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Business> Finance
UPDATED: August 30, 2007 NO.36 SEP.6, 2007
Big Bad Wolves?
Overseas hedge funds play tricks on stock index futures

"The wolf has finally come," Mr. Liu, who studied finance overseas, sighed when he heard that international hedge funds might enter the mainland securities market on the heels of QFIIs (qualified foreign institutional investors).

For most Chinese, international hedge funds are still an unfamiliar concept, but in developed international financial markets they are the capital in command. The investment strategies of hedge funds have brought new concepts of money-making through speculation to the stock market. In the futures markets, transactions leveraged by hedge funds can magnify the volatility of commodity prices. In foreign exchange markets, hedge funds are the currency speculators that worry governments the most.

Today, international hedge funds have quietly entered the Chinese securities market. What impact will they have?

Invisible private capital

"The wolf arrived some time ago," said a private fund manager. "The mere increase of the QFII quota did not satisfy the appetite of international hedge funds. Since 2001, a large amount of hedge fund capital has entered China through concealed channels, such as foreign trade settlements and the Hong Kong market, in order to gamble on the appreciation of the yuan. Today, their presence is actively felt in China's stock and realty markets."

"At present, the combined scale of all Asian hedge funds that might invest in China is approximately $20-50 billion," estimated Zhang Yuewen, post-doctoral researcher at the Institute of Finance and Trade Economics of the Chinese Academy of Social Sciences.

Without doubt, the strong growth of the Chinese economy has provided international hedge funds with a hot investment destination. In the last few years, when real estate was red hot, international hedge fund capital invested in real estate in China. They hid behind private capital players in Jiangsu and Zhejiang provinces and secretly bought many high-end properties that they later sold at substantial profit when property prices skyrocketed.

Later, China's financial reforms gave them more opportunities to create new wealth. The contrasts formed by China's surging economy and its depressed stock market of the past few years prompted them to absorb Chinese stocks at low prices. A raging stock market will make 2007 another bumper harvest year for hedge funds.

Targeting stock index futures

Presently, the biggest attraction for international hedge funds coming to China is the imminent launch of stock index futures. Using stock index futures to conduct arbitrage is their specialty.

"We find that international hedge fund capital is the supporter behind many private equity funds in China," said Chen Lin, a researcher with Guosen Securities Economic Research Institute. "They have been waiting for the birth of financial derivatives trading products, such as stock index futures, which form the perfect stage for them to flex their muscles."

Studying how foreign hedge funds manipulate stocks, seeing that if they bought a stock at 10 yuan a share, they would also buy the put option (the option to sell at a fixed price and time) on the same stock. Assuming they bought the put option for a stock at the exercise price of 9 yuan, if the stock dropped to 8 yuan, they would sell their stock at 9 yuan to minimize loss.

Hedge funds can avoid risks through hedging transactions, and also conduct arbitrage based on the same principle.

The simplest method is to utilize the short-selling mechanism of forward stock index futures to sell at a high price to make a profit. Assuming the Shanghai and Shenzhen 300 Index is at 3,000 points. If the international hedge funds use the stock index futures instrument and buy 1,000 options that are to be sold in September at 5,000 points of the Shanghai and Shenzhen 300 Index, then they would buy large volumes of the corresponding shares or index funds in the spot market between 3,000 and 5,000 points for harvest in September. At the same time, they must use good news to push the Shanghai and Shenzhen 300 Index above 5,000 points before September arrives. By then, the hedge fund can sell all shares bought in the Shanghai and Shenzhen stock exchanges and lock in large profits by fulfilling the 1,000 stock index futures options. Then, due to heavy selling by the hedge fund, the Shanghai and Shenzhen 300 Index is likely to drop drastically, causing losses to those "uninformed" copycat investors who chase rising stocks.

International hedge funds can also use the component stocks inside stock index futures categories to conduct forward transactions and earn profits. For example, if they believe a stock is overvalued, they would borrow large volumes of the stock from institutions such as the QFII and sell out. After carefully calculating the corresponding drop in the futures index following the drop of this stock, they would also buy the corresponding stock index futures call options. In the event the stated stock is dropping and actually drags the corresponding futures index to the expected level, the hedge funds would buy back the corresponding volume of this stock at a low fixed price by fulfilling the stock index futures call contracts, return the shares to the QFII lender, make profits on the price difference (sell stocks at high prices and buy them back at low prices), and pay a percentage of profit to the lender of the shares.

"We should not underestimate the research and development capabilities of international hedge funds," said Zhang Qi, researcher with Everbright Securities Research Institute. "Since hedge funds use stock index futures to conduct arbitrage, they have to pinpoint the best time to buy and sell,

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