Winners and losers in Korean equities

KOSPI graph

KBS reported recently (in an article so confused in its arithmetic as to be downright misleading – and frankly makes you wonder whether they’ve got anywhere near reality) how foreigners made $90bn gains on Korean stocks last year.

I’m sure there are rogue nationalistic elements around who might lament the fact that anyone apart from a Korean should benefit from investing in Korean stocks. Those same elements will no doubt be rubbing their hands with glee that Credit Suisse reportedly managed to lose $120mn on Korean equities in a space of just 3 months.

The story is in Bloomberg on Oct 16, and is picked up in the FT’s Lex column the next day.

The debacle, which wasn’t reported to shareholders, resulted from the Zurich-based bank’s failure to protect itself against swings in the value of Korean stock options

Credit Suisse was drawn to Korea as options trading in the country surged. In the third quarter of 2005, trading of Korean stock-index options rose 71 percent to $12 trillion, surpassing U.S. volumes for the first time, according to a December report from the Bank for International Settlements in Basel, Switzerland.

says Bloomberg. Bloomberg and the FT report how the losses arose from Credit Suisse’s issuance of Reverse Convertible Notes on Korean equities. A normal convertible is a bond which has a lower than usual interest rate, but in exchange the investor has the right to convert the bond into a company’s equity — it’s thus an attractive thing to own if you think the market’s going up; and if you’re wrong at least you’re getting a little bit of interest income and your investment should still be worth face value. And in a bull market it’s a very cheap and popular way for companies to borrow money. A reverse convertible, as the name implies, has diametrically opposed features. It pays a higher than usual interest rate, but in exchange the investor is obliged to convert the bond into a company’s equity. It’s therefore an attractive instrument to hold if you think the market’s pretty stable, or going to go up, as you’re getting a good interest rate. But if the market falls you’re going to be losing capital value. Reverse convertibles are issued by investment banks who are keen to bundle up risks & rewards in an attractive way to investors, making a bit of money in structuring the whole package.

For Credit Suisse, issuing a reverse convertible on Korean stocks is like borrowing money from investors and buying from them a put option (giving CS the right to offload the stocks in question should the prices decline) — and the put option premium is bundled up into the interest rate CS pays. But:

When Korean stocks leveled off in the third quarter after slumping in May and June, option values fell. Credit Suisse, which hadn’t taken positions to hedge against the decline in market volatility, was then forced to write down the value of its holdings

says the Bloomberg story. To the tune of $120 million. The article continues:

Korea’s structured-notes market grew 50 percent last year to about $15 billion in sales. Credit Suisse competes in it against companies including Paris-based BNP Paribas SA, Citigroup Inc. in New York, Frankfurt’s Deutsche Bank and Zurich-based UBS AG, according to research from Arete Consulting, which tracks the market for structured products.

If Citi, Deutsche and others make the same reported errors as Credit Suisse that will certainly eat into the reported $90 billion profit number.

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