Hedging EmergingMarket Currencies
New activity in emerging markets is making it easier to hedge currencies.
By Nilly Ostro
There's no doubt about it. This is the second coming for the emerging
markets. Double-digit returns are encouraging global asset managers to increase
their allocations, and swelling corporate revenues from improving economies
are encouraging corporations to increase their involvement in these markets.
While that's good news for local economies, it has forced investors and
corporates to focus on an old problem: how to hedge away the currency exposure
inevitable in immature and illiquid markets. The result: a new interest
in emerging markets currency derivatives.
There are signs that the currency hedging in emerging markets is approaching a new level of maturity. "In all these markets, you find rising levels
of liquidity as more and more investors are looking to take advantage of
the attractive local growth rates," says Joseph Erickson, partner in
charge of KPMG's risk strategy practice. In fact, bankers and investors
say that during the third and fourth quarters of 1996, activity levels in
emerging market currency derivatives had essentially returned to pre-1994
levels, and in some cases even surpassed them.
In several countries, longer-tenor products are beginning to emerge.
In Latin America and elsewhere, liquidity in currency derivatives begins
to dry up past 12 months, but many currencies are beginning to show signs
of extending outward. In many cases, local dollar-denominated yield curves
have already extended beyond one year. The Czech krona, for example, has
decent liquidity at five years, and a recent Argentinean peso 10-year bond
deal led to a couple of 10-year transactions.
The price of hedging instruments has also declined substantially. "There's always been demand for emerging markets currency hedges," notes Michael
Hedges, a director specializing in Latin American FX Sales at Deutsche Morgan
Grenfell. "It's just that in the past, prices have been in excess of
expectation of risk." Now, the reverse seems to be the case. One market
expert reports he has been hearing dealers complain that they are no longer
getting adequately paid for bearing the risk.
Many of the emerging markets are now moving away from attempting to control their currencies artificially, making hedging more attractive. "The
markets have rewarded this trend with tighter bid-offer spreads," says
Mario Montoya, senior vice president at BEA Associates. In some cases, the
cost of hedging is truly minimal, as in the case of the Hong Kong dollar.
Meanwhile, implied volatilities have also declined. Take Brazilian options for example: six-month volatilities on the real are around 3 percent5
percent. "That makes them attractive in both relative and absolute
terms," points out Guillaume Fonkenell, managing director at Merrill
All this activity doesn't mean emerging currency instability is behind
us. The past year, in fact, has brought all manner of volatility, even in
the notably more solid Eastern European currencies. "We've seen the
major collapse of the Bulgarian lev," notes Alex Bayer, chief economist
at Kafan Information Services in New York. And a market favorite, the Czech
krona, has come under particular pressure.
In a recent survey of emerging market investment barriers, consultancy
Ernst & Young found that financial instability and exchange controls
were causing people more trepidation than patent control or local inflation.
(see chart on previous page). Indeed, financial risk ranked right up there
with political instability as the two most significant barriers to emerging
The currency markets show signs of developing new definitions of "crash" and "correction." As the chances for a "crash" seem
more far-fetched, the overall outlook becomes more positive, "accelerating
the development of risk management products in these markets," says
Hedges at DMG. "What we're seeing is the development of more markets
and instruments," adds Paul Kaplan, vice president and chief economist
at Ibbotson Associates in Chicago. "That, in turn, is making the markets
There's an additional paradox. While many companies feel potentially
less concerned about the chances for violent currency gyrations in emerging
economies, they now have more reason to worry. As economies of developing
countries grow, they generate larger overall trade flows. As a result, companies
no longer require a 50 percent plunge in a local currency before they start
feeling real pain on their revenue side. "This is a paradox of sorts,"
says Richard Singer, senior manager at KPMG. "While companies may be
relaxing to a certain extent about the advent of low-probability events,
many of them have been selling more in those markets and hence their revenue
streams-and overall exposure-have been growing dramatically. The corporates
are still scratching their heads." As overall exposure in these markets
increases, the potential for loss increases as well.
The end result is that the nature of the currency activity in the emerging markets has irrevocably changed. Hedging is more common than speculating,
and customized, complex structures have given way to simple, straightforward
deals. "We have not seen the level of sophistication and complexity
that existed in 1993," concedes Merrill's Fonkenell. "Investors
and hedgers want simpler products and more liquid instruments." Aggressive,
complex structures are out. The demand for plain vanilla, standardized products
has led dealers to clamor for a standard documentation process (see sidebar
on page 24) for emerging market currency contracts.
While the market has gone back to basics, it has grown in breadth in
terms of the range of available plain vanilla fare. For example, as recently
as last year, forwards and options were only available in Mexico, Argentina
and Brazil. Today, some banks offer products denominated in the Ecuadorian,
Peruvian and Colombian currencies. And recently, barrier options and other
exotic fare have begun to pop up in such unlikely places as the Mexican
Options, in fact, have been hedgers' instrument of choice in Latin America. "There's even a nascent options market in Chilean pesos these day,"
says Hedges of DMG. Some investors, such as BEA's Montoya, have begun trading
Latin options as an asset class. "These options tend to be underpriced,"
says Montoya, "because they don't really price-in a lot of the devaluation
risk, and the underlying volatilities are no longer so high." While
big-size deals are out of the question, "the currency moves are sizable
enough that you don't need a billion-dollar position to make a lot of money."
BEA has always emphasized the use of options to manage currency risk, and
has traded emerging market currency options for its clients.
Although the cost of derivatives hedges has dropped and new instruments
are gaining momentum, many companies still rely on "tried and true"
operational hedging mechanisms for their large-volume, ongoing hedging needs.
These techniques involve adjustments in pricing, leading and lagging, sourcing,
intracompany loans, and local financing.
In Asia, where capital and exchange controls have made currency conversion particularly difficult, corporates are using other financial instruments
to hedge. "Inter-company loans and private placements of commercial
paper between cash-rich and cash-poor subsidiaries, through an intermediary,
are becoming quite useful," says Dan Felix, a senior manager with KPMG.
That's been particularly true in Korea, where holding companies are known
to structure private placements between two "different" yet legally
related companies to make use of excess won. "It's sometimes very easy
to get into a country and quite difficult to get out," notes Felix.
In Eastern Europe, for example, Ford recently did a zloty-denominated commercial
paper deal to help manage its local currency exposure.
|Standardizing OTC Currency Hedging
The advent of standardization is always a sign of market maturity, and
so it is in the emerging currency derivatives market. In recent months,
three groups have been involved in an intense effort to develop a standardized
legal framework for over-the-counter derivatives contracts. The customized
one-offs of the past are giving way to liquid, standardized trades. And
the pressure is on for a more efficient and effective documentation process.
For the past few months, the International Swaps and Derivatives Association (ISDA) has been working on creating a basic framework for documentation
of deliverable and nondeliverable (settled in U.S. currency) forwards and
options. The effort is a collaboration with the Emerging Market Traders
Association (EMTA) and the New York Forex Committee, a group of financial
lawyers convened under the auspices of the New York Fed.
"The EMTA has been hearing from its members about a real desire
for some standard documentation, and they approached us," says Elizabeth
Davy, general counsel of ISDA. "This is a growing market and we understand
there has been some delay in getting deals signed because of the lack of
A draft document is already being developed by the three parties' working group. Once the working group is satisfied with the draft, it will be sent
to all ISDA and EMTA members for comments. Getting feedback from groups
in Asia, Eastern Europe and Latin America will be particularly difficult-unlike
conventional contracts, currency contracts in emerging markets must provide
for alternative settlement mechanisms in the event the two parties cannot
settle in the underlying currency or determine its dollar equivalent (for
"Basically, we needed to develop 'disruption events' that allow
the parties to allocate the risk of certain events happening," explains
Davy. Although sovereign risk, general nontransferability and inconvertibility
are the most obvious issues, price source unavailability is probably a more
common concern. Another focus has been on developing standard "spot-rate"
ISDA is trying to keep as much flexibility in the document as possible
by using a menu or modular approach-parties can choose from a multitude
of ready-made legal clauses only the ones that apply to their particular
market and deal. The timing of a final version will depend largely on the
sort of comments the group will receive from its members, and if many suggest
significant changes, the process will obviously have to be extended.