Effective FX risk management policy in emerging markets is difficult because it is a combination of math and finance designed to

• control exposure,

• hedge the cost of protection,

• explain the risks to the business,

• try to control the downside if possible.

Each emerging market presents a unique set of challenges.

With that being said, treasurers look at emerging markets for high potential upside. However, you should also take extra precautions on risk management. The overall goal is to not just look at the market for short-term cash flow or as a low-cost manufacturing or service base but to create enough core business to eventually become profitable on its own. To help you out, we thought it would be useful to have a short discussion about this subject. If this is something that you’re interested in learning more about, read on as we discussed what you need to know about managing FX risks for emerging markets.

What Are the Risks of Investing In Emerging Markets?

Emerging markets often seem to offer new investment opportunities to investors. The higher rates of economic growth in these countries can provide higher returns than investments in wealthier developed nations, and these countries also provide diversity from the established economies. However, there are a number of risks that potential investors must be aware of before planting their money in one of these up-and-comers. Before anything else, it’s important to understand the different risks involved in emerging markets.

There are a slew of different things that you’ll have to be wary of when it comes to emerging markets. One of the things that can hurt your bottom line is the high interest rates and volatility that come with these emerging markets. Rapid devaluations can also be quite impactful for emerging markets. Couple this with the fact that emerging markets may also lack global banking partners and it’s easy to see why emerging markets pose a serious problem for even the most experienced treasurers.

Political risk is also something that you’ll want to consider. Political risk involves uncertainties associated with the political environment of a currency. In emerging markets, these risks include the possibility of government subsidies, the nationalization of industries, and social instability. Other factors that contribute to political risk include war, tax increases, loss of subsidy, change in monetary policy and laws regarding resource extraction. Major political instability can also result in civil war and shutdowns of the industry as workers either refuse or are no longer able to do their jobs.

How Do You Frame Emerging Market Exposure?

The key starting point for managing risk exposure from emerging markets is to determine the objective. It is only after the objective is established that the various options for managing or accepting the risk can be analyzed. If we look at some fundamentals, then focusing on cash flow is a close proxy to protecting value. There are some nuances to consider, though. There are various means of doing this, but they can be summarized into three main categories:

1. Fix the value of emerging market currency cash flow

2. Allow the emerging market exposure to float

3. Cap the downside

With this in mind, we present two methods of analyzing the risk of emerging market currency exposure. These methods could be used in conjunction with each other and are not mutually exclusive. A traditional method is to set up a forward foreign exchange agreement. In this case, the FX swap fixes the cash flows. Alternatively, borrowing directly in the local currency would work similarly. This can help if there are particular problems with repatriating funds or risks related to appropriating assets. Borrowing locally is occasionally more expensive and burdensome because of conditions and covenants.

It's important to note that each market is different. Varying tax, exchange control and political risk factors are all things that you have to take into consideration. This is why emerging market risks often take up a completely disproportionate amount of a treasurer’s time.

How Should You Deal with the Cash Flow Versus the High Costs of Borrowing?

Many corporate treasurers with any significant exposure to emerging market currencies will cite the high cost of borrowing in these currencies as one of the most significant pain points. Traditionally, the approach has been to sell forward all of the emerging market cash flow in order to fix it at today’s rate and avoid any material devaluation, but this approach can seem too restrictive. If there is a high level of devaluation baked into the interest charge within the forward contract, treasurers may feel compelled to avoid accepting this cost, especially when currency devaluation doesn’t appear directly in the profit and loss account as a line item. However, currency devaluation is impacting the profit and loss account by translating profits from the emerging market into reporting currency at a lower rate.

If you're looking for an example of how this works, look no further than the real and the rupee. The real and rupee have generally weakened at an accelerated rate compared to what we would expect from their relative interest rates. This has meant that fixing this rate and accepting the cost of the interest has been a financially advantageous stance. This should help to comfort the many treasurers who sell these cash flows at a fixed price and bear the cost of doing so.

In addition to comparing whether to fix the exchange rate or let it float, a strategy known as the “hybrid” strategy has also been introduced. The principle behind this strategy is that, if the currency is weaker than its long-term trend, it will tend to strengthen over the next year. Conversely, if the current rate is stronger than its long-term trend, the currency is likely to weaken.

How Does Your Risk Management Approach Change When You Consider Value Over Cash Flow?

There are two contrasting long-term trends in an emerging market. In the long run, the currency weakens against “developed world” currencies and the local currency grows according to inflation and productivity. We could view a company’s investment in an emerging market as a bet that cash flows will increase more than the devaluation of the currency. In essence, it is another dimension of the “value case” for investing in an emerging market at the outset.

If you look to look at emerging market risk in terms of value, then we need to analyze the point at which the exchange rate weakens to such an extent in the future that the Net Present Value (NPV) of the operation becomes zero — that is, the business’s value as it stands today is reduced to zero. If this sounds a little technical, it’s only because I’m trying to describe a process by which we determine how much the exchange rate weakens in the future that will erode a business’s value entirely due to currency risk. In risk management terms, this is called the pain point because it is the level at which an emerging market currency put option can be set to hedge against the loss of that business’s overall value.

What Can You Do to Help Manage FX Risks In Emerging Markets?

The importance of emerging market currencies in the global economy has grown steadily as emerging economies account for 36% of world GDP and over 27% of world trade, yet there have been eight large depreciations of emerging market currencies in the last five years, according to the International Monetary Fund. Managing the company’s financial interests in these challenging markets has become a top priority for treasurers. Which factors should they be looking at?

Many corporate treasurers with large exposure to currencies in emerging markets lack a policy due to the volatility of their currencies. These companies typically do not hedge their positions, but a more structured approach may be beneficial. When a currency from an emerging market is relatively quiet, it tends to be off people’s radar. Then, once it makes news headlines, it may be too late; the cost of hedging may already be expensive, and the opportunity will have passed you by

The risks associated with emerging markets and regulations can differ from county to county. The complexity of managing investment in these markets is extensive. Emerging market currencies are limited in their ability to convert to other currencies, and they often trade thinly compared to G10 currencies. Some of these currencies, such as the Mexican peso or the Russian rouble, can be hedged with forward contracts, while others, such as the Brazilian real, the South Korean won, Indonesian rupiah or Malaysian ringgit, must usually be hedged and settled offshore in the paired G10 currency.

In the case of the real, for example, which cannot be taken out of Brazil, there are two markets. One is based offshore and deals in non-deliverable forwards and options; this is the non-deliverable forwards (NDF) market. The other market is onshore and deals in currency swaps, forwards, and options for which a Brazilian presence is needed; this is the onshore market. A corporation with a central treasury and one in Brazil can arbitrage between these two markets by purchasing NDFs that are hedged centrally or buying locally hedged options. They can then choose the cheapest.

The main cost of hedging currencies through forward contracts is the interest rate gap. If you are borrowing or hedging with a forward contract, you need to figure out if the gap between what you're paying in interest and the amount of currency devaluation is higher than the average amount of devaluation. There's statistical supporting evidence that this is common, so it may not be a good idea to hedge all emerging market currencies all the time.

Hedging with a forward contract usually costs more than hedging with options. If you are hedging an emerging market currency, where there is a 10% interest rate differential, your forward contracts will lock in a 10% deprecation. With an option, you will pay a premium to protect yourself against the deprecation. The interest rate differential can be so high that the premium of the option becomes more attractive than the cost of a forward contract, so you can avoid locking in the depreciation.

Conclusion

We hope this article proves to be useful when it comes to furthering your understanding of how to manage FX risks in emerging markets. While it can be rather tricky, this isn’t something that you won’t be able to do as long as you are well-informed. Doing business in emerging markets exposes a company to risks that are not present in developed markets. Many of these risks are related to commercial and strategic factors. In this article, we have considered the age-old question of whether fixing the emerging market currency or selling forward and accepting the usually high-interest costs, pays off compared to allowing the exposure to float.

We considered a range of investment strategies, including the strategy of hedging against risk by adding the condition that we only fix our exchange rate when the interest rate trend is projected to be in our favor. The results of this strategy were mixed. Next, we looked at a method for managing emerging market currency risks by selecting a point of pain, which led us to create an out of the money put option as a hedge. With that being said, we can use these two strategies together to hedge different time horizons.

We understand that this may be a lot to take in all at once. Luckily, you are free to come back to this article when you need a brief refresher on this subject. For the best results, it would also be wise to utilize all the resources you have available so that you can effectively manage the risks that come with these emerging markets.

When it comes to managing FX risks, you’ll want to do all you can to ensure that your interests are protected. Bound is an auto hedging platform dedicated to making currency protection better for businesses of all sizes. For more information on what we can do for you, we implore you to visit our website today!