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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 Lynch.

Trouble remains

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 markets involvement.

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 more complete."

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.

Expanding Instruments

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 peso market.

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 standard contracts."

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 nondeliverables).

"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" definitions.

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.