| The Mexican meltdown in December 1994 was a major disaster for foreign companies and fund managers with investments in the country, and a strong reminder of the investment risks of emerging markets. But increased risk awareness, paradoxically, did not help the nascent derivatives market that had been flourishing in Mexico for a few years before the peso devaluation. Rather, it went backwards, dragging down the derivatives markets of other emerging markets in the process. In the aftermath of the devaluation, panicky investors fled to safer havens as volatility increased and liquidity dried up in the underlying stocks of these markets. In the year and a half since then, improved fundamentals in Mexico and the other emerging markets have lured them back. Not only is there is a renewal of interest in the equity and fixed-income instruments in these markets, derivatives are also making a comeback. Having learnt from the havoc that derivatives caused – not only in Mexico but in more developed markets – investors are now considerably wiser and more cautious, and it has become much harder for margin-hungry banks to make their pitch to sell these profitable products. From Chile to Singapore, 90% of derivatives markets are still in the hands of banks which structure products for their clients. There have been some attempts by exchanges in the US and in the individual countries to launch listed derivatives: for example, the recent listing by the Chicago Mercantile Exchange of Brady bond futures and option index contracts, and its plan to list the popular IPC index of the Mexican Stock Exchange. But, by and large, these efforts have not yet taken off. The exception is the Bolsa de Mercadorias e Futuros (BMF) in Brazil, which is the world’s third most liquid futures exchange and often trades up to 30,000 contracts a day. Over-the-counter products have obvious advantages to buyers since they enable them to tailor the amounts and dates of derivatives products to their contracts. Bankers say that because of this, exchange-traded derivatives do not compete with the products they offer but often complement them. “We cater for customers hedging their exposure or asset allocation in a particular country or region,” says Richard Royden, managing director of global derivatives at James Capel in New York. The most commonly used products in the emerging markets include Brady bond options, structured notes, total-return swaps, warrants, equity-linked notes, as well as more complex instruments such as cross-currency interest rate swaps, convertibility options and cashflow currency hedging. Perhaps because they are in the business of financial risk, the end-users of these products are predominantly sovereign entities and US, European, Asian and Latin American financial institutions, investment funds and hedge funds that feel more comfortable with derivatives than do corporate treasuries. But companies in the emerging markets are slowly but surely joining the game. “Most of the CFOs and treasurers of these companies have been educated in the US and they definitely have the technical skills to understand these products,” says Eric Van Laer, vice-president and head of equity derivatives marketing for Crédit Lyonnais in New York. “But they don’t have as much experience as the treasurer of a company in the US who has been using these products for the past 10 years.” Protection instead of exposure True, the level of sophistication of the local treasuries varies from country to country and, in many cases, it just boils down to specific companies. But, in particular, those local companies that have liabilities and profits in more than one currency, as well as multi-national corporations establishing operations in the region, are increasingly participating in the derivatives market. The reasons for buying derivatives have changed. Because of the Mexican peso crisis and the number of derivatives failures since 1994, which caused chaos among some Asian companies and brought about a spate of lawsuits against banks, most investors now using derivatives in the emerging markets are seeking protection rather than exposure. “Whereas before investors were more willing to take a position, whether it was on the yield curve or in the currency, now the trend has shifted, not only because of some of the issues that surfaced in those local markets, but also because of the noise in the background in the US,” argues Elizabeth Stanners, vice-president and manager of the financial engineering risk department at the Bank of America in San Francisco. Not surprisingly, going with the flow, bankers in Asia and Latin America have changed their marketing strategies and now stress the risk-management benefits of derivatives rather than their ability to generate high returns. “You see a lot of people selling calls against portfolios or using option spreads to hedge positions by buying puts and selling calls,” says Henry Urquidi, vice-president of Lehman Brothers in Miami. “Before the devaluation, people in Latin America used derivatives a lot for plain leverage since they had a lot of money to play with, but that money is no longer there so when they use derivatives it’s much more for hedging purposes.” In other cases, using a derivative can make a transaction more efficient and lower the costs, which in the emerging markets tend to be quite high, argues Varun Gosain, head of fixed-income trading in emerging markets at Banque Paribas in New York. For an investor wanting to take a position in a specific emerging market, buying a derivative often has clear advantages over buying the underlying asset, say the experts. Equity swaps, for example, are usually a cheaper way to invest than buying or selling the physical stocks directly. Dealers may have access to natural counterparties and investors save on settlement costs, stamp taxes and other local-market transaction costs. Or consider the advantages of buying a Brady bond option over a Brady bond, says Andrew Kellerman, vice-president and chief options dealer for emerging markets derivatives at Bank of Boston. “On a vanilla instrument, you buy the bond 80 cents on the dollar and a 90-day call option for two points. So you give away two points on the upside but you have only two points of downside. Simply speaking, that’s what a derivative should offer you,” argues Kellerman. One area perhaps most overlooked has been the use of derivative products to increase the availability and reduce the cost of capital for borrowing in these markets. For this purpose, the experts say that currency swaps are the product of choice for lowering borrowing costs. It is estimated, for instance, that Latin American borrowers last year alone swapped about 40% of their non-dollar debt into another currency, which enabled them to reduce funding costs without taking incremental currency exposure. In terms of regional focus, while in Latin America the Brady bond option market has flourished, Asian markets typically make more use of equity derivatives and shorter-term instruments. Since the various governments in Asia tend to have better credit and not as much debt outstanding, that market is not as liquid and the yields are therefore not as attractive. In addition, Asian derivative users have some common features. Most currencies in the region have some strong links with the US dollar. The Hong Kong dollar is pegged directly to the US dollar, while the value of the Thai baht is calculated according to a basket of currencies of which the dollar makes up about 75%. The fact that the US dollar is the base currency for most Asian corporates means that most of the derivatives transactions entered into by Asian companies are dollar-related. On the other hand, with exports growing, currency swaps and forwards are becoming increasingly widespread. Most trade-related deals tend to be plain-vanilla swaps or forwards that allow companies to swap their currencies into dollars or Deutschmarks. In general, emerging market experts say the derivatives designed for these markets are much like those used in more developed markets, with added special characteristics that can help investors weather the inherent on-the-ground risks. These include limited local financing at certain maturities, restrictions on foreign investment and repatriation of corporate profits, and the possibility that the deal may not be completed because of regulatory changes or some political or economic upheaval. This added risk is usually factored into the pricing. “One of the main issues with our emerging market clients is that we have an exposure both to the counterparty and the country,” says Reza Ali, vice-president of emerging markets derivatives at UBS Securities in New York. “So a lot of the dealers on the Street take this into account when they price any sort of derivative.” For the most part, however, every bank has its own proprietary model that allows it to price the different products in a fairly efficient manner, although, says Yves Leysen, head of derivatives marketing for the Americas at CSFP Capital in New York, in the emerging markets every transaction is different and has its own set of risk and credit characteristics that come into play when calculating the price. Spreading the risk Although the price of derivatives has come down quite a bit, their cost remains a major disincentive for many companies. In very illiquid currencies, for instance, interest rate spreads – from which forward rates are calculated – can reach 10% on either side of the central rate. Of course, from the banks’ perspective, this is a fair price since there are few alternative counterparties onto which a bank can lay off risk if a contract is unwound early. Some resort to exchange-traded products to hedge the exposure arising from the over-the-counter positions, but the frequent lack of liquidity in these markets means that this is not always a possibility. In other cases, the financial institutions will ask for some sort of guarantee, which could be in the form of collateral, some margin calls or a cash settlement. “It really depends on the strategy of the bank and how much risk it is willing to take,” says Crédit Lyonnais’ Van Laer. On the other hand, requiring too many guarantees from a prospective client may scare away the business. “If you go to a Latin American customer and you tell him he’s got to put up collateral because you can’t live with the risk, that’s not an extremely popular way of doing business,” says Van Laer. “You’ve also got to consider that the majority of investors are in these markets for the yield,” says Wesley Davis, vice-president of emerging markets derivatives at Chase Manhattan in New York. “So they wouldn’t be in them if they didn’t recognize the risks.” Be that as it may, although everybody agrees that risk comes with the territory, the problems with derivatives along the way have in many instances made banks a lot more careful about who they do business with. In fact, a movement towards collaterized transactions is slowly growing, points out UBS’s Ali. So far the wide spreads that are common with emerging markets derivatives, especially in Latin America, have made the business extremely lucrative for financial institutions. Should the market grow and the increased liquidity force spreads down, some wonder whether it would cease to be as profitable for the players in this market. But the banks are not fretting. “I think we would rather see increased volumes with tighter spreads than very little volume with big spreads,” says Lehman’s Urquidi. And if the volume of business were to grow, there would be additional benefits for both the banks and their clients. “It would cost you much less to get out of a position,” says Bank of Boston’s Kellerman. One of the factors that has until now constrained the growth of the derivatives markets in the developing economies has been the rules and regulations that are often established locally by central banks and exchanges. In fact, many countries keep a strict control on the purchase and sale of currency-related products in order to prevent capital flows from causing inflation. Korean companies, for example, must submit relevant trade documents to the ministry of finance before being allowed to enter into swaps over $3 million. The Latin American markets, on the other hand, have not placed too many limitations on the trading of these products – with the exception of Brazil, where last August the local authorities decided to prohibit the trading of equity derivatives by foreigners since this was causing inflationary pressures in a high interest rate environment. Despite these restrictions, most market participants agree that derivatives will continue to grow as these markets become more stable and mature. Although the learning curve has been rocky and steep, it seems now that corporates in the emerging markets have learnt the harsh lesson that you need to understand the risks before doing derivatives. Emerging market specialists argue that in the longer term derivatives are certain to become a vital component of corporate finance in the developing economies. As their export business grows, the use of currency options will surely increase among companies looking for more flexible ways of hedging currency risks, while the use of put options on bonds will offer them the chance of lowering borrowing costs. In the end the success and safety of these transactions will largely depend on the existence of adequate controls from local regulators and the internal safeguards of companies and financial institutions. |
