Counting the cost of hedging after market shakeout

The euro/dollar exchange rate is just about the most liquid market in the world. It is a sign of the times, then, that since the fall of Lehman Brothers in September 2008, even this market has witnessed the largest one-day moves since the euro started trading in the 1990s.

“Bid/ask spreads widened on all foreign exchange (FX) products, and lower liquidity also affected the size of trade that could be done and the impact it had in the market,” says Frederic Jeanperrin, head of FX derivatives sales for European corporate clients at Société Générale Corporate & Investment Bank (SGCIB)

Unique conditions

Inevitably, this has had a profound effect on market participants. Neil Record, founder and chief executive of Record Currency Management, has been in the business for almost 30 years, and now manages funds of close to $50bn for about 140 institutional investors. He has never seen anything quite like the current conditions, which have complicated the company’s process-driven strategy. “We would typically do 100 to 200 trades per day of at least $20m each. We are currently relying on haranguing our relationship bankers to get deals done, and we cannot use electronic platforms,” says Mr Record.

And he works with developed market currencies; in emerging markets, the ­conditions have been even more extreme.

Eric Ohayon, head of Europe, Middle East and Africa FX structuring at Bank of America.

“Volatility in major emerging currencies such as the Brazilian real was about 10% before September last year. It climbed as high as 60% in the October to December period, although it has eased a little to about 35% at present,” says Eric Ohayon, head of Europe, Middle East and Africa FX structuring at Bank of America. In turn, this volatility drives up the premium payable upfront for the call and put options that are the basis of the FX derivatives market – which makes the whole business of hedging exchange rate risk more expensive.

“Until August or September 2008, we would do two-thirds of our FX risk-taking in the options market. Now we are lucky if we do one-tenth of it that way. The premium-intensiveness of options has increased by an order of magnitude of two or three times,” says Richard Benson, portfolio manager of the Global Currency fund at Millennium Global, which manages about $14bn for institutional clients using a discretionary investment strategy.

Other changes in pricing have also made nimble trading more difficult. Mr Ohayon says risk reversals for the Brazilian real – the price differential in volatility between ­dollar/real call and put options with the same tenor and delta – has climbed from about 3vol before the global crisis to as much as 20vol in favour of dollar calls, as almost all trades are in the direction of buying dollar calls. This has made the downside in the Brazilian real much more expensive to hedge.

Managing avoidable risks

But if hedging may be more expensive, it has also become more vital than ever for ­inter­national companies and institutional investors alike.

“The FX adjustment could account for as much as 30% to 40% of your total return in 2008,” says Andrew Kaufmann, global head of FX structuring at Barclays Capital (BarCap). “FX is a risk you can do something about, whereas there may be less that you can do about, for example, the value of your real estate assets.”

As a result, although most companies that had exchange rate exposure had already carried out hedging activities, their approach has changed fast, says Antoine Jacquemin, head of FX and interest rate market risk advisory for SGCIB’s corporate clients.

“People are keen to consider hedges early on mergers and acquisitions transactions, even if they have only small notional exposure or are exposed for just a few days, because we have seen one-day moves last year that would previously have taken place only over a fortnight,” he says. And the rise in ‘south-south’ investment flows means there are more companies looking to hedge relatively exotic emerging market currency pairs, he adds.

One Asia-based FX structurer adds that more mutual fund managers in the region with exposure to international equity markets are adopting currency overlays on their portfolios – although this usage is still small compared with the US and western Europe.

Plain vanilla still complex

One possibility to avoid paying the derivative premium is to use the plain vanilla forward currency markets. While these eliminate currency risk for the tenor of the contract, they leave the client exposed to interest rate risk. “If you think that the risk for interest rates is stable or likely to be to the downside, then it may be better to enter into forwards or cross-currency swaps, rather than opt­ions,” says Mr Jacquemin.

However, the forward markets themselves have been hit by a more general problem – the surge of counterparty credit risk since the fall of Lehman Brothers. Credit risk is not something that those who work in the FX markets want to take on, and many clients will not deal with counterparties rated lower than A+, or even AA-. This is a threshold that even some of the world’s largest banks have fallen below in recent weeks.

This has consolidated business into those banks that retain higher credit ratings, but they are themselves cutting their own eligible counterparties. As a result, investors find they may not be able to fulfil orders at the best price shown on dealer display screens.

“The foreign exchange divisions of banks are doing extremely well, because the competition to bring spreads down is not there at the moment,” says Mr Record. “We are being wildly overcharged for forward contracts because of a tiny embedded credit component that is not a core part of our business,” he explains.

He is one of several buy-side players engaging with bankers to find ‘credit-free’ collateralised alternatives to the current structure of the forward market, to eliminate the counterparty risk premium. Forwards could be cleared through systems such as continuous linked settlement (CLS; see page 50), which already settles many of the world’s FX trades but does not have a full clearing function. However, many investors would prefer to avoid the ‘hub-and-spoke’ model, which would increase the visibility of their trading to other market participants.

Cross-collateralised currency products already exist, in the form of FX futures or credit support annexes (CSAs). But CSAs are not universally used, and futures are currently much less liquid than the forward market. It would require a consensus among the leading currency managers, corporate treasurers and bank FX desks to switch to these instruments as a market standard, to bring down bid/ask spreads.

Less aggressive techniques

Despite their cost, FX options look fairly priced in today’s volatile conditions. “Implied volatility in the options market is extremely high, but it is actually justified, even at these levels, until realised volatility starts to come down,” says Mr Benson.

For this reason, the options market retains some inherent advantages. “Business and market variables were so unpredictable that many who used only forwards have found themselves overhedged and locked in at poor levels,” says Scott Wacker, managing director, EMEA FX sales at JPMorgan. “Long optionality allows clients to adjust hedges by either not exercising the option or by selling it at current high volatility.”

The process of funding hedges has also become cheaper, because companies can now sell heavily out-of-the-money options at a much higher price than when volatility was at historic lows of less than 10% (see figure 1). “When people were comfortable that currencies would stay in a narrow range, if you wanted to buy a put option close to the money to hedge $100m in export receivables, you might sell maybe three or four times that in out-of-the-money calls to fund it,” says one Asia-based FX structurer.

This technique caused a wave of accidents in the final quarter of 2008 among export-oriented emerging market companies that had been using FX derivatives to hedge against further appreciation of their local currencies. The sudden and sharp depreciation forced them to pay out on the currency calls they had sold, while the put options they bought were by then well out of the money (see below: ‘Derivatives – please use responsibly’).

The prevailing market conditions mean less aggressive hedging strategies with lower implied leverage, focusing on matching hedges more exactly to client needs rather than generating excess return. Nicolas Vilar, head of currency solutions at JPMorgan, says the bank is working with clients to limit how far their hedges utilise credit lines from their preferred banks, in the current environment where counterparty risk is centre stage.

“There are structures that can give clients an exit on transactions or mechanisms for repricing. We look at, for instance, the clients’ full hedging portfolios and exposures across asset classes – FX, interest rates, commodities, equities and credit,” he explains.

As global growth contracts, foreign currency receivables – for instance, export revenues – are falling, leaving some companies over-hedged if they had put on relatively long-term trades. “People are trading much shorter-dated transactions than usual. You need to take account of the high volatility, and you don’t want to be locked into a position where you don’t have underlying receivables coming in and you still have a large derivatives exposure,” says Mr Ohayon.

All in the timing

Clients are also ready to look at timing their hedges or entering trades opportunistically when the market moves in their favour, rather than paying for a permanent hedge. And they can use products that cap their potential upside, in return for offering some downside protection. These include the ‘seagull’ trade, so called because of the shape of returns given the movement of the underlying exchange rate. It ensures that the hedge stays in-the-money if the currency moves in either direction in a wide range between two option strikes.

The return of liquidity

Although markets remain choppy and bank bail-outs continue, developed market vol­atility indices have eased from their post-Lehman peaks. There is a general consensus that FX market liquidity should begin returning to comparative normality by the end of 2009.

However, some changes in the market are more gradual, but more permanent. The difficulties with liquidity and counterparties look set to allow leading banks that stayed open for business on the FX derivatives markets to consolidate their position. This is not just a question of credit ratings – these banks also have the client base large enough to retain capacity for laying off risks as new trades are put on.

“We recognise that the FX flow we have created in house by crossing internal and customer business can be better at times than the liquidity on the street,” says Mr Wacker. The FX and interest rates team at JPMorgan has consistently received new clients through the bank’s large custodial services division, and the acquisition of Bear Stearns’ prime ­brokerage activities also pulled in additional business.

E-commerce platforms at the leading players are also a part of building the larger flow of liquidity inside individual banks. They have received a baptism of fire in 2008, as parameters were tested beyond any historic market conditions, but those that withstood the test generate greater trading volumes for the bank. JPMorgan is rolling out advances to its e-commerce platform that would include options and emerging market FX capabilities, and might bring the bank’s own algorithmic strategies onto the same platform as the orders from corporate clients and those from the custodian business, to further enhance internal liquidity.

Given the importance of scale, Mr ­Kaufmann at BarCap is also optimistic following his bank’s acquisition of Lehman’s US ­business, which included a well-regarded FX desk.

“This has helped us to reach critical mass in the US market, thanks to the increased numbers of specialists we have, and also the business coming in from Lehman’s equities and M&A teams, so it will give us greater client capabilities,” he says.

DERIVATIVES - PLEASE USE RESPONSIBLY

At the start of 2008, emerging Nmarket currencies continued their appreciating trend. But that trend reversed suddenly in the second half of the year, as risk aversion gripped investors, and US companies repatriated capital to meet commercial paper maturities.

By the end of the year, many emerging market exporters who had been hedging against further appreciation of their local currencies were reporting sometimes multi-billion dollar losses on their FX derivatives exposure. South Korean electronics firm Taesan LCD and Mexican supermarket chain Controladora Comercial were bankrupted, and India’s Axis Bank now faces litigation from companies that lost up to $3bn on FX derivatives.

Worst hit

By far the worst-hit market, however, appeared to be Brazil. Leading wood pulp producer Aracruz, raw materials giant Votorantim and food producer Sadia, which together suffered losses of more than $5bn, were just the largest of an estimated 500 companies affected.

Was it another case of banks mis-selling derivative products? All the FX desks maintain that they much prefer working with clients on an advisory basis, and follow strict guidelines to match products sold to the existing exchange rate exposure.

Part of the difficulty was that, although each bank requested basic information from clients, they did not necessarily have a complete picture of the company’s derivative exposures. “The issue arose partly because many companies felt they wanted to maintain multiple relationships with the banks, so they did trades that were multiples of what they required,” says one Asia-based FX structurer.

Corporate governance

“This only happens when there are so many banks selling the product that it becomes commoditised. Today, there are no longer 20 banks clamouring for business, so I think there will be a natural clearing out,” he adds.

And perhaps the companies’ own practices deserve greater scrutiny. “Although the trades were reported to the Brazilian clearing house CETIP, few details were given because each one was so specific, and they were recorded as just a footnote in the company accounts,” says Paulo Vieira da Cunha, emerging market strategist at US hedge fund Tandem Global Partners, who was a deputy governor of the Brazilian central bank until the end of 2007.

The Brazilian Securities and Exchange Commission (CVM) has already taken action to correct this problem, explains its director, Professor Eliseu Martins. “From the fourth quarter of 2008, we required companies to include in their reports a sensitivity analysis of all their FX derivative positions, assuming exchange rate fluctuations right up to 50%,” he explains.

But he adds the warning: “In some of these companies, there were already internal controls, but these seem to have been broken, so there is no magic answer.”

FINDING THE RIGHT THEMES FOR RETAIL INVESTORS

The carry trade – investing in high-yielding currencies with borrowed dollars or yen – was the dominant theme among FX investors in the boom years. But as emerging market currencies sold off heavily in the second half of 2008, structurers put their carry trade products on ice – at least until the heavy capital repatriation to the US and Japan eases, and attention returns instead to their rock-bottom interest rates.

In the meantime, principle protection has become the priority for anxious retail investors. Among SGCIB’s warrants range, currency warrants that allow investors to buy listed call or put options with strictly limited downside flourished in the later months of 2008. “The sense we have from intermediaries is that whereas day traders dominated before, there are now more high net worth clients using this product as a long-term investment to hedge, for example, their real estate exposures in more than one country,” says Isabelle Braly-Cartillier, head of northern European structured and listed products marketing at SGCIB.

Locking in profits

Selene Chong, head of Asia FX structuring for HSBC in Hong Kong, finds some clients are also interested in features that offer the potential to lock in some profits if their view is correct, to take advantage of the more volatile environment. “Let’s say you think a currency is going to strengthen over a certain period, but you are unsure about the timing of the move and whether it will be sustained. There are products which potentially offer an enhanced payout if a certain target level is reached at any time over that period,” says Ms Chong.

“Resettable products are also becoming more popular in the recent volatile environment. On a product where you receive a higher coupon if the currency pair trades within a particular range, these are features which reset the range each month around the spot rate at that time,” she explains.

Where banks have created proprietary FX indices, these help generate a range of new products. JPMorgan allows investors to express views on a single currency against the bank’s tradable currency indices (TCIs). “TCIs are investible versions of the trade-weighted indices that JPMorgan has produced since the 1970s. They tend to exhibit lower volatility than bilateral pairs, and minimise the risk of expressing the right view, but through the wrong currency pair,” says Nicolas Vilar, head of currency solutions at JPMorgan.

Long volatility products

Indices that allow clients to buy volatility directly are also becoming popular, both for portfolio diversification and to hedge the risk of extreme market events. With so much demand for long volatility products, banks must search for investors willing to take short volatility positions. Historically, volatility

is mean-reverting, but in today’s conditions, it would take a brave investor to be confident they could correctly time the move. And hedge funds, which usually dominate such sophisticated trades, have fewer funds to commit as they face redemptions.

Yet there are also structural sellers of volatility. Andrew Kaufmann, head of global FX structuring at BarCap, says dual currency deposits (which pay a higher interest rate but allow the bank to repay depositors in either of two agreed currencies) have become increasingly popular.

“With interest rates tending towards zero in developed markets, investors who are indifferent about which currency they receive are happy to take the higher interest rate as a premium for selling that indifference,” he explains.