11 FX Risk – Short Term Cash Flow & Reval Hedging Approach - cover fx risk, eliminate uncertainty, relative vs absolute advantage, specific payoff profilesFX OptionsFX ForwardStructured Solutions
12 Illustrative Examples FX ForwardAgreement to buy or sell one currency agst the other (eg Euro agst Ron)Current 3M Forward price (august 2010) isFX OptionGives the right but not the obligation to buy or sell one currency agst anotherIt involves paying a premium (like an insurance premium)Employed in numerous structures (with premium or zero-cost depending on desired payout profile and risk/cost appetite)Improved forwardIn comparison with forward rate, allows the client to buy at the expiry date the necessary amount at an “improved level”Spot rate =FX Forward RateImproved forward /Cost = “Zero cost” structurePossible situation at expiry:Spot < => client has to buy 1 mio EUR atSpot between and => client exercises the right to buy 1 mio EUR atSpot > => client will benefit from a relative advantage – can buy 1 mio EUR at the current Spot minus a discount of pipsExample: Spot = => client buys 1 mio EUR at – =
13 FX Risk – Hedging Long-Dated Exposures Left unhedged, FX risk can dramatically affect returns from cross- border/currency investmentsSimilarly FX denominated liabilities can be affected by drastic FX movementsWe analyze further the impact of having a short Euro / long CEE currency position unhedged over a multi-year period, evaluate the performance of traditional hedging instruments in covering such an exposure and then propose alternative and potentially more efficient ways of hedging a long- dated CEE FX exposureWe can perform a similar in depth analysis for a RON based environment on the basis of a specific portfolio
14 CEE Market Overview FX Regimes and Available Hedging Instruments By Country Estonia [A-/A1]FX: Regime: Currency BoardA number of CEE countries have currency board arrangements or FX markets that are tightly controlled by the respective central bankIn other cases, traditional FX hedging instruments are available in order to manage FX exposureLatvia [BB/Baa3]FX: Regime: Pegged to EURLithuania [BBB/Baa1]FX: Regime: Currency BoardRussia [BBB/Baa1]FX: Regime: Managed Floating Forwards, NDF, OptionsRates: IRS, CCS [up to 10yrs]Poland [A-/A2]FX: Regime: Free FloatForwards, OptionsRates: IRS, CCS, Rate OptionsUkraine [B-/B2]FX: Regime: Strictly Mnged FloatingNDFsCzech Republic [A/A1]FX: Regime: Free FloatForwards, OptionsRates: IRS, CCS, Rate OptionsHungary [BBB-/Baa1]FX: Regime: Free FloatForwards, OptionsRates: IRS, CCS, Rate OptionsRomania [BB+/Baa3]FX: Regime: Dirty FloatForwards, OptionsRates: IRS, CCS [up to 10 years]Bulgaria [BBB/Baa3]FX: Regime: Currency BoardForwardsRates: Fixed-fixed CCSCroatia [BBB/Baa3]FX: Regime: Managed FloatingForwards, Options (limited)Rates: Fixed-fixed CCS [up to 12mths]Serbia [BB-/NR]FX: Regime: Strictly Managed FloatingForwards (restrictions for non-res)Rates: Fixed-fixed CCS [3-6mths]Turkey [BB/Ba2]FX: Regime: Free float w/FX auctionsForwards, optionsRates: IRS, CCS, options on Rates
15 Traditional FX Hedging Solutions Euro-based investors that have investments in CEE countries are exposed to a significant sell-off of a CEE currency versus the Euro that may even threaten their solvency ratios. Similarly CEE borrowers that tap the deeper Euro capital markets are exposed to a sudden weakening of the CEE currencies they use to service the Euro debt.As the charts on the next page show, the general pattern is for CEE currencies to steadily appreciate against the Euro before a dramatic sell-off driven by a drying up of risk appetite. In the financial crisis, the rapid reduction in risk appetite generated FX sell offs combined with dramatic fall in market instruments’ liquidityGiven the managed float regime of RON, and the unstable correlation vs the region currencies and global risk aversion, we can further employ similar strategies for RON liable companiesIn order to protect against the potentially harmful impact of a sell-off in the local currency, Euro based investors may look to put in place hedging. Natural hedges where investments are matched in the liability currency to the extent possible is an obvious first step to take in mitigating net investment exposure, obviously limiting further the investment universe thoughAfter natural hedging opportunities have been exhausted, the obvious traditional hedge would be a forward contract and therefore we assess the historic performance of long-dated forward contracts to buy Euro / sell CEE currency in the pages that follow
16 Historical Performance of CEE currencies vs the Euro CEE currencies steadily appreciate vs Euro but can sell-off dramatically/////////Data source: Bloomberg
17 Performance of CEE Currencies versus the Euro Annual Change in Currencies with Outright Forward implied change overlayWhen CEE currencies depreciate versus the Euro, they tend to do so to a greater extent than when they appreciate against the Euro. Hedging with a 12mth forward tends to represent a significant opportunity cost to remaining unhedged but the performance of most currencies suggests the need for some hedgingData source: BloombergOutright forward-implied 12mth depreciation / appreciation
18 Evaluation of Outright Forward Hedges EURTRY The charts below show, where data is available, how hedging with a forward outright compared with the actual path of the spot rate (ex post analysis). At a given point in time, the outright forward curve is plotted from 3 months to 2 years (left-hand chart) and to 5 years (right hand chart). By also plotting the subsequent evolution of the spot rate, it is possible to see how efficient was the forward hedging strategy versus remaining unhedged.In both cases for EURTRY, with most of the red lines lying above the black line, it would have been more efficient actually to have remained unhedged rather than hedging with a forward outright. Hedging with a forward would have represented a very significant opportunity cost had a hedger entered into a 5y forward any time betweenWhen considering a 5 year forward hedge, 2005 is the most recent year against which we can evaluate the overall performance of an outright forward with such a tenor.2 year Forward Horizon5 year Forward HorizonData source: Bloomberg
19 Evaluation of Outright Forward Hedges EURPLN As the Zloty steadily appreciated against the Euro between 2004 to mid 2008, hedging with a 2 year outright forward contract carried with it a significant opportunity cost for the most part. However, entering into a 2 year forward any time beyond the end of that period would have provided protection against the sharp rise in the spot rate from 3.20 to 4.90.Over a 5 year horizon however, for the completed data periods we have available, hedging with an outright forward for the full period would once again have been costly when set against the possibility of participating in Zloty strengthAnother aspect that is evident in both the below charts is that the outright forward curve plots become flatter over time, illustrating how the forward points tended to become less steep2 year Forward Horizon5 year Forward HorizonData source: Bloomberg
20 Evaluation of Outright Forward Hedges EURHUF Outright forwards would have been of more benefit over a 2 year horizon in the case of EURHUF relative to EURTRY and EURPLN. However the ends of many of the red lines are above the black line, indicating again that it would have been preferable to remain unhedged.Again, in the case of the 5 year outright forward hedge, it would have always been preferable to have remained unhedged over such a horizon as the cost of buying EUR / selling HUF at the end would have been cheaper in the spot market than at a forward rate contracted 5 years previously.2 year Forward Horizon5 year Forward HorizonData source: Bloomberg
21 Evaluation of Outright Forward Hedges EURCZK On the one hand, the ex ante opportunity cost of having hedged with a 2 year outright forward contract in EURCZK has been relatively small, with the outright forward rate being close to the market spot rate. However ex post opportunity cost shows once again that it would have been preferable not to have had in place an outright forward hedge as the Koruna has steadily appreciated against the Euro over most of the available data horizon.We were unable to obtain any data on 5yr EURCZK forward outrights from at least 5 years ago2 year Forward HorizonData source: Bloomberg
22 Alternative Hedging Solutions Overview Consequently, given a need to hedge a short EUR / long CEE exposure, long-dated outright FX forwards have a relatively high opportunity cost when comparing the long-dated outright forward rate to the spot rate realised at the end of the hedge horizon.The fact that a number of CEE currencies are actively seeking to enter into currency convergence with the Euro within the next 5 years should at least be considered by any long-dated hedging strategyFurther we look at ways that such an exposure may be hedged without the need to commit to a long- dated FX forward.First there are “standard” solutions we considered beforeCross Currency SwapsOptionsThen we look at dynamic alternatives to long-dated forwards for hedging:Rolling ForwardsContingent Hedging
23 Hedging FX Risk with Cross Currency Swaps A cross currency swap would enable a hedger to implicitly sell one currency versus buying the other at the embedded exchange rate in the cross currency swap, usually close to the spot rate at the outset. This may be attractive where an investor buys a high yielding bond and intends to isolate the CDS and the basis spread (fixed rate vs Xbor) as forward rates embed significant depreciation of the currency of the investment.An upwardly-sloping forward curve would generally be associated with CEE interest rates being higher than Euro rates, so in return for being able to effectively sell Euro at the current market spot rate, the absolute amount of the floating rate paid by the client in CEE currency may be significantly higher than that payable in Euro.The trade-off of a known embedded FX rate for selling CEE currency / buying Euro through a cross currency swap is the higher rate of floating interest that would be paid in the CEE currency. Thus, a CCS will also be used to take a view on convergence, under which circumstances the rates on each side of the swap will converge to the same levelHUFInitial exchangePeriodic exchanges of LiborUniCreditTiriac BankBuborClientEuriborFinal exchange / periodic Amortisation of principalEUR
24 Hedging Extreme Scenarios Options Out-of-the-money EUR calls / CEE currency puts may be a preferable alternative to long-dated forwards, especially as outright forward rates tend to be a “costly” way of hedging a long-dated short EUR / long CEE currency exposure. The risk of forward rates not being realised is increased when the possibility of EMU convergence of a CEE currency is taken into accountThe strikes must be relatively far from current spot rates, driving the annualised cost of the options significantly lower than the cost implicit in a forward contract.It is true of course that the protection conferred by the option is at a higher spot rate than that of the forward; however the option allows the hedger unlimited participation in CEE currency strength below the option strikeThe overall cost of hedging can be reduced by taking a portfolio approach to the hedging and leaving part of the exposure unhedgedSimilar to outright forwards, it is also possible to implement a rolling option hedge programme, which would reduce up-front premium payment and also enable the hedger to benefit from lower forward- embedded CEE currency depreciation in the future. Up-front premium payment can also be reduced through it being financed over time by the bank, subject to the availability of credit lines.
25 Options – Advantages and Limitations Benefits of hedging long-dated FX exposure with optionsFlexibility: a hedging strategy can use multiple strikes in order to optimise the cost / protection profileKnown maximum cost: the up-front premium paidOpportunity to fully participate in CEE currency outperformance against the outright forward rate versus the EuroPossibility for premium to be recovered through early unwind of optionWhere forwards embed an appreciation of the Euro, options may be a better hedge where there is a good chance of the underlying CEE currency entering EMU within the hedge horizon and at which point forwards will be zeroLower bank credit line utilization than forwardsLimitations of hedging long-dated CEE FX exposure with optionsPremium: an up-front premium amount is payable for option protection. Cost is positively related to time to maturity, the strike rate relative to the outright forward rate to the option’s delivery date and the level of market implied volatilityPricing driven off the outright forward rate, which may embed CEE currency depreciationIf a currency does move towards EMU convergence, the implied volatility of its exchange rate versus the Euro will fall, reducing the time-related element of an option’s value
26 Rolling Forward Rationale and Methodology The idea behind a rolling hedge is to hedge the full outstanding notional amount of a medium- to long-term exposure over a shorter term horizon. The chart below profiles a 5 year asset with annual straight line amortizationThe full amount outstanding debt service payments [principal and interest] are hedged on a period-by-period basis; the advantage of this approach to hedging a long local currency / short EUR position is that a hedger does not have to lock into the wide interest differential between the respective rates for the long term and it also offers more flexibilityIf a rolling hedge is used as an alternative to a strip of long-dated outright forwards, it will also have positive implications regarding credit line utilization; the company would however need to be sure of having access to a credit line when coming to roll the hedge and there would be a liquidity impact on the client in the event of the CEE currency appreciating versus the Euro over the term of a rolling hedgeEUR hedge notional amount to be rolled at each cashflow date is the previous notional amount less intervening EUR equiv debt service cashflows [principal and interest]Total Outstanding EUR Loan Service CashflowsEUR annual debt service cashflow amount
27 Rolling Forward Fixing Risk Diversification In order to mitigate fixing risk and to better fit the liquidity and tenor constraints of the underlying FX market, a company can also consider entering into a staggered rolling hedgeThis would involve at the start entering into quarterly, semi-annual, nine month and annual forward hedges to cover, in total, the aggregate amount of the outstanding underlying exposureOnce the initial forward contract rolls off, this would be cash settled and the aggregate outstanding hedge amount reduced by any debt service due. The chart below suggests quarterly interest payment and annual principal amortizations. A new hedge would be put in place after 3 months with a 12 month tenor, and similarly after 6, 9 and 12 monthsIn this way, the investor would have the same aggregate forward protection in place but each forward contract would be smaller in size, leading to fixing risk diversification and smaller potential cash settlement requirementsEUR Debt ServiceQ1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4Year 1Year 2Year 3 …
28 Rolling versus Outright Forward Example As an illustrative example, we looked at the impact of the two alternative FX hedges on a TRY investment/bond for an Euro based investor budgeting a 20mm Euro annual cash inflow from the investmentUnder the outright forward, the hedger would enter into 5 separate contracts at the outset; under the rolling forward, there would be just oneThe TRY projected cashflow occuring at the end of Year 1 will be the same for both the outright forward and the rolling forwardAt this stage, however, the rest of the rolling hedge notional is settled at market and a new hedge put in place for another year. As the spot rate had not risen by as much as envisaged by the 12m forward rate originally entered into, the new 12m forward rate is lower than the 2 year forward rate locked into from the startExpected (budgeted) Cashflows+ve-veYr1 Yr2 Yr3 Yr4 Yr5€20m €20m €20m €20m €20m
29 Rolling Forward “Crash Scenario” In a potential ‘crash scenario’, where for example the EURTRY spot rate doubles over a short period of time, the rolling hedge provides adequate protection despite its short tenor.So in our example, the actual rate in 12 months’ time jumps from to 4.00.For example, today’s 12 month forward rate is 2.25, which is an implicit depreciation of 12.0% (as implied by current forward points).All the future debt obligations in TRY are hedged for 12 months using a forward contract. EUR 100m = TRY 225m at 2.25The depreciation of TRY causes the EUR 100m obligation to become TRY 400m.Investor receives a compensatory payment of TRY 175m via the rolling hedge, and hence is fully hedged as the benchmark for a future-dated cashflow in 12 months’ time was the forward (2.25) at the start; the client has achieved an effective hedge rate of 2.25 with the rolling forward (= [TRY 400m – TRY 175m] / EUR 100m)The hedge is rolled for a further 12 months at the new FX levels. Client is relatively indifferent to the depreciation as they have received compensation in TRY that fully covers the change in the value of their future obligations.EURTRY4.002.00t0t1PV of all future debt obligations is hedged€100m50% TRY depreciation results in compensatory paymentTRY 175m
30 Rolling versus Outright Forward Summary Hedge Effectiveness: each of the two strategies, offer full protection against adverse FX movementsCash flow effects: When hedging with a rolling forward, the hedger only pays a cash settlement amount if the currency they are selling forward has strengthened versus the contracted forward rate; the hedger will receive cash if that currency has weakenedRisks: It is actually the tighter forward points under the rolling hedge that make that hedge cheaper than having locked into high forward points for the full tenor at the outset. A rolling forward hedge therefore makes sense if a hedger thinks that the interest differential between the two currencies is likely to narrow and specifically that future forward points will be less positive than those at the outsetUnder the rolling hedge, the forward points do embed some depreciation of EURTRY on a forward basis and the hedger is obliged to exchange cashflows at these levels on the maturity date of the forward contract.An option-based hedge on the other hand allows unlimited participation in TRY strength and we look at such a hedge in a subsequent section.EUR ReceivableTRY Payable
31 Contingent Hedging of CEE FX Risk Overview Hedging with options requires the hedger to pay an up-front premium (alternatively this can be financed over the term of the option, subject to bank credit lines).Up-front option cost can be reduced by placing the option strike further out-of-the-money, reducing option tenor or covering less than the full amount of the exposure. However, up-front option premium can be reduced in a further way, through the option hedging only being put in place according to a tailored FX Algorithm.Following a rule-based algorithm increases the transparency surrounding when contingent hedging is put in place.Rather than paying up-front option premium, the client invests in a floating rate note whose outstanding amount will only be drawn upon in the event that the FX Algorithm determines that FX hedging – in the form of FX options – needs to be put in place.The FX Algorithm is designed to determine how much incremental notional hedging needs to be put in place and at what strike rate.If the contingent amount is fully used up, the investor will have to draw on other resources if it want to protect against subsequent adverse FX movements.
32 Contingent Hedging of CEE FX Risk The Algorithm Mechanics The Maximum Loss rate is determined by the client - for example, a loss of 25% due to adverse FX movementsReference market levels are calculated based on the client’s stated Maximum Loss scenario and are expressed in terms of option deltas in order to reflect the likelihood that a certain market level will be reached. In this way they reflect prevailing market implied volatilities and the relevant time horizon.The Trigger level signal to add incremental option notional is the rate at which, under prevailing market conditions, the Maximum Loss is equivalent to a 12 month 15Delta strike. A 12 month reference tenor is chosen rather than the full maturity term in order to mitigate premium spend associated with protecting against temporary spikes in the FX rateThe Hedge Rate strike at which further option notional would be bought is a 25Delta strike relative to the Trigger Level.Sufficient notional is bought at the Hedge Rate to push the Maximum Loss Rate from being a 15Delta event to being a 10Delta event. The spot rate would therefore have to reach a higher spot rate for the hedger to lose the 25% worst case determined at the outset.15Δ Option Strike with respect to TriggerAt StartOriginal Max LossCurrent SpotEUR strength / CEE weaknessTrigger LevelHedge Rate25Δ Option Strike with respect to Trigger10Δ Option Strike with respect to TriggerIf Euro strengthens above Trigger LevelOriginal Max LossNew Max LossTrigger LevelHedge Rate
33 Contingent Hedging of CEE FX Risk Analysis If the trigger is never hit the option protection is never needed, and the client will not have spent any premium and will not have been locked into any forward contracts embedding significant costs. The hedger retains the potential to participate in currency strength following any temporary spike higher of the FX rate; at the same time, peace of mind comes from the fact that protection is available to be put in place should it be required and whilst the contingent premium resource has not been exhausted.Deltas can be defined with respect to a shorter horizon than the full term of the exposure. This is to avoid the cost of implementing contingent hedging to the end of the exposure when a move higher in the FX rate may prove to be only temporary. However, if the spot rate remains persistently higher, beyond the expiry date of the contingent hedge originally implemented, additional premium may need to be spent in order to replace the expired hedge.Higher market volatility will tend to push the Trigger closer to the current spot rate, thereby increasing the chances that incremental hedging needs to be put in place. However, referencing specific Deltas helps to mitigate the cost of putting in place that contingent hedging.Market parameters can be checked as frequently as required and then the Trigger Level revised to reflect market movements.Contingent hedging is suitable for clients that have a relatively bullish view on the expected performance of the investment currency versus the base currency but whom would like to put in place “insurance” on a contingent basis in the event that the FX rate does in fact move considerably against expectations.There is a minimal opportunity cost of the contingent premium as it is invested in a UniCredit Bank AG FRN.
35 Interest Rate Risk Held to Maturity vs AFS vs Held for Trading Visibility, Correlation and Added Uncertainties – Interest Rate and CreditHedge AccountingProductsIRS and the likesIR OptionsStructured solutions
36 Interest Rate Risk Duration Gap Benchmarking Issues Regulatory FrameworkAvailable Instruments & LiquidityNeed for Structured Solutions (classical example – Reverse Floater notes or Long Receiver Swaps)
37 Think the (Im)possible? USD 1M Rates in the 80s
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