Playing the Peso

The Merc's Peso is a big success with traders. But hedgers are still on the sidelines.

By J.C. Louis

Success, it seems, never comes exactly as you plan it. The Chicago Mercantile's Exchange peso contract, launched on April 25, was designed to give corporations and institutional investors a way to hedge their exposure to one of the most volatile currencies in the hemisphere.

It has become one of the most successful new contracts in years. Average daily volume has reached 1186 contracts. Open interest is just shy of 16,000, and liquidity is improving daily. Activity, however, is concentrated not among corporate currency hedgers but among speculators and commercial and investment banks that use it in a variety of Mexican interest rate plays. These days, nearly 80 percent of the volume is arbitrage-related, according to one Chicago broker who trades for a number of Mexican institutions.

The Merc launched the contract following Mexico's 1994 peso devaluation and the subsequent US-led bailout. The Mexican government, which had prohibited financial transactions on the peso since 1985, lifted them in the hopes that the contract would heighten liquidity and help stabilize the currency. When the crisis broke, Mexican rates were poised around 18 percent and rose steadily in the months after the bail-out, soaring to above 50 percent. Rates for Cetes, one-year Mexican treasury notes, currently hover around 40 to 45 percent.

Big Difference

Those high interest rates have discouraged commercial hedgers of the peso on both sides of the border. The reason: the high-cost of hedging resulting from the Mexico-US differential in real interest rates.

This is a particularly thorny problem for US companies that sell their goods in Mexico. They would receive fewer dollars for their goods and services if the peso devalued. Demanding payment in dollars, however, is politically unpopular. By using peso futures, they could protect themselves from devaluations. But the price of the futures contracts always reflects the interest-rate differential between the two currencies, and makes any hedge prohibitively expensive.

"Many players misperceive the true hedging costs by failing to focus on both the real Mexican and real US rates to correctly determine the hedging cost," says Michael Pettis of the Hamilton Arbitrage Fund. "Above a certain real interest differential, the peso future is a hedging instrument that hedgers cannot use." "Until hedging costs come down, most companies will take the risk of further devaluation, which they will offset with commensurate price increases," says another currency trader.

Consider the example of General Motors. GM ships parts from the US to its Mexican plants, which then build cars earmarked for local distribution. But these Mexican plants have a problem. Because they "buy" parts in US dollars from corporate headquarters and sell their cars in pesos on the local market, the Mexican subsidiaries take a big hit each time the peso devalues. The astronomical costs of hedging the peso have forced even this financially savvy US corporate giant to address peso devaluations with the oldest trick in the book: Price increases, as much as the market will bear. One GM staffer who works closely with the firm's Mexican auto-dealers: "We have had five increases in a row averaging 10 percent each. Prices are going higher day by day."

Big Players

With natural hedgers loathe to bear the cost of hedging- a situation typical in high-interest, high inflation markets-the action in the peso contract has fallen to speculators and arbitrageurs.

The peso contract has begun to function as the most efficient pricing mechanism for forward interest rates. Previously, Mexican forward rates were based on Corbeturas, highly taxed and regulated peso forward agreements issued by private banks. Now, however, it is possible to construct a forward curve based on the prices of peso contracts in successive months. It is also possible to lock in this rate by purchasing, say, March contracts and selling June contracts. "The Mexican peso future so far has been helping to establish the forward curve for interest rates," says one trader at Lehman Brothers. "We started doing it because the market for forward interest rates outside Mexico was shallow," echoes a Citibank trader who trades Mexican interest rates using the peso future. "The peso futures was a good alternative to a Euro-peso curve."

The most active players in the peso contract, however, are the largest Mexican banks, who use the peso contract as a way to get cheap funding. "The risk premium on international borrowing by Mexican banks has increased dramatically as a result of peso devaluations," says one futures broker. "These institutions would pay massive premiums if they went into the market to borrow dollars under their own name. Buying the peso future against long spot dollars lets them lock in dollar funding on a generic no name basis."

A trader from Banco Atlantico, one of the top five Mexican-based commercial banks, outlined a common arb he uses to offset the increased costs to Mexican institutions of borrowing dollars, which can range from 200 to 1500 points over Libor. By borrowing pesos to buy spot dollars and then selling those dollars forward with a long peso future, Mexican institutions can lock in dollar funding cost and save 300 to 400 basis points.

This arbitrage of the money markets, however, is not without its risks. "The bet is that the interest rate differential from borrowing dollars though the forward market at lower rates will not be eaten by peso devaluations," explains one currency trader. "But the devaluations could be greater than their interest rate savings."

US traders are using the peso contract for their own purposes. Some investors purchase interest-rate based Mexican securities which offer attractive rates of return, but pay out in pesos. By buying futures, speculative investors can lock in an exchange rate for when their investments mature, thus guaranteeing their profits.

The contract is also frequently used as a proxy for trading spot currency against interest rates. This is essentially a bet about whether the peso will be stronger or weaker than the real interest rate differential. "If the market's anticipating a drop in rates, but we have no good offers enabling us to buy Cetes with yields in line with the anticipated reduction, then we would look at the implied yield in the peso futures because it is sometimes slower to price in a rate change," says one Citibank trader.

Big Risk

The spectre of non-convertibility continues to hang over the contract, though it has abated somewhat since the contract's launch. In Venezuela and elsewhere, governments have responded to rampant devaluation by refusing to convert their currency into US dollars; the rationale is to prevent a "run" on the currency. "Can you imagine what would happen if there really was a loss in convertibility?" muses one Merc official. In all likelihood, he says, convertibility would be restricted solely to importers and exporters while the Merc would institute a "net settled" contract similar to a non-deliverable forward that would eliminate any peso exchange.

A Citibank currency trader in New York confirmed that the potential loss of convertibility is not being priced in the implied interest rate differential. "Convertibility risk is, of course, the dark underbelly of spectacular returns," he says. "If you think convertibility risk is considerable in the case of Mexico, then the high interest rates on the peso may actually be too low with this new risk factored in."

Most traders, however, seem to be guardedly optimistic about Mexico's future. Many hope that the Mexican economy will stabilize with domestic growth and the heightened liquidity brought about by the Merc's peso future. They note that the Mexican government, which has recently refrained from issuing debt longer than three months, is now issuing a 1-year Cetes Treasury note with perhaps longer durations to follow.

Others point out that the lack of commercial hedgers is hardly surprise in a volatile developing economy. "Financial instruments are meant to deal with the residual rather than big risks in life," concludes one currency trader. "Given the situation in Mexico, you can't expect a futures contract to offset the inflation risk, the political risk, the devaluation or the convertibility risk. To do that, companies must ask if it is worthwhile to be in Mexico in the first place."