Emerging Markets: Hedging FX Risk
Contemporary issues including the merits of outsourcing, trade deficits and artificially suppressed exchange rates associated with countries like China and India, have captured immense attention in economic and political circles. Traditional financial risk, on the other hand, including interest rate and foreign exchange (FX) risk, have received comparatively limited coverage.
As multinationals continue to take advantage of linkages with emerging market economies vis-à-vis global supply chains, direct investment or portfolio capital, they are increasingly exposed to foreign exchange risk that typically is not adequately handled in the same manner as with major currencies such as the U.S. Dollar or the Euro.
On a broad level, emerging market currencies fall into one of three baskets contributing to the underlying risk profile:
Quintessential examples of the aforementioned are the Brazilian Real, the Korean Won and the Chinese Renminbi. In the case of the Brazilian Real, fairly fluid spot trading exists on a daily basis but without the opportunity to utilize the forward or option market to hedge future currency risk. On the Korean front, the market is subject to limitations imposed by the government in an attempt to moderate appreciation pressure on the Won. China, in a somewhat similar fashion as Korea, has historically elected to prevent exchange rate speculation and revaluation of the fixed U.S. Dollar peg by controlling the availability to offshore entities.
Emerging market FX risk represents an essential dimension in the overall well-being of multinationals, especially in view of the growth in this segment. At the close of 2003, real GDP for China and India increased by approximately 10%. In addition, similar to other countries in this sector, both China and India exhibit favorable current account balances and possess substantial levels of foreign reserves. China, in particular, is a conduit for financing deficits in the United States and elsewhere via their willingness to hold U.S. Dollars.
Although foreign exchange exposures in major economies can be addressed using mainstream risk management instruments and techniques, the same is not necessarily the case with emerging markets. In particular, exotic currencies have unique characteristics which often impede “orthodox” approaches to controlling FX risk.
Emerging market economies and their currencies are commonly afflicted with low levels of transaction activity, dramatic fluctuations (typically a depreciating trend), central bank restrictions and less developed financial markets in general. All of the aforementioned factors ultimately create conditions of elevated risk. Fortunately, there are hedging tools and methods that treasury can employ to mitigate exotic FX exposure.
The principal derivative of choice in this arena is Non-Deliverable Forwards (NDF). The NDF is considered a synthetic instrument in that it is a “cash settled” contract in a major base currency, i.e. USD, EUR etc. It is used as a proxy hedge in a situation in which an exotic currency is not actively traded in the forward market. Primary examples of these currencies include Korean Won (KRW), Brazilian Real (BRL), Philippine Peso (PHP), Chilean Peso (CHL), Taiwan Dollars (TWD), Chinese Renminbi (CNY) and Indian Rupee (INR).
On settlement, as NDF contracts are “cash settled”, there is no actual exchange of the underlying currencies. Settlement simply reflects the difference between the pre-agreed NDF rate and the existing spot rate at time of fixing. This difference should approximately offset what occurred over the same time with respect to the underlying exotic currency relative to the base currency.
In addition to NDF and similar to basic, “plain-vanilla” option contracts, exotic FX risk can be addressed utilizing a Non-Deliverable Option contract (NDO). The NDO extends to the buyer the right, but not the obligation, to buy via a “call option” or sell via a “put option” a set amount of foreign currency at a specified rate, or “strike price”, on a predetermined future date. Fundamentally, the NDO serves as an insurance policy against undesirable market trends. The significant difference between an NDF and an NDO is that the NDO gives the user the right, but not the obligation, to buy or sell a prearranged amount of foreign currency at a specified rate on a predetermined future date.
It is important to be aware that by avoiding taking adequate measures to address FX related risk, organizations are actually introducing greater elements of financial uncertainty. Considering that emerging market FX risk is becoming all the more common within international enterprises, this is now more relevant to more businesses than ever before. Non-Deliverable Forwards can be structured with durations similar to regular forwards, i.e. up to two year maturity. An NDF specifies a predetermined notional amount without any actual exchange of the exotic currency occurring. Essentially, NDFs establish a “fixing” and “settlement” date at time of placement. The fixing date is the day and time when the difference between the prevailing spot and NDF rate is determined in order settle the contract. Settlement usually occurs one to two business days after the fixing date.