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Asian Review of Financial Research Vol.34 No.4 pp.125-148
The Effect of ELS Issuance in Korea on the Volatility Skew in the HongKong Option Market
Chungwan Hong Ph.D. Student, Hankuk University of Foreign Studies
Sol Kim* Professor of Finance, College of Business, Hankuk University of Foreign Studies
Key Words : ELS(Equity Linked Security),Volatility surface,Volatility skew,Vega risk,HSCEI Index


This paper examines the effect of issuance of ELS(Equity Linked Security) with the Hong Kong HSCEI index as an underlying asset, on the volatility skew in the Hong Kong options market. The most common structure of ELS includes an autocallable option every 6 month and 3-year time-to-maturity, which pursues medium-return along with medium-risk. When trading ELS as an issuer, traders are exposed to various risks in the process of hedging - typically the vega risk caused by changes in volatility. In the case of ELS with knock-in put option, the issuer's position is generally similar to taking a long position in a put option at the moment of issuance, so vega hedge is normally executed through selling vanilla options. As the ELS with global stock indices as underlying assets has become popular since 2014, local securities companies have begun to adopt volatility surfaces to evaluate the fair price of ELS for the purpose of increasing the book sizes and enhancing trading performance. Accordingly, the demand for selling options with specific strike prices is matched with the autocall barriers. We analyze the effect of ELS issuance on market volatility including the VHSCEI index. The volatility skew is defined as the difference between the volatility indexes of the OTM(Out-of-The-Money) put option and those of the ATM(At-The-Money) option. Since the first autocall barriers of ELS are located on 80% to 95% of the strike price, the volatility index of the 90% strike put option is used. So far, most studies related to ELS examined the effect of issuance on the trading volume and volatility of underlying assets. Even in the previous studies on the effects of delta and gamma (or vega) risk hedging on the volatilities, the effect on only short-term volatility such as realized volatility or VKOSPI index was analyzed. Also there are various studies on the way of calculating the volatility surface depending on maturity and strike price. But there was no studies on the effect of the issuance of structured products in one country on the option market in another country. This study is the first study on the effect of issuance of structured products in Korea on the volatility skew in the Hong Kong options market. The detailed results are as follows. First, as the issuing volume of ELS increases, market volatility such as VHSCEI index decreases, and in particular, VHSCEI index decreases more relative to the realized volatility. This is consistent with the results of previous studies. Also, issuance of ELS lowers the volatility index of the 90% put option compared with the VHSCEI index. Second, with respect to the volatility skew of the same maturity, a strong negative correlation between the ELS issuance volume and the volatility skew since 2014 is observed. It can be interpreted that the volatility of OTM put options decreases compared with the ATM ones as the selling pressure for the OTM increases compared to the ATM. These results are the same for all OTM put options. As a result, if the volume of financial products with the same structure increases significantly, and in particular, if the underlying assets, maturities, and strike prices of the financial products are concentrated, the impact of volatility on the options market can be expected to be larger. It is necessary to sophisticate the issuing and book-managing strategies to diversify the risk of the ELS issuer and to enhance the product's yield in the future.
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