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Keys to Navigating Emerging Market FX Risk

  • By Chris Weiss
  • Published: 8/29/2016
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Companies are increasingly turning to the emerging markets (EM) for business expansion. At the same time, corporate treasurers have been faced with a sustained rally in the U.S. dollar that has adversely affected corporate profitability and heightened the need for EM currency risk management. An overview of the unique characteristics of EM currencies and hedging instruments, as well as a brief analysis of China's foreign exchange (FX) market, are explored below to demystify these important topics for corporate treasury.

EM currencies are often more volatile than their G7 counterparts and their exchange rates are typically more sensitive to geopolitical and economic events. While developed market currencies such as the euro and yen react to central bank decisions and economic releases, two-way liquidity is substantial enough in these currencies to ensure that exchange rate movements are orderly and limited except in the most extreme cases such as following the recent Brexit vote. EM currencies, however, suffer from less liquidity than their G7 counterparts such that events triggering a change in sentiment on an EM currency will cause sudden and unpredictable changes in the value of the exchange rate.

Treasurers must not be misled by EM exchange rates that appear overly stable. The appearance of stability leads many treasurers to leave low-volatility EM currencies unhedged. This approach is risky since EM monetary authorities may conduct interventions and modify FX regimes with little or no advance notice. In such instances, foreign corporations will be left with uncertainty and potentially unrecoverable FX losses. It is thus preferable to hedge these low volatility currencies at least over the short term to avoid any surprises.

Hedging EM currency risk

The two main instruments used for hedging EM currency risk are forwards and options. Although many treasurers will be familiar with the features of these instruments, the EM versions of forward and option contracts may differ significantly from those for G7 currencies such as the euro and yen.

FX forwards for many EM countries are highly regulated. One may recall that FX forward contracts allow treasurers to lock in an exchange rate today for settlement of an FX transaction at a date further in the future than the spot settlement date (usually two business days). Lengthy documentation is often required, stating the purpose of the transaction and, in many cases, the executing company must be registered as a formal onshore entity in the particular country.

Consequently, parallel offshore FX forward markets have developed that allow companies to hedge their FX exposures in a transparent, customizable and timely fashion. The offshore variants of FX forwards are known as non-deliverable forwards (NDF) and differ mainly from standard forward contracts in that there is no physical exchange of currencies involved at the contract’s maturity. On the settlement date, the company will either receive from or pay to their bank or FX dealer a sum (usually in U.S. dollars) reflecting the economic value of the NDF contract. The result is that the currency sale or purchase occurs at the pre-agreed forward rate. It is important to note that although NDFs occur completely offshore and thus do not require any onshore regulatory approvals, there is no offshore spot market, and it will thus still be necessary to comply with any onshore rules and regulations to move cash into or out of a particular country.

Option contracts on EM currencies differ from those on G7 pairs in three main ways. First, options on EM currencies are limited to simple vanilla strategies such as collars and spreads except for the most liquid of EM currencies such as those of Mexico, Brazil, South Africa and Turkey. These limitations can be due to poor liquidity in options markets or to central bank regulations. Second, premiums of options to buy U.S. dollars and sell a high volatility EM currency to be too costly to be practical for most treasurers. This is due to a bias observed in EM currency option markets for U.S. dollar buying, as well as to EM currency interest rates that are often considerably higher than those for the U.S. dollar. Lastly, options for currencies with NDF markets are known as non-deliverable options (NDOs). NDOs are similar to NDFs and do not involve physical exchange of currencies on the settlement date.

Preparing for the unknown
 
In summary, EM currency hedging requires a more active approach than that used for G7 currency risk management. Poor liquidity and unforeseen changes to economic, political and regulatory landscapes in the EM space are common and often lead to exchange rate spikes and declines that may affect a corporate’s bottom line. The hedging techniques outlined here will help in structuring an effective EM currency hedging policy, but familiarity with the environments and events taking place in the different countries is of utmost importance and can help treasurers best prepare for the unknown.

Chris Weiss is Foreign Exchange Market Specialist with Bloomberg LP.

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