The level of the Indonesian rupiah determines all things in this crucial southeast Asian market.

By Margaret Elliott

Indonesia can't boast about having the highest yields or the fastest growth rate-but don't let that distract you from its considerable charms.

The Indonesia market has recently become an intriguing variation on the emerging market derivatives theme, with a few anomalies. It boasts one of the most liquid markets for cross-currency forwards and swaps in the region, and has become the center for a variety of other derivatives plays as well.

Investors looking for high yields have been attracted to its bond market, which offers interest rates of 12 percent to 14 percent, as well as to its rising stock market. "It is the search for yield that drives the Indonesian market," says Rajiv Pandit, director of global derivatives, Asia, for BZW in Singapore. "The development of nondeliverable forwards-as has happened in other Asian derivatives markets-provides liquidity in this market."

Nondeliverable forwards are instruments that do not require the deliverance of the underlying at expiration and therefore allow foreigners who often cannot own the underlying to operate in these markets. After a relaxation last year in the trading band of the Indonesian rupiah, which is pegged to depreciate up to 6 percent a year against the U.S. dollar, investors are also seeking to take long and short positions.

As elsewhere in Asia, the government's currency policy is the pole around which the debt market derivatives circle. The Bank of Indonesia has tried to maintain an artificially weak currency in order to boost exports, but at the end of last year it announced it would end that policy. It has also demonstrated a tendency to widen the band in which the rupiah trades against the dollar. To date, the rupiah has tended to trade in the top half of the band, but in the last six months, the band has widened enough to knock out some of the binary trading ranges.

The change in the government's policy toward its currency stands to reason, says Gustiaman Deru, a director at ING Barings in Hong Kong. "Effectively, the commitment to currency depreciation against the dollar prohibits the government from pursuing a free monetary policy. Now that the economy is less sensitive on the export side and more sensitive on the import side, the high interest rate differential with the dollar is not desirable." Evidence of this shift can be seen in the drop of 250 basis points over the last year in both short- and long-term interest rates.

"If the band were to widen and ultimately disappear, and the rupiah becomes free floating-and if history is any indication-the currency should simply appreciate," says Tony Keane, head of interest rate trading at HSBC Markets in Singapore. "However, more recent developments in liquidity management suggest that this may not be the case. Indeed, as Bank Indonesia takes more control over monetary policy it is entirely feasible that the currency may remain relatively stable." One trader says investors are already putting on rupiah calls with a knockout barrier on the downside, effectively constructing a cheaper product with full upside potential. Corporates too are looking for fixed-rate swaps rather than leaving their financing open to the dollar.

New interest

As in most emerging markets, plain vanilla is the dominant flavor. The vast majority of the activity involves the use of short-term foreign exchange forwards against dollar LIBOR.

Currency swaps, however, have been used by investors as a good way to pick up yield. They've also been used by domestic and international corporates to hedge investments and cash flows. In fact, the increasing liquidity in the currency swap market has allowed investors to go further out than most areas in Asia-sometimes as far as 10 years. Any deal longer than three years, however, remains uncommon.

Because the rupiah has been trading in a constrained band, a number of collared products involving digital and barrier options have also grown up around the Indonesian rupiah swaps business, as they have around the Thai bhat and other Asian currencies. "These products," says one derivatives trader in Singapore, "allow investors to implement views on the direction of the market as well as the shape of the volatility curve."

This is a sharp reminder that Indonesia, like all emerging markets, is plagued by that least forecastable of risks-event risk. Elections are scheduled for early June, though few expect that a political change, or a more distinct shift in currency or monetary policy, will not happen until afterward. And last summer's minor riots still stick in traders' memories.

Equity derivatives are quite common, with over-the-counter deals put together by a wide range of banks for one of two reasons. "Either a customer is interested in a directional trade that reflects a point of view on an index or sector, or the customer uses equity derivatives to get over investment prohibitions and get access to the markets," explains Christian Queck, a director of ING Barings in Hong Kong. Queck sees fairly substantial deals still being done in Indonesia via equity derivatives. As investors come to trust the market more, however, he expects to see an increase in direct investment.

Credit derivatives are also available and becoming widely used. These are fairly simple deals, put together to strip out sovereign risk, to arbitrage between classes of bonds or to combine the credit risk of one country with the currency risk of another. ING's Deru points to one fashionable trade of the moment: mixing the credit of Indonesia with the Philippines peso. Customers that trade Indonesian issues in the Eurobond market often issue synthetic notes that effectively sell off the sovereign risk associated with the deal. The result is a note that gives the yield of the Indonesian Eurobond without the exposure to the default risk of the government. Another common trade involves selling an Indonesian state agency issue and buying an Indonesian corporate issue. According to Deru, the spread can be between 150 and 300 basis points, depending on the quality of the corporate issue.

It's unlikely, however, that Indonesia will fall out of favor among yield seekers any time soon. "It won't be a steady tightening of the spread between rupiah and dollar," says HSBC's Keane. "There will continue to be moments of anguish in this market."