By Lu Jianxin and Pete Sweeney
SHANGHAI, Nov 22 (Reuters) - Beijing says it it ready to unleash the forces of supply and demand on previously tightly managed financial markets, but before it can do so it needs to quickly upgrade instruments available for investors to hedge risk.
Chinese leadership said earlier this month that it would further free up markets and give them a 'decisive' role in the economy as it unwrapped its detailed reform plans after a policy-setting meeting of the Communist Party.
The transition will inevitably lead to volatility as investors reallocate portfolios to adjust for a new mix of risks, so China also needs to provide a new suite of options contracts to allow investors to cover themselves.
'Giving markets a decisive role will apparently boost price volatility, and options will be the right tool to hedge risk,' said Cai Luoyi, vice president of Shanghai CIFCO Futures Co.
Chinese regulators say they will launch a slew of stock and commodity options in the coming year, and exchanges are already conducting simulated trading for some contracts.
An option is the contract to buy or sell a product at a predetermined price at a predetermined time in the future. By purchasing such contracts, investors are able to reduce risk of future price plunges or leaps. At the same time, speculators can make profits by betting on the right direction.
'Exchange-simulated trading has now reached quite a high degree of sophistication. Software and other technical preparations are mostly complete, so some options will be launched in the first half of 2014,' Cai said.
China launched currency options derived from the yuan/dollar trade in 2011 -- the only options now traded in the country -- but capital account controls have kept the Chinese currency moving narrowly on both daily and yearly basis. With little implied volatility, volumes of yuan option trade are tiny, with only a handful of deals conducted each day.
But other markets appear better primed for options.
'Stocks and commodities are the products subject to less governmental intervention and thus more volatile in China,' said a trader at a major Chinese brokerage in Shanghai.
'Trading activity could be further boosted with options offering hedging protection. That will give birth to a real option market in China.'
Worried that more volatility of China's markets may stretch regulatory capability, the government has set different restrictions on price movements of products. For instance, even in the stock market, widely considered the least tightly regulated market, there is a 10-percent intraday limit up or down for individual stocks.
Regulators tried to develop derivatives markets over the last few decades, and established the China Financial Futures Exchange (CFFE) to host trading of financial derivatives in 2006.
The process was not without hitches. The government bond futures market, for example, was shut down for 18 years after a trading scandal, and only reopened in 2013.
Even more efforts have been made to expand the country's commodity futures markets, with a slew of new products being launched this year alone, based on everything from iron ore to eggs.
'Where water flows, a channel will form,' said Liu Zhongyuan, a veteran Chinese futures market player and chief economist at ChangJiang Futures Co, quoting a Chinese proverb meaning success will occur naturally under the right conditions.
'There should be no longer major barriers for China to launch stock and commodity option trading, in particular after China has laid the foundations for their launch with so many other types of derivatives.'
The Shanghai-based CFFE kicked off simulated trading in stock index options on Nov. 8, the third product to start testing following the simultaneous launch of stock index futures and government bond futures.
The options will be exercised European style, meaning that holders can exercise their rights only on the day when the contracts mature, in order to curb risk.
Last week, China's main Shanghai Stock Exchange started testing trading in options for four of its index heavyweight stocks, including oil giant PetroChina, a move traders said reflects regulatory desire to boost trade in blue chips, typically neglected by domestic investors who prefer to dabble in small caps.
On Tuesday, the Shanghai Commodity Exchange began simulated trading in copper and gold options. China's two other commodity exchanges in Dalian and Zhengzhou have also lodged proposals to launch options on some of their contracts.
(Editing by Simon Cameron-Moore) Keywords: MARKETS CHINA/HEDGING
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