Apr 16, 2015

Emerging Market Outlook: Are FX Forwards Still the Right Hedging Tool?

Despite the fact that the foreign exchange forward is the most widely used derivative instrument amongst corporate hedgers, some experts are now questioning the effectiveness of utilizing forwards when it comes down to hedging emerging market currencies.

In this video blog, Numerix FX expert Udi Sela discusses this issue as highlighted in the recently published Treasury Today article, “FX Forwards: the Wrong Option for EM Currencies."

Udi also elaborates on what might be most effective options strategy in today's global economic environment, and his outlook for emerging market currencies generally.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): Hi, welcome to the Numerix Video Blog your expert source for derivative trends and topics. I’m your host, Jim Jockle. Joining us today is resident trading strategist and FX expert for Numerix, Udi Sela, Udi how are you?

Udi Sela (Guest): Thank you, Jim. All well.

Jockle: Well thank you for joining us as always. As discussed in a recent story published in Treasury Today titled, “FX Forwards: the Wrong Option for EM Currencies,” though the foreign exchange forward is the most widely used derivative instrument amongst corporate hedgers, some experts are now questioning the effectiveness of utilizing forwards when it comes to hedging emerging market currencies.

So Udi, as debated in the article, is this more a case of the instrument being deployed at the wrong time, or is there a broader discussion about using FX forwards as a tool to mitigate FX exposures?

Sela: It’s a few things actually, Jim. The first thing is indeed timing. And if you take an example of Russia, let’s say you have receivables in Russian Rubles that you had to convert into dollars, had you converted them in mid-January you probably would’ve locked the highest rate ever and had locked a loss. That’s one part.

The second part is really about using forwards as opposed to not hedging at all, being exposed all the way up. Or, using derivatives such as options where you can hedge the worst case, while participating in any favorable market move.

Jockle: So in the past, we’ve talked about double-no-touch options, we’ve talked about different option type strategies. So, if forwards are not the right strategy at this point in time, what other option strategies should be considered?

 Sela: Typically, you know, the most basic hedging, and let’s say we’re talking about FX hedging or commodities hedging, is really using some kind of option. To start with a vanilla option, then you can add an element of knock-outs (barriers). So let’s stick to our Russian example. If the Ruble is now trading at 57, and you need to hedge the purchase of the US dollars, then you can buy an option which is struck at 60 or 62 Rubles for a Dollar. And then add a knock out on the downside (e.g. set at 50).

So let’s say, if the Dollar/Ruble exchange rate hits 50 Rubles for a dollar, the option would cease to exist. So basically these options are cheaper, and in the case the market goes your way, you have hedged the worst case, but eventually cover your exposure at a favorable rate. And if you want to hedge multiple cash flows, it would make sense to buy an average rate option, or what they call in other classes Asian Options. So basically you hedge at the average (predetermined) fixings. When hedging ongoing cash flows, you’re hedging cost would be lower (as opposed to a Vanilla option).  

Jockle: And so, obviously there is a lot of unrest in the marketplace right now, thinking specifically around Yemen, what other impacts can we potentially see as it relates to FX? 

Sela: Well we’ve recently seen a few economies, emerging economies, being hurt. One of the most interesting ones is Brazil, due to political unrest. So basically the Brazilian Real has weakened from levels of something like 2.30 Reals to a dollar to 3.30. Since the re-election of the existing president Dilma Rousseff, which the market did not like and the Brazilian business sector did not like either.

In a similar fashion we are seeing a weakening of the Turkish Lira, again due to political unrest and we see that now, given the different economic cycles and the growth in the US, as opposed to most other economies, emerging markets are suffering because they see less FDI (Foreign Direct Investments), and funds are being repatriated into the Western economies namely the US. That is taking a toll on those economies, and as a result of the outflows of dollars and the respective local currencies weakened dramatically.

Jockle: So, arguably we’ve been in a low-rate, low-vol environment for quite a bit at this point in time. But now the US is looking to raise interest rates probably within the next 6 months, it looks like that’s where the next market consensus is. What’s going to be the reverberation as it relates to EM currencies?

Sela: So first of all if you look at the Fed fund futures, you see that the expected rate hikes are not that dramatic. I think it’s more symbolic, so raising 25 basis points, 50 basis points, at most. I think that even after 2017 even if the Fed funds futures are predicting adequately, we will see the US rate at levels around 1% or 1.5%, so that’s not a dramatic interest rate differential.

But, in terms of funding, in terms of investing, I think that we will see more flows going into the US, equity markets, real economy. And that could really weaken those emerging economies further, in addition, great political unrest, which in return could impact Western economies, even the US economies.

Jockle: Well Udi, thank you so much for joining us and shedding light on this topic. And clearly we look forward to continue to discussing this with you again as events continue to unfold. On the Numerix Video blog it’s our goal to examine the topics that you want to talk about. Keep the conversation going on LinkedIn, and on Twitter  @nxanalytics. Check back soon for the latest industry news, blogs, videos, research and technical papers. Thank you.

 

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