Hedging Strategies for Volatile Currency Markets
Volatility, volatility, volatility! What started off as a perfect year is becoming a tsunami of sorts for currency markets. Excess baggage from the sub-prime meltdown in August 2007 in the US was something that the world never expected. Initially brushed off as a US problem, the credit crisis gave the global financial fraternity more than what it had bargained for – worldwide economic chaos complemented by inflation worries. Sad to say this was a problem that many strategists paid to look out for these disasters, myself included, were unable to put a finger on, let alone accurately forecast. Currency markets from North Asia to Latin America were all hit in different manners, with ‘risk aversion’ being the catchphrase of 2008 and for the next 12 months at least.
Starting off with north Asia, where much of the world’s reserves are held, disparaging performance for the top four currencies is noted. The yuan and new Taiwan dollar were the darlings of the market, reflecting a very strong appreciation mode in the early part of 2008 but soon faltering under the weight of risk aversion, inflation and slowing growth. The HKD, pegged tightly within a 7.75/7.85 range to the dollar, was forced to give in to the dictates of the US economic performance and monetary policy, while at the same time incurring problems of its own vis-à-vis higher inflation. The won fared the worst of the lot, enticing offshore flows in the beginning and forcing aggressive intervention by authorities to keep a lid on FX appreciation, then risking the danger of repeating the embarrassment experienced a decade ago, when foreign investors gave the currency a run for its money, resulting in an IMF bailout.
All four currencies did much damage to speculators, but what about corporates? They felt the heat too, first with getting on the wrong side of the equation through pricing in appreciation in the beginning, and then having to pay off a massive premium just to keep their views intact and their accounts in order. When currencies moved to the other end of the spectrum mid-year, hedging costs doubled. For the won, the dollar shortage in the onshore market and risk of local debt unwinding further exacerbated the negative sentiment. In a nutshell, north Asia is currently reeling under pressure, with Beijing having to tactfully shift its monetary policy towards keeping growth intact while, for the rest of the group, managing currency expectations is becoming a rather arduous full-time job for policy makers, whereby a slip would mean missing inflation and growth targets by a mile.
South Asia took off in a similar vein to their northern counterparts but faltered by mid-Q2 under the weight of slowing growth, inflation and risk aversion play. Policy makers were at crossroads during that period, having to juggle between keeping growth intact or capping inflation. While the results of that will only be known by year-end, Malaysia stood out as one of the countries having a more aggressive pro-growth policy, while the rest moved to a certain degree in lock step with tightening monetary policy. The knock-on effect was mixed as well from the perspective of capital inflows. High yielders India and the Philippines had a disastrous nine months; outflows weighing heavily on the currencies as reserves were dwindling due to intervention, while the rupiah was held in an iron-grip manner by Bank of Indonesia, thus managing to limit the downside to its currency while attracting inflows. Thailand, on the other hand, was rather late in raising rates but, given the domestic political uncertainty, did marginally well in that sense – flows were coming into the debt market in a tepid manner. Fraternal twins Singapore and Malaysia reeled under inflation; crude oil prices had a very big impact on the currencies’ performance and Malaysia was forced to reduce its state-driven subsidy for crude. As global crude prices stabilise, it is gradually increasing those subsidies again.
Figure 2
Much of what has happened, and will happen in the next 12 months, hinges on the dollar itself. Asia has yet to unshackle itself fully from export-oriented polices. Lessons from the 97/98 crisis are still fresh in our minds, but from now onwards what is vital is how Asia assimilates with the new US economic order, post regulatory and policy changes pertaining to managing risk and cleaning up of toxic debt from balance sheets of US financials institutions. We note volatility will still be at the forefront and some of the gauges in FX markets will be closely watched. Gone are the days of traders sniffing out an arbitrage play a mile away; instead, making sure that the arbitrage play is sustained without having to succumb to herd instinct will be top priority. For the dollar itself, the face of the crisis has evolved: sub-prime problems, risk aversion, money-market squeeze, bailouts and now a fiscal dilemma. The implications are grave. Whether the fiscal dilemma will be the final stage of this crisis is yet to be known, but what we are aware of is the fact that the dollar is facing a structural decline. Much of the short-term appreciation has been a flash in the pan story. We have had some 10-20 big figure moves in the August/September 2008 period, but with volatility accompanying those very moves, corporates have been hit hard.
Figure 3
Taking a closer look at hedging patterns of Malaysian corporates this year, two key factors played a big role. One was expectations of the direction of the ringgit and the other, the forward curve, the latter being decided by interest rate differentials between Malaysia and the US. With spreads in favour of the ringgit, currency gains picked up momentum in Q1 08 as the forward curve was partly driven by high expectation of the Fed continuing to ease interest rates and Bank Negara being in hawkish mode. This, however, dissipated by the end of Q2 because of a conflux of factors, including a lethargic ringgit affected by local political limbo, and the Fed and Bank Negara’s inclination to keep rates steady. The Fed changed tact during the 18 March Federal Open Market Committee (FOMC) meeting, from signalling downside risk to growth; at the 30 April meeting, it omitted its assessment and moved a notch closer towards a hawkish stance when its policy highlighted the inflation risk. Bank Negara, on the other hand, hesitated to raise rates, preferring instead not to rock the boat with higher rates, given the expected spillover effects of the global credit crisis. By the end of Q2, the US dollar/ringgit forward curve was already reflecting a tendency to remain neutral. Implied USD/MYR across the curve stayed flat, increasing the uncertainty for corporates when it came to the big question – to hedge or not to hedge?
As Q3 progressed, political uncertainties intensified and Bank Negara firmed up its view of maintaining rates, with much of the movement in ringgit firmly embroiled within the dollar saga. Risk aversion and unwinding of risky emerging market arbitrage plays were the cornerstones of FX direction. At times, the ringgit was held hostage to the international drama while, on the other hand, intervention by the local monetary authority did the trick in keeping the currency from weakening excessively. In both cases, corporates were facing a very difficult situation caused by the lack of direction, high cost of maintaining previous hedges (given the fact the ringgit had moved from an appreciation to depreciation pole), and drying up of liquidity (lack of offshore inflows into underlying instruments).
Dissecting the type of hedges that corporates did in the past nine months provides a useful indication in gauging how the next 12 months will pan out. The first three months of the year was an exporters’ market. The ringgit’s appreciation story was the best in town. Most exporters jumped onto the long-term hedging bandwagon to maximise their hedges while importers stood still and had let the natural hedge to do all the talking. The ringgit was in a premium market with implied volatility hovering around 4-5%. Outright forwards were the way to go for risk-averse clients and for those in the less aggressive camp, target redemption notes (TARNs) were a slightly exotic feature catered to those with the inclination to take up a little more risk. Those with a large risk appetite took serious bets on the directional patterns of the currency through highly leveraged knock-on forwards.
During the April-July period, the signs were creeping in. The ringgit’s appreciation mode was slowing and by mid-May, the swing to the other way was already gaining momentum. Yet, exporters were on a roll, with the ringgit in a premium market and volatility fetching around 4-5%; hedging activity by exporters continued, thinking the 3.1280 tested on 23 April would have further potential to break out towards 3.10 level, and not hedging could pose serious FX risk on their books. By this time, importers were becoming a cautious lot. At the close of the first week of May when the ringgit ended the session at 3.1680, someserious reflection was underway. Flows were moving out of underlying assets, political risk was becoming a headwind for ringgit appreciation and intervention by the central bank to stabilise the currency was becoming a daily affair. From June onwards, the wait-and-see attitude was moving towards executable trades by importers. Directional trend on the currency was becoming pronounced and panic had already set in. Importers were using both plain vanilla forwards and TARNs to hedge against the weakening currency. This time around, exporters were letting the market do the talking.
Thinking it was going to be a rather smooth ride on a weakening path, importers were hedging but the hedges were not aggressive in nature. All this changed in August – the whipsaw effect that hit the global market thanks to risk-aversion trades, tightening of dollar liquidity in money markets and a collapsing US financial system spooked the local FX market. There was a rush to cover and importers were beginning to bleed. Initial hedges against a mild depreciation were not enough. With the pace further weakening, hedges were becoming costlier and structures taken up were more aggressive as well. TARNs, cancelable forwards and knock-out forwards were sought after, and with implied volatility at the short end of the curve spiking up to almost 8-10%, it was not the time to hold back on hedging costs. Intervention to slow the pace was intense. Yet the pressure on the currency remained. As of early September, importers were still on an aggressive hedging mode. A collapse towards 3.5000 was speculated and what could further exacerbate the hedging pace is the possibility of the currency weakening past 3.5000, a level that will set importers scrambling and further elevating implied volatility in the short end of the curve. Bottom-line hedges will become costlier and the cost of intervening will increase to stem this weakening phase. In the meantime, as the ringgit is held hostage to domestic and international cycles, exporters are having a field day.
