FX Strategies In the Low Yield Environment Eddie Wang Head of FX Structuring, Asia Hong Kong October 2010
Contents 01 Key Trends 02 FX Hedging Strategies 03 FX Investment Strategies
SECTION 01 Key Trends Low Yield Environment Investing in FX Market Internationalization of CNY
Low Yield Environment 4 Interest rates of major currencies have converged Low yield environment may continue for a period of time Market players are adjusting their strategies to the new environment Currency return is becoming dominant as rate differential is absent But rate differential is cyclical and the phenomenon may be short term 3 Month Depo Rates of USD, EUR, JPY USD/JPY Rate Differential 14% 12% 10% 8% USD EUR JPY 180 160 140 120 100 USD/JPY Spot USD/JPY 3m Rate Differential 8% 6% 4% 6% 80 2% 4% 2% 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters 60 40 20 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters 0-2% -3%
Low Yield Environment 5 Impact on Market Players Corporates Low rate differential makes forward curve flat Swap points less concern for hedging cash flows No longer need to borrow in JPY to enjoy low rates But need to manage FX risk of legacy JPY loans Investors USD has become funding currency of choice Accelerated capital flows to high growth emerging markets Manage FX exposure as a result of investment Also seek returns from FX movements
Investing in FX Market 6 Daily FX market turnover grows 20% to $4 trillion from 2007 to 2010 Spot transactions have strong growth of 48% Non-bank financial institutions are main contributors Forwards, swaps and options see modest increase of 7% Trade based flows drop as global economy navigates out of financial crisis Foreign Exchange Turnover (Daily Averages in April) Turnover in OTC Derivatives Markets 38 34 30 Current USD Ratio to trade flows Ratio to trade and capital flows Trillions 4.8 4.0 3.2 Trillions 3.0 2.0 2.0 Options Currency Swaps Outright Forwards and FX Swaps 26 2.4 1.5 22 1.6 1.0 18 0.8 0.5 14 1992 1995 1998 2001 2004 2007 2010 0.0 0.0 1998 2001 2004 2007 2010 Source: IMF, BIS Source: BIS
Investing in FX Market 7 Methods for Generating Returns Carry Trade High yield commodity currencies are beneficiaries Increasing emphasis on emerging market currencies Captures yield differential in low volatility environment Market uncertainty poses risk for the strategy High Frequency Trading Electronic trading platforms offer tools to capture intraday opportunities Automated trading accounts for increasing share of trading volume Provides liquidity and creates more correlation between markets May contribute to volatility during extreme market moves
Internationalization of CNY 8 A circulation of CNY is being built between onshore and offshore Full convertibility will be a gradual and long term process Capital control is the major limiting factor CNY will become an international currency in coming decade But USD will maintain its dominance in the foreseeable future CNY Deposits in HK 2010 Global FX Market Turnover by Currency CNY 0.1% Others 35.9% AUD 8% GBP 13% USD 85% JPY 19% EUR 39% Source: HKMA Source: BIS
Internationalization of CNY 9 A Tale of Three Markets Onshore Deliverable Market in China Onshore deliverable spot and forward are accessible to onshore entities Market is open for documented trade flows but restricted for capital flows Offshore Non-Deliverable Market Outside China Non-deliverable forward and option are active among offshore participants NDF is lower than onshore deliverable forward in China Offshore Deliverable Market in Hong Kong Deliverable spot in HK is lower than onshore spot Current trading volume is small but growing Forward and option market are also developing
SECTION 02 FX Hedging Strategies FX Risk of Emerging Market Hedging Strategies
FX Risk of Emerging Market 11 Currency risk is an important factor for emerging market investment Emerging market currencies tend to rise steadily in normal times But they can drop sharply during times of crisis Usually companies hedge cash flows and leave balance sheet risk unhedged Need to develop risk management framework suited to risk tolerance Equity Indices of China, India, Korea, Malaysia Spot Prices of CNY, INR, KRW, MYR 450% SSEC BSESN KS11 KLSE 140% USD/CNY USD/INR USD/KRW USD/MYR 400% 350% 300% 130% 120% 250% 110% 200% 100% 150% 100% 50% 90% 80% 0% 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters 70% 00 01 02 03 04 05 06 07 08 09 10 Source: Reuters
Hedging Strategies 12 Offshore Hedge USD based company needs to hedge projected cash flow in China Onshore market may be difficult to access due to strict requirements Offshore market is available using cash settlement USD/CNY Bonus Forward Company sells USD/CNY Expiry: 1 Year At Expiry: Upper Level = Initial Spot + 0.06 If USD/CNY > Upper Level, Strike = Upper Level; If USD/CNY Upper Level, Strike = USD/CNY + 0.03 0.03 Payoff (CNY) Initial Spot Upper Level USD/CNY -0.03
Hedging Strategies 13 Proxy Hedge USD based company needs to hedge assets in Malaysia But USD/MYR NDF market is small and illiquid Strong correlation between USD/MYR and USD/SGD in past 5 years Buy USD/SGD forward as proxy hedge for USD/MYR USD/SGD forward market is liquid and deliverable 1 year forward hedge can be rolled over if company continues to hold assets USD/MYR & USD/SGD Spot Prices Back Testing of Proxy Hedge 4 USD/MYR USD/SGD 1.8 6% Variation 3.5 1.6 4% 2% 3 1.4 0% -2% 2.5 1.2-4% 2 05 06 07 08 09 10 Source: Reuters 1-6% -8% 05 06 07 08 09 Source: Reuters
Hedging Strategies 14 Portfolio Hedge USD based company has exposure to multiple emerging markets Currency basket can be used to manage portfolio risk Purchase an option on the basket as insurance against extreme moves Premium of basket option is cheaper than individual options Basket Option Basket: CNY (25%), INR (25%), KRW (25%), MYR (25%) Company purchases USD Call / Basket Put for 1 Year Strike = 105% of Initial Spot Premium = 2% of USD Notional
SECTION 03 FX Investment Strategies Uridashi Market Investment Strategies
Uridashi Market 16 Japanese investors have been in low yield environment for a long time Uridashi bond is denominated in a foreign currency and sold to retail investors Issued in high yield currencies such as AUD, ZAR, NZD, BRL Investor takes credit risk of issuer and currency risk of conversion Popular form of investment in Japan in recent years Uridashi Issue in Billions of JPY 4,500 4,000 3,500 3,000 Uridashi Issue by Currency Others, 1% USD, 3% BRL, 5% NZD, 8% 2,500 2,000 1,500 1,000 500 ZAR, 14% JPY, 53% 0 04 05 06 07 08 09 10 AUD, 16% Source: Bloomberg (Projected for 2010) Source: Bloomberg
Investment Strategies 17 Convertible Note Similar concept as Uridashi bond 1 year note denominated in USD Not principal protected possibility of conversion Coupon = 6% p.a. Strike = Initial Spot At Maturity: If AUD/USD 90% of Initial Spot, Investor receives principal and coupon in USD; If AUD/USD < 90% of Initial Spot, Investor receives principal and coupon in AUD, Converted at Strike
Investment Strategies 18 Passport Option Investor engages in discretionary trading to generate returns Investor purchases passport option on the balance of trading account Currency Pair: EUR/USD Expiry: 6 Months Investor pays Premium: 5% of Notional Limit Investor can buy or sell EUR/USD spot within the Notional Limit Profits and losses are aggregated in the trading account At Expiry: If trading account balance is positive, Investor receives the profits; If trading account balance is negative, the losses are covered by the Passport Option
Q & A 19
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