Emerging market currency exposure is becoming more important to investors and corporations alike. In the post-crisis world, emerging market regions have been seen as an investment alternative to the troubled G10. An environment of extremely low yields in developed markets has made the higher yields available in emerging markets more attractive – particularly as the fiscal and national debt positions of many emerging sovereigns now compare favourably to those of developed economies. With a large proportion of global economic growth contributed by emerging nations, the case for investment in emerging markets appears even more convincing.
Corporations, meanwhile, can also benefit from strong growth in emerging economies. As the developed world continues to de-lever, consumers in emerging markets are typically benefiting from rising wages at the same time that consumer credit growth accelerates. The connectivity and size of the emerging markets (EM) sector is greater than it has ever been. Devaluations of EM currencies used to have confined, local impact; now they affect investors and corporations all over the world.
But how to protect against the risk of these devaluations? They are still prone to occur, despite the increasing levels of development in the various regions. Local issues, both economic and political, still take people by surprise and damage investment in the country. Many investors and corporates maintain a mandatory policy of hedging their forex risk, no matter how expensive it may be in the long run.
And make no mistake, hedging EM currency exposures can be very expensive. A USD-based company which hedged 100 percent of its exposures with quarterly forward contracts in BRL, for example, would have paid out 150 percent of its original notional amount over the last decade. The high interest rates in BRL relative to USD meant that the forward contracts priced in devaluations that did not usually occur, leaving the company with a cost at the end of the majority of the hedge contracts. Is the remedy worse than the disease?
Fortunately this is not the only way to protect against EM currency risk. We illustrate some alternatives in this article, and show that using different hedge contracts, or intelligent hedge timing, can reduce overall hedge costs while maintaining a good level of
devaluation protection.
The choice of hedging instrument
First it is worth considering the hedge instrument. Forwards are the dominant choice, as they are treated more favourably under accounting standards, and they are simple and easy to understand. However, this simplicity does not imply that they are low risk. As the BRL case shows, they can have a severe and consistently negative impact. Let us consider a simple at-the-money call option as an alternative.
In Fig.1, we present the cashflows (including costs) that a USD-based hedger would have received if they had hedged their BRL exposure once per quarter with a three month contract. The two lines show the cumulative cashflows which would have accrued had the hedger used either a forward or an at-the-money call option. For the options, the premium has been deducted from the payout so that the total cost of the option is correctly included in the cashflow.
The difference is very striking. The ruinous cost of hedging with the forward contract is cut to one third of its value by the use of vanilla call options – but without much reduction in protection, the options provided an effective hedge in the 2008 crisis period.
This is quite remarkable. And it is not only BRL that shows this feature. In Fig.2 we have repeated the analysis for other EM pairs. Though in some cases there is not much data, overall the pattern is very clear. On average, the 3m hedge cashflow is 0.9 percent for options, and -1.4 percent for forwards, for data since 2003 in many cases.
This is not quite the end of the discussion on hedge products; for any specific combination of currencies, it might be that OTM (out of the money) options have offered good value, and the effects of correlations should not be ignored. But the information above is unambiguous enough to mean that options should be seriously considered in any discussion of EM currency hedging.
The importance of timing
The choice of instrument study implicitly assumes that hedging is continuous. However, if the hedger has strong information about the likely timing of any currency devaluation, then the choice of instrument becomes irrelevant, and obviously a forward hedge should be entered into prior to the devaluation event. How can we find the elusive Holy Grail and get real information about likely timing of devaluations?
In a sense, the IMF has done some of the job for us. They have been using, and publishing, early warning indicators for more than a decade. But their signals tend to be longer term, designed to catch crisis events far enough in advance to take effective action. We would like to know about potential crises just a few months in advance in order to guide, say, a quarterly hedging strategy. This is a completely different timescale to the less precise circa two-year warning that the IMF hopes to have in order to allow remedial action to be taken should a country's macroeconomic fundamentals deteriorate.
Many investors and corporates maintain a mandatory policy of hedging their forex risk, no matter how expensive it may be in the long run
In order to provide a shorter-term warning signal, we incorporate financial market indicators that tend to be available on a daily basis and do not suffer the longer publication lags typically encountered for economic data. A sharp deterioration in rapidly-evolving market factors, coinciding with an elevated level of risk as signalled by macroeconomic indicators, should provide a timely warning that market participants see currency depreciation as imminent. In other words, macroeconomic imbalances may persist for an extended period but market factors should help to signal when a critical point has been reached.
Including market factors has another benefit that is related to the way in which currency crises tend to differ in origin and evolution. The Asian crisis that began in 1997, for example, was clearly of a different nature to, say, earlier Latin American crises.
By including market-based factors, we increase the chances of being able to identify crises that occur for reasons other than misaligned macroeconomic fundamentals. In total, we included nine macroeconomic indicators (current account, money supply, inflation, industrial production, trade data (exports), short-term debt, non-performing loans, domestic credit, economic surprises), and four market indicators (real effective exchange rate, forex implied volatility, equity market performance, global risk sentiment). Using these factors we were able to create a risk index for each country.
In order to test the effectiveness of the warning signals provided by this method, we performed a simple back test. To account for the potentially significant carry earned by holders of EM currencies, we considered carry returns rather than simple exchange rate developments. A high reading for our early warning index is taken as a signal to remain un-invested for the subsequent two months. Fig.3 shows how risk-adjusted carry trade returns were enhanced.
Decision making
It is clear that both hedge timing and hedge instrument are important decisions. Imperfect knowledge of the future means that even warning indices like the one described above can only help with a decision, rather than give certainty. Different risk tolerances and company policies mean that there is no one single hedge strategy to fit all cases. However, the above results can be used to give guidelines, which can inform and enhance any EM hedging programme.
They may be simply stated: if risk is high, consider hedging with a forward. At intermediate risk levels, an option may be more appropriate. And when risk levels are very low, consider a lower hedge ratio, or not hedging at all. These are simple guidelines and should be more widely understood and applied than they are. The study of history can be a powerful tool to help us manage the future.
For more information: www.cbcm.commerzbank.com; email: jessica.james@commerzbank.com or jonathan.fullwood@commerzbank.com
Commerzbank won Best Liquidity Provider, in the 2013 Foreign Exchange Awards.
