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Based on theoretical and empirical research results from uniquely designed analysis frameworks, KCMI Research Papers draw out implications as well as policy directions for Korea’s financial industry and markets.

보고서 1
Analysis on the Characteristics of Korea’s Strip Bond Market and Plans for Facilitating the Market [21-01]
Senior Research Fellow Kim, Pil-Kyu / Jan. 08, 2021
This study aims to analyze the characteristics and economic effects of Korea’s strip bond market in terms of the secondary market and the market’s issuers, investors, and yields, based on which to propose ideas for facilitating the market. A strip bond is a debt obligation which is broken into coupon and principal components and issued as several zero-coupon bonds. Investor can benefit from investing in those bonds as they offer a broader opportunity for long-term, arbitrage investment and eliminate the reinvestment risk a coupon bond usually has. In addition, more information on zero-coupon bonds with diverse maturities in the strip bond market could help complete the yield curve, making the market more comprehensive.
 
Korea’s strip bond market has been introduced in March 2006 for the purpose of improving the liquidity of benchmark Korea Treasury Bonds, revitalizing the long-term bond market, and effectively responding to market demand for long-term zero-interest bonds. It was 2010 that the issuance of strip bonds began picking up. A more significant increase has been observed around the on-exchange secondary market since 2016.

This paper analyzed the primary and secondary market data to grasp the main characteristics of Korea’s strip bond market. The results confirm the market’s wide-ranging benefits to investors. First, strip bonds have the effect of expanding the supply of long-term duration bonds in response to investors’ demand for long-term assets. With the average maturity of domestic strip bonds continuously on the rise, the proportion of stripped long-term government bonds has been also increasing. The prolonged maturity of those bonds results from two factors. First, the insurance sector increased investment in long-term bonds in response to regulatory changes. Second, institutions holding long-term debt are increasingly using strip bonds for the purpose of duration matching.

The main institutions that invest in strip bonds include insurers, pension funds, asset managers and banks. As a result of analyzing the behavior of major strip bond investors using the trading data of the over-the-counter market, insurers and pension funds tend to invest in long-term strip bonds in order to eliminate maturity mismatches between assets and liabilities. By contrast, asset managers are found to prefer high investment returns, investing in short-term principal strips and coupon strips that have relatively high spreads. Banks act as strip bond providers while investing in various types of strip bonds for higher profitability.

The most notable feature in Korea’s secondary market for strip bonds is the divergence of bond types and market participants between the on-exchange and the over-the exchange markets. The KRX—Korea’s on-exchange market—is a marketplace where principal strips that mature less than one year take up a large proportion of trading, while the OTC market sees a diversity of stripped principal and coupon components changing hands. Recently, liquidity of strip bonds in the KRX has improved significantly, mainly because of the government’s regulatory actions such as introducing a primary dealer system for strip bonds that mandates the dealers to engage in market making for strip bonds with less than one-year maturity. Such a boost in the on-exchange secondary market is certainly viewed positively as it has improved the liquidity of short-term strip bonds, and has helped complete the yield curve of short-term, risk-free bonds. However, its crowding-out effect of contracting trades of longer-term strip bonds is posing a negative aspect.

The introduction of strip bonds provides the effect of improving long-term government bonds and off-the-run bond liquidity. A comparative look at strip bonds with other risk-free bonds, strip bonds’ liquidity is lower than that of short-term KTBs and two-year Monetary Stabilization Bonds, but is higher than long-term KTBs. Stripping long-term KTBs helps boost the liquidity of those otherwise illiquid bonds. 

According to the analysis in this paper, Korea’s strip bonds showed higher excess spreads than government bonds do. The average yield on Korea’s strip bonds was found to be consistently higher than the mark-to-market yield on KTBs with the same maturity. Such a result could have been affected by strip bonds’ higher price sensitivity to interest rate changes, compared to coupon bonds with the same maturity. This paper also compared the yields on principal and coupon strips, and found coupon strips’ spread to be higher than principal strips, which is consistent with previous studies on strip bond prices in other countries. Because stripped interest payments are issued as various small-amount bonds, they are illiquid and serve for investors whose investment purpose and strategy are often different from those investing in stripped principal components. Also noteworthy was strip bonds’ spread varying widely across strip types, maturities, interest rate hikes, and trading venues, all of which suggest diverse factors behind how strip bonds are priced.

For steering Korea’s strip bond market towards sustainable development, several improvements are needed in the areas of issuers, investors, secondary market and market infrastructure. Plans are needed to help the issuers to accurately grasp the demand of strip bonds and to elastically supply them. Investors should refine their strategy, fully reflecting the market’s characteristics. Also necessary is a plan to introduce diverse packaged products based on strip bonds. The secondary market needs improvements in price efficiency, which could be achieved by improved liquidity of strip bonds. Last but not least, it is necessary to promote more information on the strip bond market and the underlying bonds to be analyzed and provided.
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보고서 1
Guidelines for Managing Outsourcing Risk of Financial Services Firms: Overseas Cases [20-01]
Senior Research Fellow Cho, Sung Hoon / Dec. 07, 2020
Outsourcing, which means allowing a third party outside the company to perform activities or functions that the company has performed internally, is a strategic decision-making aimed at reducing costs, enhancing management efficiency, and strengthening core competencies, and this importance is the same in the financial services industry. In particular, outsourcing is becoming more important as the value chain of the financial services industry changes according to the recent rapid technological development called the ‘4th industrial revolution.’ However, in Korea, there have been opinions that the statutory regulations on outsourcing are rigidly operated, limiting financial services firms’ use of outsourcing, and thus failing to respond to rapidly changing environments, and outsourcing regulations are on the trend of easing.

Major foreign countries, such as the United States, European Union, United Kingdom, and Singapore do not regulate outsourcing of financial services firms by law. Instead, regulatory or supervisory agencies have created and provided guidelines or guidances for outsourcing management of financial services firms. The guidelines of these agencies commonly emphasize the roles and responsibilities of the board of directors and top management in making and managing outsourcing decisions. In addition, the management process leading to outsourcing risk management, due diligence and selection of outsourcing suppliers, design and conclusion of outsourcing contracts, and supplier monitoring is presented in a similar manner.

All global financial services firms have developed a ‘Code of Conduct’ to manage their outsourcing and apply them to their suppliers. The Code of Conduct commonly contains matters concerning business ethics and integrity, labor and human rights, environment and sustainability, diversity and inclusion. This report also introduces the contents of JP Morgan’s ‘Minimum Control Requirements’ as a specific internal guideline for outsourcing management, which are very specific and detailed as defining minimum control requirements to effectively control IT outsourcing and manage related risks.

If Korea’s outsourcing regulations are continuously eased and ultimately shifted to principle-based, guidelines as soft norms will be needed, and these guidelines should be specific and specialized to provide practical assistance to financial services firms. Financial services firms’ internal outsourcing management guidelines should also be specialized, detailed and technical, and efforts should be made to secure the technical capabilities of their own personnel to create and implement these internal guidelines. With the increase of IT outsourcing, the importance of risk management related to data and information of customers and firms is growing, and firms need to raise awareness of the responsibilities of the board and top management for outsourcing management.
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보고서 1
Effects of FX Hedging on Korea’s Outward Portfolio Investment [19-01]
Senior Research Fellow LEE, Seungho and others / Jan. 25, 2019
Korea has seen a rapid increase in foreign financial assets owned by local residents on the back of persistent current account surpluses. In particular, Korea’s outward portfolio investment has shown a pronounced upward trend since the global financial crisis. In the context of portfolio investment, effective management of exchange rate risk is very important to maximize the benefits of global diversification because exchange rate fluctuations could give rise to gains or losses. In this regard, the challenge facing major institutional investors in Korea is to have a foreign exchange (FX) risk management policy tailored to institution-specific characteristics.  

FX risk management by domestic institutional investors in relation to outward portfolio investment is still in its infancy. Many institutions do not have a well-established FX hedging policy or they usually take a conservative approach to managing FX risk arising from exchange rate changes. More specifically, most institutions or funds tend to emulate their larger peers (e.g., public funds) in designing an FX hedging policy rather than taking into account their unique features. As a result, domestic institutional investors maintain FX hedging policies under which their outward portfolio investments are hedged at the asset-class level with global stocks unhedged and global bonds fully hedged. However, the effects of FX hedging at the asset-class level are hardly consistent across countries and across periods. Furthermore, given the intended purpose of an FX hedging policy is to manage FX exposures within an international portfolio, hedging FX risks at the individual asset class level is a local optimum so that this approach does not guarantee a global optimum for a global multi-asset and multi-currency portfolio, which makes asset-level FX hedging become a limited tool.
    
In this study, we aim to highlight key considerations, decision-making criteria and analytical frameworks that major domestic institutional investors engaging in outward portfolio investment should take into account when formulating their FX risk management policies. We conduct a multi-faceted analysis on changes in the risk return profiles of global portfolios (based on final investment returns converted into Korean won) when FX hedging policy is established either at the asset-class or portfolio level. In addition, we examine the effects of FX hedging on the foreign exchange market in that the foreign exchange market is affected by the FX hedging policies of institutional investors engaging in outward portfolio investment, and accordingly the foreign exchange authorities directly or indirectly regulate FX hedging policy formulation and implementation by institutional investors, which in turn affects FX hedging practices in the market.   
More specifically, we investigate the effects of asset-level FX hedging on stocks and bonds issued in four developed economies (the US, Japan, Eurozone, and the UK) and two emerging market economies (China and Brazil) since 2004 in order to explore the efficiency and persistence of the asset-level FX hedging policy adopted by the majority of Korean institutional investors. Our empirical analysis yielded different results for developed and emerging market economies when it comes to foreign stocks. As for developed countries including the US, a strong negative correlation was found between stock and currency returns, which means leaving foreign stocks unhedged would be an effective risk minimizing strategy. On the other hand, the full hedge strategy performed better in Brazil, one of the emerging markets. But no significant difference between fully hedged and unhedged foreign stocks was found in the case of China. Also, we analyze the impacts of asset-level FX hedging on the foreign stocks and bonds in different periods, taking the 2008 global financial crisis into consideration, to measure the persistence of static FX hedging policy. We find that there can be no assurance that FX hedging effects will be persistent. However, the findings provide strong support for fully hedging foreign stocks, which is the FX hedging policy widely used by domestic institutional investors engaging in outward portfolio investment. 

We also analyze the effects of portfolio-level FX hedging on the foreign stocks and bonds to confirm the importance of portfolio hedging, which is the focus of our study.  The analysis of the portfolio-level hedging showed different results in several respects from the analysis of the asset-level hedging described above. With the asset-level FX hedging over the entire sample period, it seems desirable for foreign stocks to be unhedged and for foreign bonds to be fully hedged. With the portfolio-level FX hedging, however, full hedging looks effective for all asset classes to minimize the overall portfolio volatility. In addition, the analysis of global multi-asset class and multi-currency portfolios reveals that as the number of currencies and asset classes included in the portfolio increases, the use of a full hedge should be reduced, if possible, in order to maximize global diversification effects and mitigate the volatility of the overall portfolio. Not only that, we find FX hedging at the total portfolio level would be more stable in terms of persistence of the hedging effects. 
Turning to the foreign exchange market, we discover that the FX hedging of outward portfolio investments has a negative impact on the swap rate in the FX swap market rather than the spot rate, but this finding is not statistically significant. Nevertheless, it is difficult to exclude the possibility that when Korean residents invest in foreign bonds, if over- hedging of exchange rate risk as seen today continues and the investment volume rises steadily, then such hedging activities would create demand for FX swaps, which would eventually result in greater imbalance in the FX swap market. 
The following implications can be drawn from the results: First, further review is required for asset-level FX hedging policies, which domestic institutions have in place as a result of imitating their larger peers, in terms of consistency or persistence of the effects. A shift in FX hedging should be made by institutional investors with global multi-asset and multi-currency portfolios to make FX hedging decisions at the portfolio level rather than the asset-class level. 

Second, a single bottom line instead of a double bottom line, which seeks higher returns and less risks at the same time, should be adopted as criteria for determining an optimal FX hedge strategy. Recognizing that FX hedging is an intrinsic part of risk management, institutions need to develop a FX hedging policy that reflect risks lurking in their portfolios. Further, the FX hedging policy should factor in institution-specific characteristics, such as the size of investment, debt or maturity structure, and risk tolerance, as well as portfolio-specific features.   

Third, it is worth noting that FX hedging could have greater influence on the FX market because of continuously growing outward portfolio investments. The foreign exchange authorities need to keep in mind that the practice of over-hedging for foreign bonds in the absence of clear FX hedging policies among Korean institutional investors would reduce the positive effects of a virtuous cycle in which idle foreign currency-denominated funds arising as a result of current account surpluses are channeled into portfolio investment, and that such over-hedging practice would add more imbalance and volatility to the FX market. In the meantime, institutional investors investing in overseas markets should formulate their FX hedging policies considering that the effects of FX hedging in global portfolio investments on the FX market, may differ between the spot market and the swap market depending on whether or not to hedge.   
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