derivatives outlook_ change coming in 2012 - more regulations, volatility expected

8/3/2019 Derivatives Outlook_ Change Coming in 2012 - More Regulations, Volatility Expected

1/28

November 25, 2011

Samsung Securities (Korea) www.samsungpop.com

This report has been prepared without anyundue external influence or interference, andaccurately reflects the views of the analyst(s)covering the company or companies herein.

All material presented in this report, unlessspecifically indicated otherwise, is under copyrightto Samsung Securities. None of the material, norits content, nor any copy of it, may be altered inany form or by any means, transmitted, copied, ordistributed to any other party, without the priorexpress written permission of Samsung Securities.This memorandum is based upon informationavailable to the public. While we have taken allreasonable care to ensure its reliability, we do notguarantee that it is accurate or complete. Thismemorandum is not intended to be an offer, or asolicitation of any offer, to buy or sell the securitiesmentioned herein. Samsung Securities shall not be

liable whatsoever for any loss, direct orconsequential, arising from any use of thismemorandum or its contents. Statements, if any,relating to affiliates of Samsung Securities are alsobased upon information available to the public anddo not necessarily represent the views of themanagement of such affiliates.

DERIVATIVES ISSUE

Change coming in 2012

More regulations, volatility expected

DerivativesOutlook

2011 review: Stock markets rallied in 1H on liquidity injections by developed countries

and a resurfacing of risk appetite, but eurozeone risk led to more volatility. Buffeted by

sovereign risks, the financial markets have found themselves at the mercy of

uncertainties that appear to be more and more political and long-term in nature. As risk

escalated, asset correlation levels increased in 2H11.

A mixed year: With the markets highly volatile, trading volume of Korean equity

futures (index and single-stock) has jumped h-h in 2H, while that of option products

(index options and ELWs) has stagnated or declined. But global products (nighttime

futures and options) have overcome weakness to become established as investment

vehicles permitting real-time tracking of the worlds stock markets. In the equity-linkedsecurities (ELSs) market, average monthly issuances plummeted from KRW3.2t in 1H

to KRW2.5t in 3Q alongside a plunge in the stock market and growing concerns over

financial products in general. The Korean equity-traded fund (ETF) market has

experienced record growth, with more than 100 ETFs listed on the KRX and their net

asset value surpassing KRW10t. Due to a decline in issuances of derivative-linked

securities (DLS), 2H trading of OTC derivatives will likely be flat y-y.

2012 strategy: We anticipate dramatic changes in 2012. A crisis-struck eurozone will

either come together or shatter; the global economy could fall into recession or begin to

gradually recover. Next year will be the first that derivatives, long a symbol of

deregulation, will fall under the numerous regulations agreed to in the wake of the

financial crisis. Given concerns over the global economy and eurozone, we expect the

worlds stock markets to remain highly volatile through 1H. In consideration of volatilityrisk, we advise investors to: 1) implement knock-in put and 100-110% put spread

strategies to limit downside risk; 2) execute a 100-110% call ratio spread strategy to

hedge against upside risk; and 3) include US VIX-tracking ETFs in their portfolios.

More regulations:We anticipate more regulations for OTC derivatives in 2012, aimed

at: 1) curbing speculative investments and protecting investors (eg, through an increase

in the contract multiplier of option products); and 2) preventing incomplete sales and

enhancing information transparency. Regulatory risk will likely lead to declines in the

number of traders and trading volume of on-exchange derivatives products. On a

positive note, however, there should be opportunities in hedge funds, new products, and

revisions to Koreas Commercial Code (KCC). We advise caution when it comes to

Korean hedge funds, which may not be as attractive as advertised due to a slew of

regulations and limited investment targets. To reduce transaction costs, algorithmictrading needs to be applied in order execution of long/short strategies, and investments

in commodity-based options and ETFs need to expand in the pursuit of alpha.

Structural products suitable for hedge funds will need to be developed. Furthermore,

revisions to the KCC and Financial Investment Services and Capital Act (FISCMA)

should allow companies to issue a wider variety of securities, derivative-linked bonds,

and DLSs.

AnalystsGyun [email protected] 2020 7044

Trisha [email protected] 2020 7823


2/28

November 25, 2011

Derivatives Issue

2

2011 review

Risk on in 1H, risk off in 2H

Stock markets generally rallied in 1H on liquidity injections by developed countries

mainly quantitative easing in the US that boosted liquidity around the world and sparked

inflationand a resurfacing of risk appetite, while some markets remained sluggish

(Europes debt crisis weighed on the PIGS, inflationary pressure on BRICs, and a

tsunami/earthquake disaster on Japan). In 2H, however, only a few frontier countries ( eg,Indonesia and Chile) advanced, as a credit crisis in the eurozone deepened. Southern

European countries have seen stock markets tumble around 30% since end-June, while

the Korean and US markets have pulled back around 10% as Europes debt woe have

escalated into a structural crisis for the global economy.

Equity market returns (1H11) Equity market returns (2H11, through Nov 15)

Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities

Stock marke ts bullish in 1H, but

faltered in 2H due to Europea n

debt crisis

CONTENTS

2011 review p2

A mixed year p5

2012 strategy p10

More regulations p19

(9.5)

(8.1)

(4.0)

(3.9)

(3.6)

(2.8)

(1.6)

0.1

0.8

2.4

5.0

5.1

6.7

(15.0) (10.0) (5.0) 0.0 5.0 10.0

Greece

India

Japan

Australia

Taiwan

Hong Kong

China

Italy

UK

Korea

US

Spain

Germany

(%)

(42.5)

(24.2)

(20.5)

(19.6)

(13.6)

(13.4)

(13.0)

(10.4)

(10.2)

(8.4)

(7.2)

(6.6)

(4.8)

(50.0) (40.0) (30.0) (20.0) (10.0) 0.0

Greece

Italy

Spain

Germany

Hong Kong

Taiwan

Japan

India

Korea

China

UK

Australia

US

(%)


3/28

November 25, 2011

Derivatives Issue

3

2008 all over again?

The crisis in Europe this year has been reminiscent of what happened in the US in 2008.

After falling on a crisis confined largely to PIGS countries in 1Q, stock markets stabilized

in 2Q, but have fallen since 3Q as fears of a Greece-to-Italy contagion have elevated

systemic risk. We saw similar movements after the collapses of Bear Stearns and LehmanBrothers and financial-sector bailouts in 2008.

The VKospi also moved similarly in 2011 and 2008, spiking in 1Q08 and 1Q11 to double

its preceding two-month averages, stabilizing for five months, and surging in 3Q08 and

3Q11 to triple the averages of the preceding five months on growing systemic risk.

Financial crisis continued to create market volatility through 1H09, when the VKospi

stood at 39%, more than 40% above its 1H08 average of 27%. Using this as a guide, we

expect the index to remain elevated through 1H12, averaging 30% (vs 18% in 1H11).

VKospi (2008) VKospi (2011)


Risks different now and then

In some ways, the markets have responded differently to the liquidity risk of 2008, and

sovereign risk of 2011. The eurozone problems with sourcing funds and dealing with risk

have become highly politicized and will likely take a long time to resolve. The nature of

contagion has differed, with credit ratings at US companies in 2008 steadier than at

European companies in 2011, and CDS premiums on emerging market (EM) and Korean

bonds displaying less sensitivity to issues in the eurozone issues than they did to the

meltdown in America in 2008.

CDS for North America and EU corporate bonds* CDS premiums on EM* and Korea government bonds

Note: * Based on 125 investment-grade corporate bonds

Source: Bloomberg, Samsung Securities

Note: * Based on 15 emerging market nations


2011 reminiscent of 2008

VKospi soars at height of 2008

and 2011 crises

Volatility likely to stay high

through 1H12

Liquidity risk ruled in 2008;

sovereign risk has held sway in

2011

0

10

20

30

40

50

60

70

80

90100

Jan 08 Apr 08 Aug 08 Dec 08

Bankruptcy of Bear Sterns

Bankrupcty of Lehman Brothers

(%)

0

10

20

30

40

50

60

Jan 11 Apr 11 Jul 11 Nov 11

Financialcrisis inSouthern Europe

European credit crisis

(%)

0

50

100

150

200

250

300

Jan 07 Dec 07 Dec 08 Nov 09 Nov 10 Oct 11

iTraxx EU 5-year IG C DX N orth Am erica 5-year IG

(Bps)

0

100

200

300

400

500

600

700

800

900

1,000

Jan 07 Dec 07 Dec 08 Nov 09 Nov 10 Oct 11

CDX EM 5-year IG Korea 5-year CDS

(Bps)


4/28

November 25, 2011

Derivatives Issue

4

Despite an EU-nation default or other clear display of rising systemic risk, asset market

trends have changed drastically in 2011, with investor preferences quickly switching from

risky assets in 1H to safety in 2H. A weakening US dollar and declines in inflows of

speculative capital created strong demand for gold, silver, and the euro in 1H11, but

growing risk pushed investors toward US treasury bonds and weighed on returns from

risky assets in 2H.

Global asset markets (1H11) Global asset markets (2H11)

Note: Return over end-2010 ~ Jun 2011


Note: Return over end-Jun ~ Nov 15, 2011


Growing risk in financial markets tend to trigger greater correlation among asset prices,

as it becomes more difficult to find alternative safe assets (see the Nov 10, 2011 article in

theWall Street Journal, As Correlations rise, Theres Nowhere to Hide). While

developed market (DM) stocks and treasury bonds were the only assets with correlation

coefficients of more than 0.5 in 1H, stronger correlations than this were seen in DM stocks,

treasury bonds, the euro, and oil prices in 2Hsuggesting that the stock, bond, forex, andcommodity markets were all moving in sync in response to eurozone issues.

Meanwhile, gold showed less correlation with other assets, as investorslooking for a safe

investment and hedge against inflationflocked to the metal.

Asset class correlation (1H11) Asset class correlation (2H11)

Note: Red = correlation of +0.5 or more; blue = correlation of -0.5 or less


Note: Red = correlation of +0.5 or more; blue = correlation of -0.5 or less


S&P 500DAX

Nikkei 225Euro spotYen spotUS treasuryGerman gov. bondJapanese gov. bondWTIGold

S&P500

DAX

Nikkei225

Eurospot

Yenspot

UStreasury

Germangov.

bond

Japanesegov.

bond

WTI

Gold

-0.5-0 0-0.5 0.5-1

S&P 500DAXNikkei 225Euro spotYen spotUS treasuryGerman gov. bondJapanese gov. bondWTIGold

S&P500DAX

Nikkei225

Eurospot

Yenspot

UStreasury

Germangov.

bond

Japanesegov.

bondWTIGold

-0.5-0 0-0.5 0.5-1

Growing risk leads to more pr ice

correlation amon g assets

Gold an exception

Extreme preferen ce for safe

assets seen in 2H

1.3

2.4

4.1

4.4

5.0

6.6

9.2

12.3

0 5 10 15

USD/JPY

Kospi

US 10-year treasury

WTI oil

S&P 500

Gold

EUR/USD

Silver

(%)

(10.2)

(6.4)

(4.8)

0.8

4.1

4.4

18.3

54.5

(40) (20) 0 20 40 60

Kospi

EUR/USD

S&P 500

Silver

WTI oil

USD/JPY

Gold

US 10-year treasury

(%)


5/28

November 25, 2011

Derivatives Issue

5

A mixed year

Futures trade volume up due to increased volatility

As the markets grew more volatile, futures trading volume jumped from 3Q. The average

daily trading volume of Kospi 200 futures contracts surged from 330,000 in 1H to

380,000 for July-November, while the figure for equity futures soared from 190,000 to

300,000 (the latter received a boost from the banning of shorting in August).

Trading of Kospi 200 options, however, fell steadily, due to rising prices rose, a shortage

of tradable exercise prices, and a drop in equity-linked warrant (ELW) trading volume

due to regulations that ate into hedging demand and participation in Kospi 200 option

trading by securities firms.

Daily average trading volume: Kospi 200 futures vs SSFs Daily average trading volume: Options vs ELWs

Note: As of Nov 15, 2011

Source: KRX, Samsung Securities



Investor breakdown, by product

(%) Retail investors Foreign investors Securities ITCs

Index futures

Jan-Oct 2010 26.2 29.5 41.3 0.8

Jan-Oct 2011 30.5 31.9 33.9 1.0

Index options

Jan-Oct 2010 32.5 31.5 33.1 0.9

Jan-Oct 2011 32.8 37.2 29.1 0.1

Single stock futures

Jan-Oct 2010 70.2 6.2 16.9 0.7

Jan-Oct 2011 64.6 17.3 10.1 0.3

Note: Average over the period observed; among institutional investors, only ITCs are considered


Futures trading volume up in 2H

Option and ELW trading volume

down

CONTENTS

2011 review p2

A mixed year p5

2012 strategy p10


0

50

100

150

200

250

300

350

400

450

500

Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11

Index futures Index futures

('000 contracts)

0

1

2

3

4

5

6

7

0

2

4

6

8

10

12

14

16

18

20

Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11

Index options (LHS) ELW (RHS)

(Mil contracts) (Bil shares)


6/28


7/28


8/28

November 25, 2011

Derivatives Issue

8

Koreas exchange-traded fund (ETF) market has had a year of explosive growth in 2011.

More than 100 are ETFs listed on the KRX with a net asset value of over KRW10t, making

Korea one of the most advanced ETF markets in the Asia Pacific region.

ETF trading volume has surged on speculative demand for inverse and leverage ETFs

amid steep market pullbacks in August and pronounced volatility afterward. Theconcentration of trading on these, though, has left other ETF products marginalized.

Securities lending & borrowing (SBL) for ETFs also rose, primarily due to efforts to

minimize tracking error by including Kospi 200 ETFs in inverse/leverage ETFs (rather

than for short selling). The SLB balance for ETFs has risen to KRW500b as the size of

inverse/leverage ETF assets has increased. ETF SBL faces a double taxation issue,

because of the inclusion of ETFs in other ETFs in some cases.

Korean ETFs: NAV and number of products ETFs: Daily average trading volume and SLB





More than 100 ETFs listed on

KRX

Trading volume of

inverse/leverage ETFs sur ges

SLB for ETFs also up

0

200

400

600

800

1,000

1,200

0

20

40

60

80

100

120

Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11

NAV (RHS) No of products (LHS)

(KRWb)(No of products)

0

50

100

150

200

250

300

350

400

450

500

0

20

40

60

80

100

120


Trading volume (LHS) SLB (RHS)

(KRWb)(Milshares)


9/28

November 25, 2011

Derivatives Issue

9

OTC trading to contract

Over the counter (OTC) trading tends to track ELS and DLS issuances, as most OTC

derivatives are equity-related. With ELS issuances increasing to more than KRW3t per

month, trading of OTC options and swaps jumped a respective 24% and 100% y-y in 1H11

(from KRW104.9t in 1H10 to KRW130.9t and KRW7t to KRW14t). Interest-rate swaptrading also rose 57% y-y from KRW64t in 1H11 to KRW101t in 1H11, on an increase in

IRS transactions to hedge against interest-rate changes, with bond investments surging

alongside growth in ELS issuances.

Credit-related derivatives trading surged from KRW0.3t in 1H10 to KRW3.5t in 1H11,

mainly for credit-default swaps (CDS) on overseas bonds of domestic companies. Based

on trade balance, CDS selling jumped from KRW2.4t to KRW4.7t, with TRS buying in

1H11 increased by KRW0.2t y-y. Meanwhile, CLN buying increased by KRW1.5t to

KRW2t over the same period.

OTC derivatives: Trading volume trends

Note: 3Q11 data to be released at end-Dec 2011

Source: FSS, Samsung Securities

However, with ELS issuances plunging from 3Q11, we expect OTC trading to contract in

2H11. Global systemic risk is causing credit risks to rise and credit lines to decrease,

limiting room for securities firms to issue ELSs. Securities companies are further limiting

trading in derivatives 3- and 12-month volatility levels spiking due to the plunge in the

stock market, and value at risk (VaR) and hedging costs jumping as a result. We expect

OTC trading by securities firms to increase just 5% from KRW492t in 2010 to KRW515t in

2011. OTC trading in 1H11 totaled KRW286t.

Variance swap term structures

Note: Data at end of each month observed


Trading stimulated by ELS

issuances in 1H11

Credit-related d erivatives trading

up noticeably

OTC trading to contract in 2H11

on decline in ELS issuances and

unfavorable m arket environment

0

20

40

60

80

100

120

140

4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11

Options Swaps Forwards

(KRWt)

0

10

20

30

40

50

60

Jan 11 Mar 11 Jun 11 Aug 11 Sep 11 Oct 11 Nov 11

1-month 3-month 6-month 12-month 18-month

(%)


10/28

November 25, 2011

Derivatives Issue

10

2012 strategy

Three changes

We anticipate dramatic changes in 2012. A crisis-struck eurozone will either come

together or shatter; the global economy could fall into recession or begin to gradually

recover; and stricter regulations on derivatives will likely lead to more capital-market

risks and increases costs for businesses, or trigger an outflow of funds from financial

markets into real economies.

Developments in Europe will go far toward determining the direction of the global

economy. Moving beyond an intervention by the European Central Bank and an

expansion of the European Financial Stability Facility (EFSF), EU members with

conflicting interests must find a solution. Ailing and crisis-stricken countries need to slash

spending and pursue sweeping reforms that could result in prolonged recessions, while

leading nations (such as Germany and France) need to continue on a path of monetary

expansion to support their weak neighbors and prevent a credit crunch in the eurozone. A

weakening euro will not make things easier. Efforts to prevent the worst and the ensuing

economic fallout are likely to trigger more public displays of discontent in 2012.

A full-blown financial crisis in Europe would impact not only eurozone countries but the

global economy, so a recovery in the latter will hinge on solutions for the former. Austerity

measures will likely lead to reduced exporting to some countries that, combined with

restrictions on domestic consumption aimed at controlling inflation, could delay

recoveries of EM economies. While developed countries could turn to quantitative easing

in response to spreading eurozone risks, such measures would likely create more of

financial burden and inflationary pressure.

In the US, the Dodd-Frank Act, the Volker Rule, and OTC derivatives regulations agreed

upon by the G-20 should be implemented in 2012. Derivatives regulations proposed by

the US and Europe focus on standardizing OTC derivatives, clearing them through a

central clearing counterparty (CCP), limiting leverage, and strengthening supervision. A

tax on financial transactions, if implemented, would also amount to a derivatives

regulation. Such regulations should ultimately weaken the standing of financial capital.

Derivatives, long a symbol of financial innovation amid a period of deregulation in the2000s, are likely to be shunned because of regulatory pressure in 2012, in the aftermath

of the financial crisis.

Eurozone woes: Conflicts of

interest and fear of recession

Global economic recovery to

hinge on solutions to eurozo ne

issues

Derivatives, long a symbo l of

innovation, likely to be shunned

due to heavy r egulation in 2012

Key things to watch: Eurozo ne,

global economy, regulations

CONTENTS

2011 review p2

A mixed year p5

2012 strategy p10



11/28

November 25, 2011

Derivatives Issue

11

Shift to high volatility regime

We expect to see a spike in financial market volatility in 2012, at least in 1H12 as investors

try to gauge whether a financial crisis will destroy or solidify the eurozone, and growth in

the global economy continues the slowdown that began in 2H11.

From the regime-switching perspective, we believe the high volatility regime that haspersisted in 2011 will continue up to 1H12. (We define a period of low average returns and

high volatility as a high volatility regime, and a period of high average returns and low

volatility as a low volatility regime.).

The Kospi 200 was characterized by a high volatility regime from 2H07 to 1H09, a low

volatility regime until 1H11, and a high volatility regime from 2H11. With the last high

volatility regime lasting from 2H07 to 1H09, we expect the current high volatility regime

to continue through 1H12.

Volatility regime switching

Note: 2-phase regime switching model applied; weekly data used


Three-month implied and medium-term historical (60- and 180-day) volatility trends of

the Kospi 200 indicate that volatility levels remain higher h-h in 2H11, with the medium-

term historical volatility continuing to rise. The same patters have been seen in the

implied and historical volatility trends of the Hang Seng Index. While implied volatility in

early 4Q appears to have temporarily stabilized in both Korea and Hong Kong, historical

volatility levels continue to steadily ascend.

We would need to see at least two months of steady stock price trends to argue that

medium-term volatility had switched to a downtrend. It is unlikely that the markets will

remain steady, considering the EU debt that will mature between end-2011 and early

2012, and the growing concerns of a breakup of the eurozone. Consequently, we believe

historical volatility in Korea will remain elevated in 1H12.

Volatility to re main high through

1H12

High volatility regime in 2011

to continue in 2012

Implied volatility and medium -

term historical volatility

continuing upwards

0

50

100

150

200

250

300

0

1

2

Jan 05 Sep 05 May 06 Jan 07 Sep 07 May 08 Jan 09 Sep 09 May 10 Jan 11 Sep 11

Prob. of low volat ilit y (LH S) Prob. of high v olat ilit y (LH S) Kos pi 200 (R HS)

(Pts)(x)


12/28

November 25, 2011

Derivatives Issue

12

Kospi 200: Implied and historical volatility Hang Seng: Implied and historical volatility


Implied volatility in OTC-traded Kospi 200 options has also risen. The options impliedvolatility remained relatively stable at around 20% until the end of June, before turning

up and averaging 20% by November. From a term-structure basis, at end-November 6-

month and 1-year ATM options had an implied volatility of 30-32%, while the figure for

110% OTM options was 30%. With the OTC market pricing 1H12 volatility at 30%, VKospi

levels will likely stay near 2H11 levels for the time being.

Kospi 200 call option volatility, by expiration and strike Kospi 200 put option volatility, by expiration and strike


Meanwhile, US y-y GDP growth and the VIX tend to move in opposite directions, with the

VIX bottoming out during the bull economy of the early 1990s and surging when the dot-

com bubble burst and a bear market emerged in the early 2000s. The VIX set new record

highs during the bear market brought on by the housing market crash of 2008, and has

been rising again in 2011 amid concerns over an economic slowdown.

Similar dynamics have been seen in domestic marketsthe VKospi remaining at low

levels during the bull economy of 2004-2007 and rose as economic growth started to slow

in 2008. This year, with economic growth slowing and Eurozone issues weighing on

markets, it has hit highs unseen since 2009.

We expect volatility to remain high in both US and Korea, with volatility indices

continuing to trend up since 3Q11 and economic growth expected to slow in 2012.

OTC market pricing optionvolatility at 30-32%

Volatility indices r ising on

econom ic uncertainties

Volatility to re main high in 2012

as economic growth slows

0

5

10

15

20

25

3035

40

45

Jan 1 Mar 2 May 1 Jun 30 Aug 29 Oct 28

3-month implied vola tilit y 60-day implied vola ti lit y

180-day implied volatlity

(%)

0

5

10

15

20

25

3035

40

45

Jan 1 Mar 2 May 1 Jun 30 Aug 29 Oct 28

3-month implied vola tili ty 60-day implied vola tilit y

180-day implied volatility

(%)

0

5

10

15

20

25

30

35

40

45

3M 6M 9M 1Y 2Y 3M 6M 9M 1Y 2Y

90% 100% 110% 115%

Jun 2011 Nov 2011

(%)

0

5

10

15

20

25

30

35

40

45

3M 6M 9M 1Y 2Y 3M 6M 9M 1Y 2Y

90% 100% 110% 115%

Jun 2011 Nov 2011

(%)


13/28

November 25, 2011

Derivatives Issue

13

US GDP growth vs VIX Korean GDP growth vs VKospi


With GDP growth at home and abroad expected to slow in 2012, and economic growthexpected to be lowest in 1H12, volatility should remain high in 1H12.

GDP growth: Consensus forecasts

Country (%) 4Q11 1Q12 2Q12 3Q12

US 2.3 1.7 2.1 2.4

Japan 0.7 1.6 2.3 1.6

EU (0.6) (0.4) (0.5) 1.2

China 8.1 8.0 8.3 8.6

Korea 4.1 3.5 3.8 4.1

Note: GDP forecasts for countries other than Korea obtained from Korea Center for International Finance atend-October; Korean GDP forecasts based on FnGuide consensus as of Nov 15, 2011

Source: KCIF, FnGuide, Samsung Securities

US and Korean volatility indices tend to remain below 30% as long as GDP growth ratesremain positive, and surpass 30% when GDP growth turns negative or goes flat.

Unusually strong GDP growth (above 4% in the US) also tends to bring higher volatility,

indicating that volatility rises when economies overheat.

US GDP growth & VIX distribution Korean GDP growth & VKospi distribution

Note: Quadratic trend line applied; since 1991


Note: Quadratic trend line applied; since 2003


Volatility rises in overheated andslowing economies

0

10

20

30

40

50

60

70

(6)

(4)

(2)

0

2

4

6

1Q91 1Q93 1Q95 1Q97 1Q99 1Q01 1Q03 1Q05 1Q07 1Q09 1Q11

GDP growth y-y (LHS) VIX (RHS)

(%)(%)

0

10

20

30

40

50

60

70

(5)

(4)

(3)

(2)

(1)

0

1

2

3

4

1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11

GDP growth y-y (LHS) VKospi (RHS)

(%) (%)

R = 0.3409

0

10

20

30

40

50

60

70

(6) (4) (2) 0 2 4 6

(VIX)

(GDP growth, y-y)

R = 0.5826

0

10

20

30

40

50

60

70

(6) (4) (2) 0 2 4

(GDP growth, y-y)

(VKospi)


14/28


15/28

November 25, 2011

Derivatives Issue

15

Investment strategy for 2012

With stock market volatility likely remain high in 1H12, predicting the Kospis direction is

difficult. The eurozone crisis should linger, and worries of an economic slowdown in the

US and China are likely to grow. Consensus forecasts have Korean corporate earnings

falling significantly in 2012. The US and Korea will likely continue with quantitativeeasing to prevent economic growth from slowing, while in Asian countries any success

with anti-inflationary measures should boost consumption and enable economic

recoveries. That said, growth in the global economy appears set to slow in 1H12, due to

lingering economic tightening, reduced consumption, and sluggish growth in China and

other EMs.

With seemingly little chance of the eurozone crisis being resolved in the near term,

investors need to prepare for a stock market downturn. We recommend they apply a 95%

knock-in put option to defend against tail risk and be able to roll over investments into

short-term (less than three months) ones when necessary. If they want to reduce costs

and prepare for a bear market, a 90-100% put spread would be appropriate.

Constructing a portfolio around safe assets should be beneficial, but investors need to

consider the possibility of a solution to the eurozone crisis emerging or the US economy

recovering. Instead of reducing risk-asset exposure, we recommend using options to

hedge against the risk of both an unexpected downturn and upturn in the markets. We

recommend a 100-110% call ratio spread (for upside risk) and a butterfly strategy (for

range trading). Peak profit for the former can be set either at the Aug 2011 level (when the

eurozone crisis broke out) or the 2011 high (115% OTM).

Tail risk: Long knock-in put options Bear market: Put spread position

Note: Based on long 95% knock-in put with implied volatility of 29%, remainingdays to maturity of 180 days, interest rate of 3.55%, and dividend of 1.49%


Note: Based on long ATM put with implied volatility of 29% and short 10% OTMput with implied volatility of 34%, remaining days to maturity of 90 days,interest rate of 3.55%, and dividend of 1.49%


Prom ising strategies for

increased volatility for 1H12

Knock-in put option or 100%-

110% put spread strategy

100-110% call ratio spread

recommended for upside risk,

butterfly strategy for range

trading

(20)

(10)

0

10

20

30

40

50

60

70

160 170 180 190 200 210 220 230 240 250 260 270

Now After 3 months Expiry

(Pts)

(10)

(5)

0

5

10

15

20

180 190 200 210 220 230 240 250 260 270 280 290

Now After 2 months Expiry

(Pts)


16/28


17/28

November 25, 2011

Derivatives Issue

17

Equity derivatives market in 2012

The index-futures basis generally moves in sync with the stock market, trending up

during the 2004-2007 stock market boom and widening gradually since 2009. (A

mismatch occurred in 2008, when the basis hit a post-2000 peak while the stock market

fluctuated markedly.)

Index-futures basis trends, by year Index-futures basis magnitude (average basis / Kospi 200)

Note: Based on average market basis



We doubt the basis will continue to widen in 2012, although it could briefly, depending on

market movements. Taking advantage of unusual price gaps, Korean hedge funds are

likely to aggressively utilize arbitrage opportunities between futures and options/ETFs.

Korean hedge funds are likely to use single stock futures (SSF) as a proxy for underlying

stocks to go short while implementing long/short strategies, and may feel it prudent to

have a certain amount of SSFs for some stocks in case short selling is banned again.

Disparity ratios (the difference between futures theoretical and market prices) of many of

the 25 listed SSFs remain in negative territorymeaning SSFs are undervalued relative to

and could be sold below theoretical prices. Investors should recognize the possibility of

losing amounts on SSFs commensurate with such disparity ratios.

2011 price and disparity ratio of major single stock futuresName Average price

(KRW)Daily average trading volume

(contract)Average basis

(KRW)Basis / futures price

(%)Average disparity ratio

(%)

Samsung Electronics 880,056 2,407 2,523 0.29 (0.10)

Hyundai Motor 212,113 8,340 468 0.22 (0.21)

Hynix Semiconductor 26,406 99,363 90 0.34 (0.09)

Woori Financial Group 13,093 28,274 51 0.39 (0.06)

Kia Motors 68,906 19,920 225 0.33 (0.10)

Daewoo Securities 18,503 14,627 41 0.22 (0.19)

Note: Based on nearest-expiration futures over Jan 3Nov 15, 2011


Index-futures basis generally

moves in tandem with stock

market

Basis likely to fluctuate in 2012

Hedge funds to u tilize SSFs often

Negative SSF d isparity ratios bad

for sellers

(3)

(2)

(1)

0

1

2

3

4

2003 2004 2005 2006 2007 2008 2009 2010 2011

Max Mean Min

(Pts)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

2003 2004 2005 2006 2007 2008 2009 2010 2011

(%)


18/28

November 25, 2011

Derivatives Issue

18

Only one stock this year has had a derivatives-liquidity ratio (DLR, or futures trading

volume (x10)/stock trading volume) exceed 10%. We advise considering the DLR,

intraday trading volume, and disparity ratios collectively when using SSFs for long/short

strategies.

SSFs: Average daily DLRs (2011)SSF DLR* (%) SSF DLR (%)

SK Innovation 10.25 Samsung C&T 3.23

Hynix Semiconductor 9.81 Korean Air 3.13

Woori Financial Group 8.62 Doosan Infracore 3.12

Hyundai Motor 8.61 Kepco 2.81

SK Telecom 8.04 Posco 2.60

Daewoo Securities 7.09 E Mart 2.40

Hyundai Heavy Industies 6.99 LG Display 2.39

Samsung Electronics 6.55 NHN 2.34

Kia Motors 6.27 Hana Financial Group 2.30

KT 5.82 Shinhan Financial Group 2.06

GS E&C 4.97 KB Financial Group 1.88

Hyundai Steel 3.99 KT&G 1.73

LG Electronics 3.51

Note: Data over Jan 3Nov 15, 2011 observed; * DLR = futures trading volume (x10) / stock trading volume


DLRs low


19/28

November 25, 2011

Derivatives Issue

19

More regulations

Era of regulations

There have been some policy contradictions in the domestic derivatives market in 2011

on-exchange derivatives have been increasingly regulated, but investment banks less so.

Regulations began to increase after the stock market plunged on Nov 11, 2010, as a

massive unwinding of positions revealed growing settlement risk arising from poor risk

management. Authorities have looked to mitigate settlement risk, reduced the severity ofmarket shocks (through program trading rules designed to lessen long-short imbalances

and the resultant market volatility during closing auctions), and set futures/option

positions limits for institutional investors at a maximum of 10,000 contracts per day

(based on net-position delta).

New ELW regulations were also put in place in Oct 2010 (measures to monitors liquidity

providers [LPs]) and May 2011 (larger base deposit and more efficient pricing).

Guidelines to raise public awareness about the importance of fairness in direct market

access and pre-order risk checking were also announced.

We expect more of the same in 2012. Regulators have proposed raising the contract

multiplier of option products from KRW100,000 to KRW200,000-250,000, a measure

that would: 1) drive out small investorsas the value of one tick would climb by

KRW5,000-25,000, or 0.01-0.05pts; and 2) reduce option trading volume from

professional traders who manage delta position using futures, because the delta ratio of

futures and option products would become 1:1 (vs 1:0.2 now).

The measure would also likely reduce ITM stock liquidity, boosting transactions of only

deep OTM stocks. It can also dampen pricing efficiency and futures-option arbitrage

trading, while the negative impact on retailers (key players in Kospi 200 options, along

with foreign investors and securities firms would likely trigger a disproportionate increase

in foreign dominance of the market.

Some academics are arguing that the distribution channel for DLSs should be expanded

to improve price transparency and information dissemination, and prevent sales

involving conflicts of interests or that are incomplete. They say excessive commission

rates and issuances/sales of DLSs make it unreasonably difficult for investors to selectproducts. In Europe, the authorities plan to standardize the investment performance, risk,

commissions, and guaranteed returns of packaged retail investment products (PRIPs) to

allow investors to easily compare different products.

Standardization and the establishment of integrated information systems could benefit

investors, but considering the nature of DLSs, we believe firms need to be able to set

different estimates for funding rates and market conditions, and thus commission rates.

Rather than promote product development, standardized information may risk more

price competition in DLS market that is already highly competitive. All in all, the

standardization should weigh on financial investment firms and eventually damage

investors.

Regulations enacted after stock

mar ket plunged on Nov 11, 2010

More regulations for ELWs

Controversy over raising contract

multiplier of option products

Rise in multiplier wou ld hurt

price efficiency

DLS regulations being considered

Further DLS regulations would

benefit investor s little

CONTENTS

2011 review p2

A mixed year p5

2012 strategy p10



20/28

November 25, 2011

Derivatives Issue

20

Regulations have been implemented to ensure OTC derivatives market transparency and

prevent systemic risk. The G20 has agreed that all standardized OTC derivative contracts

must be cleared through a CCP. In establishing an advanced financial market

infrastructure, the KRX plans to establish a CCP by 2H12. The success of the institution

will likely depend on the degree of use by banks, which account for most domestic OTC

derivatives deals (in the form of interest-rate swaps). Banks may not be put off by theadditional costs incurred in using a CCP, particularly if CCP-cleared contracts make up a

miniscule proportion of the OTC derivatives market. Some countries, like Hong Kong, are

proposing to phase in CCPs depending on the growth phase of each financial market in

question. Much debate will likely ensue before a consensus on expanding financial

infrastructure is established.

Tighter regulations of on-exchange derivatives could hurt the overall derivatives market,

given the immaturity of Koreas OTC derivatives market (compared to those of developed

countries) and the limited use of OTC derivatives by domestic institutional investors.

Regulations are likely to reduce liquidity and raise transaction costs for on-exchange

derivatives, preventing them from serving as an efficient hedging tool in issuing ELSs and

DLSs, and impeding the development of financial products.

We expect a tax on financial transactions, now being discussed in the developed world, to

be debated in Korea in 2012 under the guise of a derivatives-transaction tax. Taxation of

on-exchange derivatives has been discussed for several years, but not been implemented

due to questions over market protection, the possibility of an outflow of national wealth,

and the legitimacy of taxing inherently zero-sum derivatives. As discussions on the issue

pick up overseas, however, Korea could begin to tax equity-related derivatives, which are

considered to have relatively little ramifications on the real economy.

Led by the Dodd-Frank Act in the US and the European Securities and Market Authority

(ESMA), tightening regulations will likely hold back growth in the global derivatives

market. Domestically, regulations will likely tighten in an effort to restrict speculation in

on-exchange derivatives and better protect investors. For the most part, overseas

regulations are aimed at minimizing systemic risk, while domestic regulations are focusedmore on individual product risk and are likely to reduce the number of participants and

trading volume.

CCP may hur t OTC derivatives

mar ket by incurr ing additional

cost

Regulations of on-exchange

derivatives may deter growth of

OTC der ivatives

Financial- or der ivatives-

transaction taxes being seriously

considered

Overseas regulations focus on

preventing systemic risk,

dome stic regulations on

individual product risk


21/28

November 25, 2011

Derivatives Issue

21

Hedge funds comingwith many regulations and restrictions

Onshore hedge funds will be introduced in Korea in 2012 under a slew of regulations,

including: 1) minimum assets-under-management requirementseg, KRW10t for asset

management firms; 2) minimum investment requirementsie, retail investors with over

KRW500m or qualified investors; and 3) restrictions on fund managementeg, leverageand limit on the use of derivatives. Regulators focus seems to be systemic risk monitoring

and investor protection.

In accordance with the FISCMA, only prime brokers will be allowed to provided a full

range of serviceseg, SBL, margin lending, commissions, settlement and custody, and

capital introductionto hedge funds, while financial investment companies lacking a

prime brokerage license will be allowed to serve as execution brokers. In other words, the

authorities should be able to indirectly regulate hedge funds by limiting the business

scope of prime brokers and receiving updates on their activities.

Korean hedge funds will likely invest more in Korean assets (than overseas ones) and in

stocks (not bonds), because: 1) bond arbitrage in Korea is difficult because few firms have

the credit lines needed to engage in it; 2) issuances and trading volume of credit bonds are

limited; and 3) arbitrage using foreign stocks is so limited that Korean prime brokers will

likely be forced to limit long/short strategies to Korean stocks. Forex transactions will

continue to be strictly regulated, and commodity investing remains in its infancy due to a

lack of research and systems designed to carry out direct investments in overseas futures.

In a nutshell, limits on investment strategies and assets for hedge funds are likely to make

the devices less attractive than many hope.

To overcome such issues, most hedge funds are likely to adopt similar approaches (such

as factor-model or pair-trading) in implementing long/short equity strategies. When the

same strategies are applied to a group of limited assets, order-execution factorsspeed,

cost, stop-lossesare likely to prove important.

We expect transaction cost analysis (TCA) and algorithmic trading strategy to be essential

to minimizing transaction costs. Long/short trading profitability depends on the directionand sustainability of share pricesthough returns can be affected by the impact of

position building and liquidation. Transaction costs are actually the key determinant in

statistical arbitrage or pair trading. When the size of an order of a stock used for a long or

short strategy exceeds a certain percentage of hourly trading, volume-weighted average

price (VWAP) is crucial. Brokers with algorithmic trading systems to minimize market

impact and TCA services should play a crucial role in enhancing hedge fund returns.

It will be equally important for hedge funds to find new investment targets. Applying a

similar investment strategy to a limited investment universe generally results in less alpha

creation due to competition. Hedge funds are likely to view commodity futures as their

best investment target, utilizing managed-futures or commodity trading advisor (CTA)

strategies to exploit the low correlation of process movements among commodities and

between them and traditional assets.

Given the difficulties of understanding the characteristics of single products and market

participants, we believe hedge funds will first have to focus on commodity index futures

or ETFs and then expand into single product futures. Commodity indices should come

first, given their diversity (eg, S&P GSCI, DJ-UBS CI, Deutsche Bank CI, and Rogers

International CI) and differences in composition portion and rebalancing cycles.

Kore an hedge funds to be

introduced with regulatory focus

placed on systemic risk and

investor protection

Authorities to indirectly regulate

hedge funds by supervising prime

brokers

Small scope of investment targets

and dearth of investment

strategies could reduce

attractiveness of hedge fun ds

Speed and cost cutting key to

long/short strategies

Algorithmic trading strategy

essential for orde r execution

Alpha creation w ill require

Korea n hedge funds to enter

commodity market

Comm odity index futures or ETFs

likely to be good option s initially


22/28

November 25, 2011

Derivatives Issue

22

More than 80% of CTA strategies are based on systemic approaches and combine

fundamental and technical analysis. Hedge funds and prime brokers will need to develop

investment models and hire research talent to conduct commodity-correlation analysis,

engage in single product system trading, and evaluate supply-demand dynamics. To

execute CTA strategies, Korean hedge funds will need execution brokers for overseas

commodity futures markets and back-office support. Ofthe worlds top-10 CTA programs,more than 70% take a systemic approach that simultaneously invests in multiple products.

Best performing CTAs (2010)

Rank CTA Program 2010 return (%)

1 Global Ag 86.29

2 Global Investment Management 79.96

- GIM High Frequency

3 Blue Fin Capital 70.91

- Compact Omega

4 Tactical Investment Management 68.92

- Institutional Commercial

5 AIS Futures Management 66.30

- 3X-6X

6 24FX Management 63.15

7 Hawksbill Capital Management 57.56

- Global Diversified

8 Commodity Futures Services 55.93

- IPATS

9 Friedberg Commodity Management 52.33

- Currency

10 Clarke Capital Management 52.19

- Jupiter

Note: Return based on individual fund under investment company

Source: Barclays, Samsung Securities

Best performing CTAs (Sep 2011)

Rank CTA Program Sep return (%) YTD return (%)

1 Friedberg Commodity Management 41.14 2.12

Currency

2 Pere Trading Group 38.46 37.43

Pere Trading Program

3 B eechdale Capital Management 29.79 (2.44)

Gamma Traders

4 Di Tomasso Group 22.79 1.85

Equilibrium Trading

5 Lakshmi Capital Management 15.86 86.39

Global Macro

6 Qbasis Fund Management 15.41 (5.74)

Qbasis Futures Fund

7 Currency Insight 13.17 0.98

Diversified Systematic

8 Hamer Trading 12.96 33.25

Diversified Systematic

9 LJM Partners 12.58 (13.10)

LJM Fund.

10 Cambridge Strategy Asset Management 12.51 9.21

Asian Markets Alpha

Note: Return based on individual fund under investment companySource: Barclays, Samsung Securities

Hedge funds and prime brokers will also have to give much thought on how to use

collateral. Hedge funds will be able to use initial assets as collateral for leverage and for

signing derivatives contracts with prime brokers. The latter can engage in SBL and

rehypothecation (when borrowing from other financial institutions).

Prime brokers can create extra profit through collateral-backed repo transactions (like

they did in the US prior to the 2008 financial crisis), while hedge funds can increase

leverage through repetitive transactions of cash borrowing and bond purchasing, repo

selling, and bond purchasing and repo selling. In the process of a repo-based leverage

expansion, however, collateral values can rise or fall, triggering deleveragingmaking the

question of how to use collateral an important one.

Investment model, research pool,

and back-office system n eed to be

put in place

How to u se collateral a key issue

Rehypothecation warrants

attention


23/28

November 25, 2011

Derivatives Issue

23

Using repos to create leverage

Note: NRI, Suggestion for improvement of Repo and SLB, 2011

Source: KSD, Samsung Securities

To hedge against risk and diversify profit sources, hedge funds will likely tap into a variety

of derivatives, but from an overall perspective we expect their derivatives investments to

be limited, as only asset management firm are authorized to operate them. That said, as

hedge funds grow larger, how they utilize cash assets should become more essential and

investing in DLSs or structured products (vs deposits, such as commercial paper) more

effective.

Securitized derivatives and structural products in which hedge funds can invest (eg,

dispersion or variance swap products, or credit derivatives index-based products) will

need to be developed.

Cash borrowing &

bond purchasing

Repo selling

100 cash

Bond purchasing &

repo selling

100 cash &

bond purchasing

Repo selling &

100 cash

Bond purchasing 300 &

repo selling 300

Hedge funds expected to invest in

DLSs or structured products

Development of securitized

derivatives and structural

products necessary


24/28

November 25, 2011

Derivatives Issue

24

Product development needs to continue

We now expect VKospi futures to be introduced in 2012 (vs our previous forecast of 2H11).

Given the increasing awareness of the VKospis usefulness in predicting market

movements, VKospi derivatives need to be introduced, to enable investors to hedge

against stock portfolio volatility and price risks.Trading volume of VIX futures (with a contract multiplier of USD1,000), listed on the

CBOE Futures Exchange, touched a yearly high in August as the US market nosedived on

European issues. The VIX averaged more than 35% for the month and peaked at 48%.

Trading of VIX futures soared on: 1) demand to hedge against volatility-driven losses; and

2) speculative demand betting on the direction of volatility.

VIX and S&P 500: Returns since 2008 VIX futures: Monthly trading volume (2011)

Note: Weekly data used


Source: CBOE, Bloomberg, Samsung Securities

VKospi futures, if introduced, would help hedge against volatility risk in equity portfolios.Just as the VKospi reflects stock market instability, risk reversal (RR) reflects the volatility

of the KRW/USD rate. Given the high correlation between the VKospi and RR (61% based

on post-2010 daily data), VKospi futures could also be used to indirectly hedge against an

upheaval in the forex market.

VKospi and Kospi: Returns since 2008 VKospi and risk reversal

Note: Weekly data used


Note: Difference between call and put options with 25% delta


VKospi futures to be introduced

in 2012

Trading volume of VIX futures

soars amid European crisis

VKospi inversely related withKospi, bu t positively related w ith

RR

y = -3.0354x + 0.6088R = 0.56

(50)

(40)

(30)

(20)

(10)

0

10

20

30

40

50

(20) (15) (10) (5) 0 5 10 15 20

(VIX)

(S&P 500)

0

5

10

15

20

25

30

35

40

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Jan 11 Mar 11 May 11 Jul 11 Sep 11

Trading volume (LHS) VIX (RHS)

('000 contracts) (%)

y = -2.1973x + 0.7472R = 0.3959

(50)

(40)

(30)

(20)

(10)

0

10

20

30

40

50

(20) (15) (10) (5) 0 5 10 15 20

(VKospi)

(Kospi)

0

2

4

6

8

10

12

0

10

20

30

40

50

60

Jan 10 Aug 10 Mar 11 Oct 11

VKospi (LHS) Risk Reversal (RHS)

(%) (%)


25/28

November 25, 2011

Derivatives Issue

25

The VKospi is calculated by building a 30-day imaginary option using nearest- and next-

to-nearest-month options. While nearest-month options are often fairly priced in the

market, next-to-nearest-month options tend to be overvalued or undervalued due to low

liquiditythey account for less than 2% of Kospi 200 option trade volume. As their low

liquidity limits the ability to replicate the VKospi, and the VKospi lags market-implied

volatility during rollover periods (four days before expiry), arbitrage between VKospifutures and replicated futures is difficult.

VKospi futures can serve as a useful tool to hedge against or speculate on volatility. But

arbitrage trading between VKospi futures and replicated positions will not be possible as

long as next-to-nearest-month options are traded thin. Only when it enables arbitrage

trading as well as speculative/hedge trading can the VKospi successfully take root.

We expect options on ETFs to be introduced along with VKospi futures. In US exchanges

like the CBOE, ISE, AMEX, and PHLX, ETF options are being increasingly traded, with

trade volume of ETF options jumping to 70% of the level of single stock option (SSO)

trade volume this year, from 50% last year. SSOs make up the lion's share of the US

option market.

We see a greater need for options on sector or commodity ETFs than index ETFs, given

the presence of Kospi 200 options. Listing of sector ETF options could stimulate trading

of SSOs not traded at all now, by creating demand for arbitrage or correlation trading

between sector ETFs and sector ETF options, or between sector ETFs and constituent

SSOs. It could also encourage arbitrage trading between single stock ELWs and sector

ETF options as well as hedge trading. This, in turn, would encourage institutional

investors to participate in the ELW market, which speculators currently dominate.

To help the sector ETF option market take off (and avoid the path of SSOs), market

makers should be designated, bloc trading allowed, and FLEX options introduced. These

tools should also be applied to SSOs to revive the SSO market.

Daily average trading volume of CBOE ETF options 2011 trading volume of US-listed options (Jan~Oct)

Source: CBOE, OCC, Samsung Securities Source: OCC, Samsung Securities

Underlying assets for SSFs should also broaden from the current 25 stocks, as hedge

funds will want to make use of long/short strategies. SSFs should be available for at least

all Kospi 50 constituents in 2012. For reference, 1,470 SSFs (including ETF futures) were

listed on the US stock exchange as of November.

Liquidity of next-to-nearest-

month op tions crucial to active

trade of VKospi futures

ETF options should be

introduced-in US, trade volum e of

ETF options amou nts to 70% that

of SSOs

Listing of sector ETF optio ns to

stimulate trading of SSOs and

enable arbitrage trading w ith

single stock ELW s

Bloc trading should be allowed to

help sector ETF option marke t

take off

Underlying assets for SSFs should

broaden as hedge funds are

launched

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000


(Shares)

2,101

290

1,508

1,939

245

1,022

0

500

1,000

1,500

2,000

2,500

Equity Index ETF

2011 2010

(Mil. shares)


26/28

November 25, 2011

Derivatives Issue

26

Revisions to the Commercial Code and FISCMA to allow micro-unit derivatives

Revisions to the Korean Commercial Code and the FISCMA will allow companies to issue

a wider variety of securities to secure funds or manage voting rights. The KCC revisions

will go into effect in Apr 2012; the FISCMA revisions took effect in Sep 2011.

After the revisions take effect, companies will be able to issue classes stocks offeringdividend payments based on different rules from common shares (eg, dividends fixed to

KRW1,000 per share or based on an adjustable-rate for certain preferred stocks), shares

with voting rights different than those of common shares, and redeemable shares and

convertible stocks. Mandatory and reverse convertibles will allow companies to issue

preferred equity redemption cumulative stocks (PERCS) or dividend enhanced

convertible securities (DECS), which gained popularity in the US in the 2000s.

PERCS offer higher dividends than common shares, are subject to conversion at maturity,

with caps set on the number of common shares into which they can be converted. DECS

offer additional OTM call options on PERCS, allowing the shares to be converted to

common shares only when share prices exceed conversion prices (OTM levels) at

maturity. However, without a cap placed on conversion rules, DECS holders can profit

from the rise in share prices. Companies tend to partner up with the corporate finance

division of investment banks to issue PERCS and DECS. As a result of the revision,

securities firms will be able to expand past conventional roles of issuing common shares

ie, conducting IPOs and rights offerings.

Meanwhile, the FISCMA revision allows the issue of independent warrants such as call

options on newly issued shares. Instead of opting to conduct the pricing (setting the

exercise price and issue price) of the call options by itself, we expect individual companies

to turn to investment banks for the issue of independent warrants.

We expect the issue of independent warrants and the increase in variety of preferred

shares to help spark stronger OTC trading. As the role of investment banks expands from

the simple issue of shares to active book management, we expect the firms to increasingly

turn to OTC options markets to hedge against risks, leading to more OTC trading volume.

Companies will also be allowed to issue a wider variety of bonds, such as dividend-

participating bonds, bonds exchangeable into stocks or other securities, as well as

derivative-linked bonds (DLBs). Financial products that have the characteristics of a bond

but had been categorized as DLSs will be re-categorized as DLBs. While only securities

firms with OTC licenses had been allowed to issue DLSs in the past, banks will be allowed

to issue DLBs after the revision. In effect, regulatory changes will intensify competition

between banks and investment banks and increase financing options for companies.

KCC and FISCMA re visions to

allow new classes of shares

Companies to turn to investment

banks for the issue of class stocks

FISCMA revision to allow

issuance of independent warrants

Increased variety to spark

stronger trading in OTC markets

Regulatory changes to spark

competition between banks and

investment banks


27/28

November 25, 2011

Derivatives Issue

27

Global Disclosures & DisclaimersGeneral

This research report is for information purposes only. It is not and should not be construed as an offer or solicitation of an offer to purchase or sell anysecurities or other financial instruments or to participate in any trading strategy. This report does not provide individually tailored investment advice. Thisreport does not take into account individual client circumstances, objectives, or needs and is not intended as recommendations of particular securities,

financial instruments, or strategies to any particular client. The securities and other financial instruments discussed in this report may not be suitable for allinvestors. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein andinvestors should seek the advice of a financial adviser.

This report may not be altered, reproduced, distributed, transmitted or published in whole or in part for any purpose. References to "Samsung Securities" arereferences to any company in the Samsung Securities, Co., Ltd. group of companies.

Samsung Securities and/or other affiliated companies, its and their directors, officers, representatives, or employees may have long or short positions in any ofthe securities or other financial instruments mentioned in this report or of issuers described herein and may purchase and/or sell, or offer to purchase and/orsell, at any time, such securities or other financial instruments in the open market or otherwise, as either a principal or agent. Any pricing of securities or otherfinancial instrument contained herein is as of the close of market for such day, unless otherwise stated. Opinions and estimates contained herein constitute our

judgment as of the date of this report and are subject to change without notice.

The information provided in this report is provided "AS IS". Although the information contained herein has been obtained from sources believed to be reliable,no representation or warranty, either expressed or implied, is provided by Samsung Securities in relation to the accuracy, completeness or reliability of suchinformation or that such information was provided for any particular purpose and Samsung Securities expressly disclaims any warranties of merchantability orfitness for a particular purpose. Furthermore, this report is not intended to be a complete statement or summary of the securities, markets or developmentsreferred to herein.

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derivatives outlook_ change coming in 2012 - more regulations, volatility expected

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