Managing Currency Mismatch. May 2010
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- Dorthy Preston
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1 Managing Currency Mismatch May 2010
2 FX Volatility 2
3 Very High Volatility in Asian Currencies Currency Performance % Jan-06 Jun-06 Dec-06 Jun-07 Dec-07 May-08 Nov-08 May-09 Nov-09 Apr-10 KRW INR IDR MYR Source: Bloomberg 3
4 G10 Currencies Not Spared Either Currency Performance % Jan-06 Jun-06 Dec-06 Jun-07 Dec-07 May-08 Nov-08 May-09 Nov-09 Apr-10 GBP EUR AUD JPY Source: Bloomberg 4
5 USD/HKD Remains within the Band Regulators Paying more Attention to USD / HKD Mismatch USD/HKD Exchange Rate Sep-04 Jul-05 Apr-06 Jan-07 Nov-07 Aug-08 Jun-09 Mar-10 USD/HKD Source: Bloomberg 5
6 Main FX Hedging Strategies 6
7 Two Common Approaches to FX Risk Management Individual Investment Basis Bond Portfolio Basis Existing USD Portfolio USD Coupon & Principal USD Returns Insurer Insurer HKD Coupon & Principal USD Coupon & Principal Instrument to lock in the HKD value of USD portfolio Bank Bank Advantage: Advantage: Perfect cashflow matching No individual execution Disadvantage: Disadvantage: Need to execute with every investment Does not match cashflows perfectly 7
8 Individual Investment Basis Cross-Currency Swap Mechanics HKD Notional (final principal exchange) EUR Bond X% on EUR Notional Insurer X% on EUR Notional Bank Y% on HKD Notional EUR Notional (bond principal repayment) EUR Notional (final principal exchange) Coupons and principal perfectly matched No FX Risk Credit diversification achieved 8
9 Portfolio Hedging: Forwards vs. Options Hedging with FX Forwards Hedging with FX Options Value of FX Portfolio Value of FX Portfolio No Hedge Final Exchange Rate Hedged w/ a Forward No Hedge Final Exchange Rate Hedged w/ an Option Both options and forwards provide downside protection in a scenario where portfolio depreciates However, options allow the owner to benefit if portfolio currency appreciates The asymmetrical payoff requires an upfront premium whereas forwards have zero upfront cost However, given that policy liabilities are mostly known and fixed, paying an upfront premium to maintain redundant upside may not be considered an optimal strategy 9
10 Benefits of Currency Risk Management 10
11 Making Investment Decisions Separating FX and Investment Decisions 2009 Corporate Investment Grade Issuance HKD 1.4Bn USD USD 1080Bn USD EUR 780Bn USD Option 1: Buy only HKD Bonds Advantage: No FX risk Disadvantage: Tight pricing Concentration risk Limited liquidity Option 2: Buy in the International Market and Manage FX Risk Separately Advantage: Diversification Attractive pricing Liquidity Disadvantage: Can t think of any... Source: Dealogic (excludes issuances from Government / Supranational entities) 11
12 HKD Fixed Income Assets are Limited HKD volume cannot be seen on the chart Investment Grade Corporate Issuances ($Bn) 2,500 2,000 1,500 1, EUR USD HKD Source: Dealogic (excludes issuances from Government / Supranational entities) 12
13 Recent US Corporate Investment Grade Issuance Recent US Corporate Investment Grade Bond Deals(1) Total Deal Size Tranche Size Ratings Treasury Issue Date Issuer Tenor ($MM) ($MM) Maturity Moody's S&P Coupon Spread 4/28/2010 Tyco International /15/2015 Baa1 A % ,000 4/30/ % 128 4/27/2010 NBC Universal 10 4,000 2,000 4/30/2020 Baa2 BBB % ,000 4/30/ % 183 4/26/2010 Advance Auto Parts /1/2020 Ba1 BBB % 200 4/22/2010 BioMed Realty Trust Inc /15/2020 Baa3 BBB % /1/ % 75 4/20/2010 Thermo Fisher 750 Baa1 A /1/ % /15/ % 165 4/21/2010 AngloGold Ashanti Holdings 1,000 Baa3 BBB /15/ % 200 4/20/2010 Nordstrom Inc /1/2020 Baa2 BBB % /16/ % 163 4/13/2010 Southern Copper Corporation 1,500 Baa2 BBB- 30 1,100 4/16/ % /15/ % 80 4/12/2010 Lowe's Companies 1,000 A1 A /15/ % ,200 4/26/ % 95 4/12/2010 Telefonica Emisiones SAU 5 3, /27/2015 Baa1 A % ,400 4/27/ % 130 4/8/2010 Worthington Industries Inc /15/2020 Baa2 BBB 6.500% 263 4/8/2010 Avery Dennison /15/2020 Baa2 BBB 5.375% 150 4/8/2010 Boston Properties LP /15/2020 Baa2 A % 175 4/7/2010 Valmont Industries /20/2020 Ba1 BBB % 274 Notes Sources: Morgan Stanley, Thomson, Bloomberg 1. Includes all corporate non-financial / non-utility issuances over $50MM 13
14 Recent EUR Investment Grade Issuance New Issue Analysis for Selected EUR Issues Issuer Rating (Moody's/ S&P) Pricing Date Maturity Notional Order Book (estimates) Spread to m/s (bps) Spread to CDS (bps) Change of Control -/- 23-Apr-10 7y 200 MM 550 MM X Aa3 / A+ 21-Apr-10 20y 1.5 Bn X -/- 19-Apr-10 7y 300 MM 1.6 Bn /- 16-Apr-10 7y 500 MM Baa2 / BBB+ 15-Apr-10 8y 750 MM 5.7 Bn X -/- 14-Apr-10 5y 350 MM X Baa1 / BBB+ 13-Apr-10 5y 500 MM X -/- 09-Apr-10 5y 100 MM X A2/A- 08-Apr-10 15y 750 MM X Baa2/BBB- 08-Apr y 600 MM X A1/AA- 07-Apr y 500 MM X Baa3/BBB- 07-Apr-10 8y 500 MM A3 / A- 31-Mar-10 10y 1 Bn 2.5 Bn 70 5 X Baa1 / BBB+ 31-Mar-10 10y 500 MM X - / - 31-Mar-10 4y 500 MM 4.7 Bn 45 - X - / - 31-Mar-10 7y 500 MM 5.4 Bn 70 - A3 / A- 25-Mar-10 10y 1 Bn 4.25 Bn 73-7 X - / BBB- 25-Mar-10 5y 500 MM 5.9 Bn X Baa2 / BBB 24-Mar-10 7y 750 MM 6.5 Bn X A3 / A- 22-Mar-10 10y 750 MM 3.6 Bn X Baa3 / BBB- 18-Mar-10 7y 850 MM Baa1 / BBB 18-Mar-10 2y 300 MM A3 / BBB+ 17-Mar-10 2y 500 MM 7 Bn X A3 / BBB+ 17-Mar-10 5y 1.35 Bn 9.5 Bn X A3 / BBB+ 17-Mar-10 10y 1.35 Bn 9.5 Bn X Baa2 / BBB- 16-Mar-10 10y 750 MM 4.1 Bn X 14
15 Recent Sterling Bond Issuance New Issue Analysis for Selected GBP Issues Issuer Rating (Moody's/S&P) Pricing Date Maturity Notional Order Book (estimates) Spread to Gilt (bps) at issue Spread to m/s (bps) at issue Baa3 / BBB+ 16-Apr-10 15y / NC7y 450 MM X Baa1/A- 26-Mar-10 30y 500 MM 2 Bn X BBB/BBB 25-Mar-10 26y / NC8y 115 MM X A-/A- 25-Mar-10 20y 300 MM X A-/A- 25-Mar-10 25y 100 MM X Aaa/AAA 22-Mar-10 37y 600 MM X Baa3/BBB- 17-Mar y 200 MM 1 Bn Baa1/BBB+ 16-Mar-10 30y 200 MM X Baa1/BBB 09-Mar-10 30y 200 MM X - 26-Feb-10 10y 275 MM Baa2/BBB 04-Feb-10 31y 130 MM X Aa2 / AA- 20-Jan-10 30y 300 MM 1.1 Bn X A2 / A+ 14-Jan-10 12y 400 MM 500 MM X - 07-Jan-10 7y 350 MM 1.9 Bn A1 / AA- 11-Dec-09 30y 250 MM X Baa2 / BBB- 10-Dec-09 7y 400 MM 1.5 Bn X - / BBB- 04-Dec-09 7y 250 MM 1.3 Bn / A- 01-Dec-09 30y 235 MM X - / A- 27-Nov-09 27y 700 MM X Baa3 / BBB- 25-Nov-09 10y 400 MM 2.6 Bn Baa1 / - 26-Nov-09 7y 200 MM 300 MM X Baa1 / A- 24-Nov-09 13y 650 MM BN X - 17-Nov-09 12y 300 MM X Baa1/BBB+ 13-Nov-09 25y 485 MM X Baa3/BBB- 13-Nov-09 7y 250 MM Change of Control 15
16 HKD Private Placement March 8 th : HKD Private Placement with 4.33% annual coupon 16
17 Yield Pick-Up from USD Bond March 15 th : USD Issuance with a USD yield of 5.04% On the day of issuance, a USD yield of 5.04% would have swapped into a HKD yield of 4.60% This demonstrates that investing in a USD bond and properly managing the FX risk through cross currency swaps can result in a yield pick-up 17
18 Choice of FX Hedging Tenor 18
19 How Long to Hedge? Looking at the Implied Cost of Hedging USD/HKD Forward Rate Curve as at April 29, USD/HKD Forward Source: Reuters 19
20 Comparing the Cost of Different Tenors Looking at the Implied Cost of Hedging Spot Rate Year Forward Rate 7.31 Cost 0.45 Cost as a Percentage of Spot Rate 5.8% Cost Per Year 0.58% (or 58 bps) Annualized Cost of Hedging Across the Curve (bps) Jul-10 Jan-11 Jul-11 Cost of Hedging Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Source: Morgan Stanley 20
21 Implied Hedging Cost Looking Back in Time Historical Annualised Implied Hedging Cost based on historical 3-month and 5-year Forward Points (0.005) (0.015) (0.025) month Implied Cost (p.a.) 5-yr Implied Cost (p.a.) Source: Morgan Stanley 21
22 Implied Hedging Cost Looking Back in Time Strategy Comparison Starting as of June 2000 Rolling 3-month cost versus Locking in 5 year cost (0.03) (0.05) (0.08) (0.10) Month Rolling Cost 5 Year Hedging Cost Source: Morgan Stanley 22
23 Savings Benefit of 5-Year Hedge Historical Savings Benefit Savings: average 3-month hedging cost 5-year hedging cost (0.005) (0.010) (0.015) (0.020) Average Rolling 3 Month Cost 5 Year Cost Savings Source: Morgan Stanley 23
24 When are Savings Realized? Correlation Between Savings and 5-year Implied Hedging Cost (0.01) 5-year Cost (0.01) (0.02) (0.02) Savings Source: Morgan Stanley 24
25 Savings Benefit of 3-Year Hedge Historical Savings Benefit Savings: average 3-month hedging cost 3-year hedging cost (0.005) (0.010) (0.015) (0.020) Average Rolling 3 Month Cost 3 Year Cost Savings Source: Morgan Stanley 25
26 When are Savings Realized? Correlation Between Savings and 3-year Implied Hedging Cost year Cost (0.005) (0.010) (0.015) (0.020) Savings Source: Morgan Stanley 26
27 Practical Aspects of FX Derivatives 27
28 Practical Aspects of FX Derivatives Frequently Asked Questions about FX Derivatives Are long dated USD/HKD FX derivatives available? USD/HKD FX derivatives with tenor up-to 15 years are available Do FX derivatives expose Insurers to bank s counterparty risks? Minimum counterparty risk due to collateralisation Would changes in MTM of FX derivatives cause net P&L Fluctuation? No Is it difficult to obtain hedge accounting treatment from auditors? No Is it practical to enter into one CCS for each bond? Yes Is there a difference between rolling shorted FX forward and using a long dated floating/floating CCS (a basis swap) Yes, a basis swap locks in the current basis value 28
29 Common FX Hedging Strategies Long Dated USD/HKD FX Derivatives are available 29
30 Decomposing a Fixed-Fixed Cross-Currency Swap USD Fixed Rate Insurer MS Bond USD Floating Rate USD Fixed Rate final exchange: USD notional amount + final exchange: USD notional amount Insurer USD Fixed Rate MS Insurer USD Floating Rate MS HKD Fixed Rate HKD Floating Rate + basis final exchange : HKD notional amount USD/HKD Fixed-Fixed Cross-currency Swap final exchange : HKD notional amount + HKD Floating Rate + basis Insurer MS HKD Fixed Rate 30
31 Common FX Hedging Strategies the USD/HKD basis final exchange: USD notional amount USD Floating Rate Insurer MS HKD Floating Rate + basis final exchange : HKD notional amount 31
32 Accounting Impact of FX Derivatives P&L impact of FX derivatives and Foreign Currency Bond due to changes in different market variables market variables P&L (holding US bond) without FX Derivatives Floating/Floating Cross Currency Swap (Basis Swap) FX Forward or Fixed /Fixed Cross Currency Swap WITHOUT Cashflow Hedge Accounting FX Forward or Fixed /Fixed Cross Currency Swap WITH Cashflow Hedge Accounting spot FX Yes (due to FX translation gain/loss) Yes Yes Yes HK interest rate No No Yes No (1) US interest rate No (unless bond is classified as trading) No Yes No (1) basis No Yes Yes No (1) (1) Changes in derivatives MTM due to this variable will be deferred in cashflow hedge reserve in equity statement 32
33 The USD/HKD Peg 33
34 What can happen to the USD/HKD Peg? Some Possible Scenarios Existing Peg remains indefinitely Convertibility Band Widened Peg realignment Unpeg and HKD becomes a free floating currency Unpeg from USD and repeg to CNY 34
35 Conclusion 35
36 Risk Management is about more than Risk Reduction OTHER BENEFIT OF RISK MANAGEMENT FX RISK MANAGEMENT INCREASED INVESTMENT FREEDOM MORE COMPETITIVE COMPANY MORE EFFICIENT ASSET ALLOCATION 36
37 Thank you! 37
38 Contact Details Julien Begasse tel : Julien.Begasse@MorganStanley.com Alan Yip tel : Alan.Yip@MorganStanley.com 38
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