Alfred Park Head of Research Daewoo Securities

By Alfred Park
Head of Research, Daewoo Securities

Seoul stock markets have grown in leaps and bounds during the last several years. As the benchmark KOSPI topped 1700 points, the aggregate market capitalization of companies listed on the main bourse and Kosdaq has surpassed $1 trillion.

The hopes for a sustainable rally in the stock market and thus consequentially, stable wealth accumulation in the minds of investors is escalating to an unprecedented level.

All this points to the likelihood for further development of the country's financial markets in terms of depth as well as diversity, providing market makers, financiers, and investors with a host of tools and instruments to better manage their financial risk and/or enhance returns.

Against this backdrop, and the much anticipated Capital Market Consolidation Act in the offing, derivative markets and products have demanded public attention in prolific fashion.

Many have taken to the fact that the proliferation of derivative products has been an integral part, rather than a mere sideshow, of market expansion and is a worldwide phenomenon, which is set to continue with even wider spectrum.

As such, growth of derivative products in Korea _ especially those of equity-linked _ has been nothing short of spectacular and subsequently, will bring forth a number of market implications going forward.

Equity index futures, or KOSPI 200 futures, made its commercial debut in 1996 and has recorded cumulative traded value of 470 trillion won as of end of 2006, making it the world's 5th largest index derivative product in volume traded. Equity index options, or KOSPI 200 options, introduced a year later in 1997, was received with adulation by market participants, especially retail investors, and has grown with more popularity than index futures to the tune of 3 trillion won in terms of daily traded value on a notional basis.

It is, by far and large, the most actively traded index derivative product in the world. The commercial success of options resulted in commercialization of 'sibling' products such as equity-linked securities (ELS) and equity-linked warrants (ELW) since 2003 and 2005 respectively, which are also growing at an equally rapid rate even.

Will the expansion of derivative products help facilitate further development of Korea's capital markets? How will crossover financial activities and market integration across asset classes as well as geographical mandates affect future rate of growth? Will there be any factors that may hinder or even arrest the future development of derivative market and its underlying markets in Korea?

With these three critical questions banging loudly in my ears, I can't help but conclude that the use of derivatives can be a double-edged sword unless quality of growth _ as opposed to outright growth in size _ is pursued and insured.

Use of derivatives and structured products is based on a buyer's (of derivatives or structured products) distinct objective and risk parameters. As different entities have different needs _ hedging, yield enhancement, liability management, capital protection, cost reduction, trading, or leveraging _ in using derivatives to best manage the final end of their desired course of actions, a countless number of combinations with differing interests are pitted against one another to actually accommodate one another, thereby forming the market.

Market making is another element that adds to the breadth of the market.

By making prices and hence being short on volatility, market makers are in effect continuously writing short-dated options, giving their clients the right to buy and sell at fixed prices without being confident that they can get out of the position at the same level.

If I were to make the market, the first thing I will make sure is that I have a well structured perception of the true or central value of a security and the value of my tradeoff against liquidity traders that add noise (and this volatility) to the market.

Under these conditions of information asymmetry, I would attempt to track the fundamental value of the security by maintaining a probability density estimate based on the order flows I receive.

In addition, I would try to extend my market-making algorithm by controlling inventory and increasing (or decreasing) the bid/ask spread in response to competition observed.

Higher my conviction for the ``fundamental'' value of the security, the more actively I would make the market in both cash and derivative markets, in order to capture interaction effects.

In short, in the world of market making, ``edge'' is a key word, and the ``edge'' comes from one's capacity to correctly assess the difference between the security's market price and its ``fundamental'' value and its interdependent effects with the Greek letters in equation.

Without the ``edge'' attributable to core competency, one can suffer from a corrective adjustment in the event of a significant market move. Korean investment banks and securities firms have, in fact, largely resorted to only 'passive' market making in the cash market and virtually absent in the derivative markets for this very reason.

Since the start of derivative product boom in Korea several years ago, international banks and investors have done more than their share in forming the market.

International banks and investors alike account for nearly 30-40 percent of total turnover in listed futures and options, and have dominated in equity-linked product offerings.

While international banks have a cost advantage as they hedge underlying risks _ often offsetting one another _ in their trading book on a global basis, the element of their core competency stems from their superior understanding of the dynamics of derivative markets and functional utility of derivative products in the context of causality between the derivatives and their underlying assets.

Successful development of derivative products is integral to the fruition of Korea's ambitious Capital Market Consolidation Act, of which, the primary objective is to upgrade the capabilities _ or lack thereof _ of the country's financial sector by increasing the core competency of financial entities of Korean nationality.

The pursuit of quality and balance as opposed to outright growth _ in size _ of derivative markets has to be the first item on the agenda of both policymakers and market participants or else, a disparity in economic power between the local financial entities and their international counterparts will widen even further.

Proliferation of hedge funds and advanced commercialization of derivatives worldwide are pushing investors to increasingly develop a dual mental account.
Global investors can and will likely support their asymmetric return target by implementing portable alpha and overlay strategy, combined with deft risk management.

In the advanced markets of the United States and the United Kingdom, long-only managers are no longer considered mainstream in the institutional arena and leverage has become an integral part of everyday life money management at instant availability by way of electronic connectivity.

My observation has it that, while changes that have taken place in Korea over the last couple of years are certainly significant, changes that are sweeping through the investment industry worldwide are simply seismic.

It is imperative that Korea puts in place the prerequisite conditions that precede further expansion of the derivative market.

More than anything, Korea has to get to the basics and come up with an executive plan that is more than just feasible as well as regulatory policies that induce logically sound long-term investment.

For one, it must start with the ``center of influence'' propagating and implanting the ``power of reasoning'' in every market participant _ institutional, corporate, and retail.

The creation of ``virtuous circle'' leading to ``reinvention of the capital market'' is absolutely necessary and it takes more than simply enlarging the market.