Methodology brief
Introduction to hedging emerging
markets currency risk
· Hedging emerging markets' currency risk is the same conceptually as in developed markets, but is often different in practice
· These differences in practice are attributable to underdeveloped capital markets and administrative market barriers
· Monitoring currency risk is integral to assessing the merits of the hedging decision
Hedging emerging markets currencies is similar in concept to hedging developed markets currencies, but it can be different in practice. Investors hedging emerging markets currency risk need to be more explicit in tailoring their hedge by specifying conditions normally assumed in developed markets.
There is one distinguishing characteristic of emerging markets: These markets are in a capital development phase where their investment needs are higher than those of developed markets and where their domestic savings do not cover these needs. This is a result of a combination of low savings rates (private or government or both) and of domestic capital markets too underdeveloped to match the investment needs. This results in higher interest rates than in developed markets, which attracts investment to the country's domestic interest rate markets. Investors in emerging local money markets are attracted by the possibility of earning excess returns measured in their domestic currency by lending in the emerging currency's money market. This lending activity, creates long local currency positions that supplement the market for hedgers, who wish to short the currency.
This contrasts with the dynamic that exists in developed markets' currencies, where hedge providers are more likely to be investors hedging an opposing move of the currency. In $DM, for example, investors have no such persistent, longterm excess return expectation,
Since emerging markets countries wish to attract capital, they need to offer attractive rates. They can do this either by setting interest rates high enough to cover volatility of the currency or by offering lower interest rates while simultaneously trying to lower expectations for the volatility of the currency. This is done through currency policy, which specifies price levels at which the authorities will use the country's reserves to guide the price of the currency. Assuming the r1narket views the policy as credible and all else equal, the more rigid the limits, the less the volatility expectations, the lower the interest rate need be.
Notice that in setting a currency policy the authorities are trying to influence exante excess return estimates of investors in the currency. Whether the authorities have the willingness and ability to defend their limits will be factored into investors' excess exante return estimates. The more credible the policy makers, the less the required return. Authorities justify their efforts to interfere in the market by highlighting the beneficial effects that credible policy has on domestic interest rates. Policy makers may go further, placing direct or indirect controls on inflows into or outflows from their currency in attempts to further dampen volatility. These convertibility restrictions include prohibitions/ restrictions on short sales, prohibitions/limitations on borrowing in the local currency, registration requirements, capital entry/exit taxes, minimum holding periods, etc. In general, these restrictions can be circumvented, but the legal costs of doing so may be high.
Developed versus emerging markets: the basics
Developed market currency hedging decisions center around one concept: price. The hedger wishes to protect his investment from variations in the price of his investment in a foreign currency when measured in his home currency. For example, a DMbased investor with an investment in U.S. dollars wishes to protect the value of his investment in DM terms. If, during his investment, the dollar depreciates versus the DK his investment is worth less in DM terms, and he suffers losses independent of his investment decision.
To hedge against these losses, the investor can lock in the rate at which he will be able to purchase DM to repatriate his investment (either on the entire investment, or, perhaps, just on the income from the investment). He does this by buying DM in a forwardrate agreement. This forward will be priced by comparing the opportunity cost of holding shortterm deposits (Libor) in the two currencies such that the investor should be indifferent to holding either. In this example, the U.S. dollar investment, were it to be repatriated immediately to DK would purchase DM spot, invest it in DM Libor, forgoing the U.S. dollar Libor interest rate over the period of time being hedged. Thus, the stylized equation that describes this operation would be: spot FX x (1 + DM interest rate/1 + U.S. interest rate).
Notice that this investor pays the interest rate differential between the two currencies. This is the cost of his hedge. Also note that the cost of his hedge may be negative when his home currency (DM) interest rates are higher than his investment currency rates, i.e. where shortterm deposit rates are higher at home.
This basic transaction is at the heart of every currency hedging decision, whether emerging markets or developed markets. In other hedging instruments, such as swaps or options, an FX forward is focal. For example, a basic option will be struck at exactly that FX forward rate, allowing the investor to focus on the optionality of the hedging decision, i.e. the probability with which the investor believes he Will want to enter that FX forward position. Or, in the case of crosscurrency swaps, the investor does not wish to lock in the relevant interest rates, but rather, wishes to focus on the spread of the interest rates with respect to each other as each interest rate floats.
The emerging markets currency regimes
None of this is different in emerging markets. What is different is that investors act in currencies with currency regimes, which may or may not include restrictions on convertibility of the currency.
The two extremes of currency regimes can be defined as:
Fixed/pegged rate
The country explicitly fixes its currency to that of a G7 market, usually the dollar, DM or yen, or some combination of these (basket currency). A looser version allows the emerging currency to depreciate against the peg or basket at some preannounced rate. The most extreme version is a currency board, where by law the monetary base of the emerging currency is backed by the reserves of the country, such that in the case of a run on the currency, the entire monetary base can be converted to the reference currency.
Floating rate
The country allows its currency to float. Often these countries intervene in either the spot or forward market to influence the value of the currency.
The implications of each policy is clear. In fixed or pegged FX rates, historical volatility of the FX is low. Hedge providers (investors) will require an interest rate that reflects the probability of one of two scenarios occurring: (1) return if the regime holds; and (2) return if the regime doesn't hold, given some devaluation. The interest rate differential will imply some drift of the spot FX by the forward date: To the extent that this implied devaluation is higher than the trend devaluation, more of the second scenario is being priced in. Since historical volatility is low, implied volatility of options mainly represents changes to the peg. Thus, options markets typically are illiquid, since few investors are willing to write what is, in essence, regime shift insurance without the possibility of being able to hedge themselves.
In floating exchange rate regimes, spot FX volatility has a larger impact on the afterdepreciation return; accordingly, interest rates would be higher than if the same currency were fixed rate, all else equal. The forwards capture this value, reflecting this higher interest rate differential, which the hedger pays. Options allow the hedger to focus on the probability that this interest rate differential is the correct one.
Exhibits 1 and 2 show the Thai baht, which moved from being a basketpegged currency to a freely floating currency in early 1997. The currency had followed the smooth path suggested by the basket. The interest rate market began to feel the effects first, as markets began to doubt the FX policy. Policy makers, however, thought the level of interest rates punitive and added liquidity to force rates down. As the money stock increased, the reserve coverage ratio dropped, and dollar buying ensued. As reserves were depleted, the central bank finally gave up the peg and allowed the baht to float. Interest rates have remained high, both on expectations of further dollar purchases and to cover the higher FX volatility with the floating exchange rate.
What justifies an FX policy?
These two types of currency regimes highlight different stages in a country's development cycle. Fixed/pegged currencies are generally used as part of some stabilization effort, as in Argentina or Brazil. In these cases, the FX rate is used to anchor inflation expectations in that portion of the economy subject directly to foreign competition: tradeable goods. Eventually, nontradeable goods prices fall as well, as the impact of tradeable goods prices filters through the economy. In the early stages of a credible stabilization effort, the real FX rate tends to appreciate as the FX weakens less than (lagging) inflation, resulting in real appreciation of the currency. In this scenario, investors who earn high nominal rates above expost devaluation win, while hedgers who pay exante devaluations based on these high nominal rates lose. Investors will be cautious about the level of commitment to the stabilization effort (five stabilization efforts broke down in Brazil before the current effort took hold).
In the floatingrate case, policy makers are challenged with trying to influence the real level of their exchange rate, given a level of capital flows willing to enter the country at the country's current level of interest rates. For example, for much of 1996 the economies of southeast Asia and eastern Europe experienced large quantities of capital inflows. Lowering domestic rates, to dissuade this capital, was not a complete solution, given domestic economic conditions. Accumulating reserves was one option taken, but the currencies were also allowed to appreciate. While this had favorable effects on inflation, it had negative effects on the countries' external balances. Foreign borrowing by locals increased, given the prospects of an appreciating domestic currency. However, at some point, the market began to doubt the capacity of some of the countries to sustain such currency appreciation. Where interest rates were not raised to retain this capital, the FX weakened.
Policy makers also have the option to restrict capital movement as a way of influencing the level of their FX rate. Investors, naturally, require compensation for the additional costs of dealing with these restrictions, as well as compensation for the possibility of variance in the level and/ or type of the restriction. In some cases, capital entry restrictions exist, as authorities attempt to limit the effect of capital inflows on domestic variables.
Onshore or offshore hedging?
Hedgers can contract their hedge either "onshore" (the hedge provider counterparty is a local bank) or "offshore" (the hedge provider counterparty is abroad in a developed market). Three factors separate onshore from offshore contracts: convertibility, credit and legal.
Offshore contracts provide more protection: Since hard currency is guaranteed to be delivered, the hedger is left with no direct convertibility risk. Also, the credit of the counterparty is usually higher in offshore contracts since local counterparties will be constrained by the sovereign credit ceiling of the country in which they are located. Lastly, the legal environment in the offshore country tends to be more developed.
Onshore markets tend to develop in countries where free convertibility of the currency does not exist, like Brazil. Offshore markets tend to develop in countries where the domestic market is relatively underdeveloped, like China. Note that in a normal DM$ contract, these questions never arise since the relevant countries are each AAA in their highly developed domestic markets.
Offshore markets generally depend on free convertibility of the currency being hedged, since the hedge provider needs to be able to borrow in the local currency to hedge himself. This might not be true in the case of hedge providers willing to take outright positions. In practice, when the underlying market becomes unstable, the offshore market dries up (as investors are reluctant to sell hard currency), and hedgers are forced into the onshore market. To avoid sharp interest rate increases, local authorities sometimes resort to capital controls (forbidding the borrowing of local currency, among other things), which further segregates the on and offshore markets. These restrictions are designed to shortcircuit the tendency of the offshore market and onshore market to arbitrage.
To further reduce costs and tailor hedger needs, contracts can also be "deliverable" or "nondeliverable." In nondeliverable forwards, the currency purchased forward is never actually delivered; rather, a markedtomarket equivalent (either in the purchased currency if offshore or in the domestic currency if onshore) is delivered. Nondeliverable forwards offer menus of options to hedgers in the cases of "convertibility events" (when the currency becomes convertibility constrained).
Pricing is rational if not transparent
The good news is: Pricing of these instruments is rational, if not always transparent. Forwards are all priced on the theory of covered interestrate parity, and options are priced as present values of expected future cash flows. In practice, there are some twists: The riskfree rate used to price the forward and option may not be the observed riskfree rate, but rather, in the case of onshore nondeliverable forwards, an "onshore" riskfree rate. Also, the implied volatility of the option will likely not assume a normal distribution, thus precluding the use of the BlackSholes model.
Three questions are key to the hedging decision:
(1) How much of the investment should be hedged, i.e. the full notional (balance sheet) or just the profits (income)? The larger the amount hedged, the higher the cost. In emerging markets, typically only earnings are hedged.
(2) Is convertibility of the currency in doubt such that an offshore contract makes sense? Or, is hedging price movements with the intention of not repatriating the investment sufficient? The more the protection, the higher the cost.