31 May morning study

CURRENCY MANAGEMENT FOR EMERGING MARKET CURRENCIES

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/section/currency-management-for-emerging-market-currencies-1

Learning Outcome

• discuss challenges for managing emerging market currency exposures

Most of the material in this reading has focused on what might be described as the major currencies, such as the EUR, GBP, or JPY.

This focus is not a coincidence: The vast majority of daily flow in global FX markets is accounted for by the top half dozen currencies.

Moreover, the vast majority of investable assets globally, as measured by market capitalization, are denominated in the major currencies.

Nonetheless, more investors are looking at emerging markets, as well as “frontier markets,” for potential investment opportunities. And many developing economies are beginning to emerge as major forces in the global economy. In the following sections, we survey the challenges for currency management and the use of non-deliverable forwards as one tool to address them.

Special Considerations in Managing Emerging Market Currency Exposures

Managing emerging market currency exposure involves unique challenges. Perhaps the two most important considerations are

(1) higher trading costs than the major currencies under “normal” market conditions, and

(2) the increased likelihood of extreme market events and severe illiquidity under stressed market conditions.

Many emerging market currencies are thinly traded, causing higher transaction costs (bid–offer spreads).

There may also be fewer derivatives products to choose from, especially exchange-traded products.

Although many global investment banks will quote spot rates and OTC derivatives for almost any conceivable currency pair, many of these are often seen as “specialty” products and often come with relatively high mark-ups.

This mark-up increases trading and hedging costs. (In addition, the underlying foreign-currency asset in emerging markets can be illiquid and lack the full array of derivatives products.)

These higher currency trading costs would especially be the case for “crosses” in these currency pairs.

For example, there is no reason why an investor in Chile (which uses the Chilean peso, currency code CLP) could not have an investment in assets denominated in the Thai baht (THB).

But the CLP/THB cross is likely to be very thinly traded; there simply are not enough trade or capital flows between these two countries.

Typically, any trade between these two currencies would go through a major intermediary currency, usually the USD. Hence, the trade would be broken into two legs: a trade in the CLP/USD pair and another in the THB/USD pair. These trades might go through different traders or trading desks at the same bank; or perhaps one leg of the trade would be done at one bank and the other leg through a different bank. There may also be time zone issues affecting liquidity; one leg of the trade may be relatively liquid at the same time as the other leg of the trade may be more thinly traded. The reason is because liquidity in most emerging market currencies is typically deepest in their domestic time zones. In any event, there are two bid–offer spreads—one for each leg of the trade—to be covered. This is often the case for many of the cross-rate currency pairs among developed market currencies as well. However, the bid–offer spreads are usually tighter for major currency pairs.

The liquidity issue is especially important when trades in these less-liquid currencies get “crowded,” for example, through an excessive build-up of carry trades or through a fad-like popularity among investors for investing in a particular region or trading theme. Trades can be much easier to gradually enter into than to quickly exit, particularly under stressed market conditions. For example, after a long period of slow build-up, carry trades into these currencies can occasionally be subject to panicked unwinds as market conditions suddenly turn. This situation typically causes market liquidity to evaporate and leaves traders locked into positions that continue to accumulate losses.

The investment return probability distributions for currency (and other) trades subject to such relatively frequent extreme events have fatter tails than the normal distribution as well as a pronounced negative skew. Risk measurement and control tools (such as value at risk, or VaR) that depend on normal distributions can be misleading under these circumstances and greatly understate the risks the portfolio is actually exposed to. Many investment performance measures are also based on the normal distribution. Historical investment performance measured by such indexes as the Sharpe ratio can look very attractive during times of relative tranquility; but this seeming outperformance can disappear into deep losses faster than most investors can react (investors typically do a poor job of timing crises). As mentioned in the prior section on volatility trading, price volatility in financial markets is very cyclical and implied volatility can be subject to sharp spikes. These volatility spikes can severely affect both option prices and hedging strategies based on options. Even if the initial option protection is in place, it will eventually have to be rolled as options expire—but then at much higher prices for the option buyer.

The occurrence of currency crises can also affect hedging strategies based on forward contracts. Recall that hedging a long exposure to a foreign currency typically involves selling the foreign currency forward. However, when currencies are under severe downward pressure, central banks often react by hiking the policy rate to support the domestic currency. But recall that the higher interest rates go in a country, then, all else equal, the deeper the forward discount for its currency (enforced by the arbitrage conditions of covered interest rate parity). Having to sell the currency forward at increasingly deep discounts will cause losses through negative roll yield and undermine the cost effectiveness of the hedging program.

Extreme price movements in financial markets can also undermine many hedging strategies based on presumed diversification. Crises not only affect the volatility in asset prices but also their correlations, primarily through “contagion” effects. The history of financial markets (circa 2012) has been characterized by a “risk-on, risk-off” environment dominated by swings in investor sentiment between speculative enthusiasm and pronounced flight-to-safety flows. In the process, there is often little differentiation between individual currencies, which tend to get traded together in broader baskets (such as “haven currencies”—USD, JPY, and CHF—and “commodity currencies”—AUD, NZD, and ZAR). Investors who may have believed that they had diversified their portfolio through a broad array of exposures in emerging markets may find instead in crises that they doubled-up their currency exposures. (Likewise, there can be correlated and extreme movements in the underlying assets of these foreign-currency exposures.)

Another potential factor affecting currency management in these “exotic” markets is government involvement in setting the exchange rate through such measures as foreign exchange market intervention, capital controls, and pegged (or at least tightly managed) exchange rates. These measures too can lead to occasional extreme events in markets; for example, when central banks intervene or when currency pegs change or get broken. Short-term stability in these government-influenced markets can lull traders into a false sense of overconfidence and over-positioning. When currency pegs break, the break can happen quickly. Assuming that investment returns will be normally distributed according to parameters estimated on recent historical data, or that correlation factors and liquidity will not change suddenly, can be lethal.

It bears noting that currency crises and government involvement in FX markets is not limited to emerging market currencies, but often occur among the major currencies as well. The central banks of major currencies will, on occasion, intervene in their own currencies or use other polices (such as sharp movements in policy rates) to influence exchange rate levels. These too can lead to extreme events in currency markets.

Non-Deliverable Forwards

Currencies of many emerging market countries trade with some form of capital controls. Where capital controls exist and delivery in the controlled currency is limited by the local government, it is often possible to use what are known as non-deliverable forwards (NDFs). These are similar to regular forward contracts, but they are cash settled (in the non-controlled currency of the currency pair) rather than physically settled (the controlled currency is neither delivered nor received). The non-controlled currency for NDFs is usually the USD or some other major currency. A partial list of some of the most important currencies with NDFs would include the Chinese yuan (CNY), Korean won (KRW), Russian ruble (RUB), Indian rupee (INR), and Brazilian real (BRL). The NDF is essentially a cash-settled “bet” on the movement in the spot rate of these currencies.

For example, a trader could enter into a long position in a three-month NDF for the BRL/USD. Note that the BRL—the currency with capital controls—is the price currency and the base currency, the USD, is the currency that settlement of the NDF will be made in. Assume that the current all-in rate for the NDF is 5.5180 and the trader uses an NDF with a notional size of USD1,000,000. Suppose that three months later the BRL/USD spot rate is 5.5300 and the trader closes out the existing NDF contract with an equal and offsetting spot transaction at this rate. Settlement proceeds by noting that the USD amounts net to zero (USD1,000,000 both bought and sold on settlement date), so the net cash flow generated would normally be in BRL if this was an ordinary forward contract. The net cash flow to the long position in this case would be calculated as(5.5300 − 5.5180) × 1,000,000 = BRL12,000But with an NDF, there is no delivery in the controlled currency (hence the name non-deliverable forward). Settlement must be in USD, so this BRL amount is converted to USD at the then-current spot rate of 5.5300. This leads to a USD cash inflow for the long position in the NDF of

BRL12,000 ÷ 5.5300 BRL/USD = USD2,169.98

The credit risk of an NDF is typically lower than for the outright forward because the principal sums in the NDF do not move, unlike with an outright “vanilla” forward contract. For example, in the illustration the cash pay-off to the “bet” was the relatively small amount of USD2,169.98—there was no delivery of USD1,000,000 against receipt of BR5,518,000. Conversely, as noted previously, NDFs exist because of some form of government involvement in foreign exchange markets. Sudden changes in government policy can lead to sharp movements in spot and NDF rates, often reversing any investment gains earned during long periods of seeming (but artificial) market calm. The implicit market risk of the NDF embodies an element of “tail risk.”

Finally, we note that when capital controls exist, the free cross-border flow of capital that enforces the arbitrage condition underlying covered interest rate parity no longer functions consistently. Therefore, the pricing on NDFs need not be exactly in accord with the covered interest rate parity theorem. Instead, NDF pricing will reflect the individual supply and demand conditions (and risk premia) in the offshore market, which need not be the same as the onshore market of the specific emerging market country. Some of the most active participants in the NDF market are offshore hedge funds and proprietary traders making directional bets on the emerging market currency, rather than corporate or institutional portfolio managers hedging currency exposures. Volatility in the net speculative demand for emerging market exposure can affect the level of forward points. We also note that the type and strictness of capital controls can vary among emerging markets; hence, the need for knowledge of local market regulations is another factor influencing currency risk management in these markets.

SUMMARY

In this reading, we have examined the basic principles of managing foreign exchange risk within the broader investment process. International financial markets create a wide range of opportunities for investors, but they also create the need to recognize, measure, and control exchange rate risk.

The management of this risk starts with setting the overall mandate for the portfolio, encoding the investors’ investment objectives and constraints into the investment policy statement and providing strategic guidance on how currency risk will be managed in the portfolio.

It extends to tactical positioning when portfolio managers translate market views into specific trading strategies within the overall risk management guidelines set by the IPS.

We have examined some of these trading strategies, and how a range of portfolio management tools—positions in spot, forward, option, and FX swap contracts—can be used either to hedge away currency risk, or to express a market opinion on future exchange rate movements.

What we have emphasized throughout this reading is that there is no simple or single answer for the “best” currency management strategies. Different investors will have different strategic mandates (IPS), and different portfolio managers will have different market opinions and risk tolerances.

There is a near-infinite number of possible currency trading strategies, each with its own benefits, costs, and risks. Currency risk management—both at the strategic and tactical levels—means having to manage the trade-offs between all of these various considerations.

Some of the main points covered in this reading are as follows:

• In professional FX markets, currencies are identified by standard three-letter codes, and quoted in terms of a price and a base currency (P/B). ✅

• The spot exchange rate is typically for T + 2 delivery, and forward rates are for delivery for later periods. Both spot and forward rates are quoted in terms of a bid–offer price. Forward rates are quoted in terms of the spot rate plus forward points. 🟠

• An FX swap is a simultaneous spot and forward transaction; one leg of the swap is buying the base currency and the other is selling it. FX swaps are used to renew outstanding forward contracts once they mature, to “roll them forward.” 🟠

• The domestic-currency return on foreign-currency assets can be broken into the foreign-currency asset return and the return on the foreign currency (the percentage appreciation or depreciation of the foreign currency against the domestic currency). These two components of the domestic-currency return are multiplicative. ✅

• When there are several foreign-currency assets, the portfolio domestic-currency return is the weighted average of the individual domestic-currency returns (i.e., using the portfolio weights, which should sum to one) ✅

• The risk of domestic-currency returns (its standard deviation) can be approximated by using a variance formula that recognizes the individual variances and covariances (correlations) among the foreign-currency asset returns and exchange rate movements. ✅

• The calculation of the domestic-currency risk involves a large number of variables that must be estimated: the risks and correlations between all of the foreign-currency asset returns and their exchange rate risks. ✅

• Guidance on where to target the portfolio along the risk spectrum is part of the IPS, which makes this a strategic decision based on the investment goals and constraints of the beneficial owners of the portfolio. 🟠

• If the IPS allows currency risk in the portfolio, the amount of desired currency exposure will depend on both portfolio diversification considerations and cost considerations. 🟠

  • Views on the diversifying effects of foreign-currency exposures depend on the time horizon involved, the type of foreign-currency asset, and market conditions.

  • Cost considerations also affect the hedging decision. Hedging is not free: It has both direct transactional costs as well as opportunity costs (the potential for favorable outcomes is foregone). Cost considerations make a perfect hedge difficult to maintain.

• Currency management strategies can be located along a spectrum stretching from: 🟠

  • passive, rules-based, complete hedging of currency exposures;

  • discretionary hedging, which allows the portfolio manager some latitude on managing currency exposures;

  • active currency management, which seeks out currency risk in order to manage it for profit; and to

  • currency overlay programs that aggressively manage currency “alpha.”

• There are a variety of methods for forming market views.

  • The use of macroeconomic fundamentals to predict future currency movements is based on estimating the “fair value” for a currency with the expectation that spot rates will eventually converge on this equilibrium value. ✅

  • Technical market indicators assume that, based on market psychology, historical price patterns in the data have a tendency to repeat. Technical indicators can be used to predict support and resistance levels in the market, as well as to confirm market trends and turning points. ✅

  • The carry trade is based on violations of uncovered interest rate parity, and is also based on selling low-yield currencies in order to invest in high-yield currencies. This approach is equivalent to trading the forward rate bias, which means selling currencies trading at a forward premium and buying currencies trading at a forward discount. 🟠

  • Volatility trading uses the option market to express views on the distribution of future exchange rates, not their levels. ✅

• Passive hedging will typically use forward contracts (rather than futures contracts) because they are more flexible. However, currency futures contracts are an option for smaller trading sizes and are frequently used in private wealth management. 🟠

• Forward contracts have the possibility of negative roll yield (the forward points embedded in the forward price can work for or against the hedge). The portfolio manager will have to balance the advantages and costs of hedging with forward contracts. 🟠

• Foreign-currency options can reduce opportunity costs (they allow the upside potential for favorable foreign-currency movements). However, the upfront option premiums must be paid. ✅

• There are a variety of means to reduce the cost of the hedging with either forward or option contracts, but these cost-reduction measures always involve some combination of less downside protection and/or less upside potential. ✅

• Hedging multiple foreign currencies uses the same tools and strategies used in hedging a single foreign-currency exposure; except now the correlation between residual currency exposures in the portfolio should be considered. ✅

• Cross hedges introduce basis risk into the portfolio, which is the risk that the correlation between exposure and its cross hedging instrument may change in unexpected ways. Forward contracts typically have very little basis risk compared with movements in the underlying spot rate. ✅

• The number of trading strategies that can be used, for hedging or speculative purposes, either for a single foreign currency or multiple foreign currencies, is near infinite. The manager must assess the costs, benefits, and risks of each in the context of the investment goals and constraints of the portfolio. There is no single “correct” approach. ✅