong Kong;
editing by Mark Bendeich)
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