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LONDON, July 8 (Reuters) - China's stock market turmoil is increasingly feeding through to its currency, driving up the cost of hedging against swings in the offshore yuan exchange rate while derivatives markets signal a bias for more weakness ahead.
With mainland share markets down 32 percent over the past four weeks, the offshore-traded yuan fell to four-month lows on Wednesday against the dollar on concern over a pick-up in capital outflows from China.
Traders also reported hectic trading in the options market as a pick-up in volatility and the stock market rout encouraged a rise in demand for yuan puts.
While volatility is low compared to other emerging markets, the implied gyrations are remarkable for a currency which is still tightly controlled by the People's Bank of China. The yuan-dollar exchange is currently allowed to fluctuate by 2 percent either side of a midpoint fixed by the bank each day.
One-month implied volatility, a gauge of expected swings in a currency that is derived from options prices, has spiked to six-week highs, this graphic shows:
Implied volatilities climb when a currency weakens and investors rush to hedge against further losses.
"The moves in the Chinese stock market are causing broader concerns.. We don't think the currency will ultimately be affected by this but some people may be getting concerned that there could be an adjustment coming," said Dominic Bunning, senior FX strategist at HSBC.
"The market is pricing a bit more potential uncertainty."
Chinese authorities have unveiled a plethora of measures to steady the equity market that has seen $3 trillion wiped off its market capitalisation since mid-June, raising fears for economic growth. But the rout has continued with the market dropping another 6 percent on Wednesday.
The slump may have brought forward the timeline of a crisis, Bank of America Merrill Lynch said in a note.
Credit Agricole analysts said markets were nervous about policy failure but that "even in the event of success a lot of foreign equity capital may choose to leave the country. This is causing strong demand for the dollar, which is expressing itself in surging dollar-yuan vols."
Traders may be adding more short bets on the yuan.
Risk reversals - a gauge of demand for options betting on a currency rising or falling - indicate a bias for dollar strength against offshore yuan, with one-month risk reversals showing the highest bias for the dollar strength since mid-April.
Reporting by Sujata Rao; Graphic by Nigel Stephenson; Editing by Mark Heinrich