During the past year, the Mexican peso has exhibited an atypical upward resilience relative to the US dollar. Against the backdrop of overall dollar strength compared to euro, Japanese yen and British pound, the peso’s performance is all the more impressive. Whether this is an anomaly or a more enduring trend going forth is up for debate and should be taken with a pinch of salt considering the notorious difficulty even the most astute have in predicting future currency movements. Furthermore, corporate treasuries are commonly not structured to bear the consequences of predictions that fail to materialize.
In the decade since the peso crisis of the mid 1990s, the peso has depreciated approximately 53 per cent in nominal terms (with highs and lows ranging from 7.5 to 11.5). While the tendency of the peso to chronically lose ground over time is not a revelation, something interesting becomes apparent when analyzing intra-decade movements similar to the present. A cursory review of a historical peso graph from 1996 provides several poignant insights:
- While the overall peso decline is irrefutable, within the decade there were an equal number of years in which the peso either remained neutral or appreciated compared to the dollar (most notably 1999 to 2002 and again in 2004 to 2005).
- In a minority number of years when the peso has depreciated, the decline has been moderately severe and fairly rapid (approximately 20 per cent to 25 per cent over 1998 and 2002 periods respectively).
- In the majority of years, the peso forward discount points in the over-the counter (OTC) interbank market would have exceeded the actual underlying peso depreciation that occurred.
Considering the aforementioned, one natural conclusion for treasury is to sufficiently weigh the prevailing discount points incorporated into foreign exchange (FX) derivative pricing against the likelihood of a corresponding adverse peso movement. Appreciating that most treasuries are not engaged in the active practice of ‘timing the market’, it is this dimension that is at the nexus of deciding to hedge part or all of a peso-denominated exposure. To consider hedging to be without any merit would be as imprudent as blindly accepting a currency prediction as absolute.
Consider the following example. A corporation is evaluating multiple scenarios to address an ongoing peso liability, e.g. forecasted cash flow exposure related to funding a Mexican domiciled subsidiary. Under the terms of their foreign exchange policy framework, treasury is afforded the latitude to hedge a minimum of 50 per cent but not greater than 100 per cent. Treasury additionally possesses the discretion to utilize forward contracts, plain vanilla options and certain basic option structures. Possible alternatives include:
- Purchase a peso forward contract providing the right (and obligation) to acquire peso in the vicinity of 11.00 to 11.10 for relevant dates in the future. The difference in rates relative to the spot is reflective of anticipated future depreciation to offset interest rates between the US and Mexico.
- Purchase a peso vanilla call option providing right but not obligation to acquire peso. Treasury advances requisite premium for the option. They retain the ability to participate to fullest extent should the peso strengthen and are also protected against adverse movements beyond exercise price of contract. Frequently, the strike price is structured to parallel prevailing forward rates.
- Purchase a zero-premium ‘range forward’ establishing a best and worst case scenario. Hedging a peso denominated exposure with a range forward requires the hedger to simultaneously buy a peso call and sell a put option. Currency amounts and maturity dates for both options are usually the same and both strikes are set ‘out-of-the-money’. Convention refers to the difference between the two strikes as the exposed range with the midway point between the strikes at or near the forward.
These scenarios offer different ‘risk-reward’ characteristics that warrant stringent evaluation and will certainly not be effective in all situations. Nonetheless, all alternatives may have provided inherent advantages in this past year in which the peso has actually appreciated. As opposed to purchasing foreign exchange via the spot market on an ad-hoc basis, utilizing a ‘take the points’ approach with certain derivatives would have allowed the firm to:
- Enhance pricing by capitalizing on forward points and via exposure aggregation.
- Improve predictability of forecasted cash flows by proactively addressing risk.
- Establish parameters providing upside opportunity while limiting adverse volatility.