EM currencies: are options the way forward?
Recent currency movements have highlighted the limitations of the forward as a hedging option for emerging market (EM) currencies.
The forward is the most widely used derivative instrument amongst corporate hedgers. It is a useful tool for corporations that don’t have a hedging budget or an available credit line to be used for selling options, but want to mitigate exposures at a given moment.
For other users, though, Numerix client solutions group vice-president Udi Sela argues the merits of options.
“The ability to be able to sell options is important when hedging emerging-markets exposures as implied volatilities can be extremely high during times of crisis,” he says. “For example, USD/RUB 3M implied volatility hovered around 60% during the second week of January 2015, but is currently at 22.5%.”
The obvious limitation of a forward is that the hedger locks the rate and might not benefit from favourable market moves while being hedged.
On January 15, USD/RUB traded at 65 roubles to one US dollar, observes Sela.
“Say we needed to hedge a long rouble exposure and convert these roubles into dollars in one year’s time,” he says. “The one-year forward rate was just over 76.25, which would have meant locking a forward rate at the all-time highest level.
“Buying an option would have provided protection against a worst-case scenario while benefiting from a favourable market move – these currencies now trade below 50 roubles to one dollar.”
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EM currencies tend to be more volatile and hence the risk of locking an expensive hedging rate could be higher. However, Sela also points out that the extraordinary conditions of the global economy – weak demand, quantitative easing, deflation risks, the removal of the Swiss franc band – have produced currency swings across G7 economies, meaning that forward hedges for other currency pairs might also have become ‘painful’.
Depending on the direction of exposure, forwards have always been a difficult tool to use in hedging EMs, primarily because of the expected depreciation driven by interest-rate or inflation-rate differentials, says Amol Dhargalkar, who heads up the corporates team at Chatham Financial.
“It can be difficult for a firm to gain comfort with significant depreciation over short time periods, though the last year or so has shown just how dramatic currency rate movements can be even in developed markets,” says Dhargalkar.
The limitation of forwards stems from their pricing relative to the current spot rate, he says, adding: “In some cases, firms may have to underwrite a hit of 10% or more on the underlying exposure, leading many to trade-off cost of hedging for increased risk.”
Peter-John Theuninck, currency analyst at Baydonhill, accepts that the restriction on pricing associated with the instrument makes the deployment of a forward contract a challenge.
“Securing the price allows the buyer of the instrument to fix their costs, but it also means that they lose the ability to reduce their costs through favourable market movements,” he says.
Central bank and regulatory limitations prevent certain currencies from being hedged through a vanilla deliverable forward contract. Non-deliverable forward (NDF) contracts can be purchased for those needing to hedge risk against exotic currencies, but using such an instrument adds to the complexity of physically remitting the funds to the receiving party.
However, this does not mean the forward’s days are numbered. While FX options have gained in popularity, the simplicity in pricing and the accounting clarity provided by forward contracts means they will continue to be widely used in the market, says Theuninck.
Currency exchange restrictions in some EM countries prohibit the use of a deliverable forward contract, but in most cases the FX market has adapted and offers the use of NDF contracts, explains Robert Celata, executive vice-president PNC Bank.
“These non-deliverable contracts require a cash gain or loss settlement [typically in US dollars] at maturity rather than the delivery and receipt of the underlying currency pair,” he says. “The non-deliverable forward is an appropriate risk-management tool for emerging-market currencies.”
As with all hedge instruments, there might be restrictions or limitations due to the size or the tenor of the hedge, says Celata, adding: “There may be external issues such as liquidity or volatility that impact execution.
“There may also be counterparty risk issues [the credit quality of the counterparty] that impact the ability or desire to hedge.”
Companies do not necessarily hedge EM currencies, as there is often not a developed FX market, concludes Treasury Alliance Group partner Daniel Blumen.
“The risk they have is sovereign or strategic if they are investing in an emerging market,” he says. “If there are local operations with both sales/payments, the currency risk is naturally hedged.”