Are non-deliverable currencies are always expensive to cover? What are you views recommendations for such exposures?
This question was asked during the Proformative
Are non-deliverable currencies always expensive to cover? (Webinar Attendee Question)
Answers
Hi Kurt
A currency is usually non-deliverable when the market for that currency is not liquid (small amounts traded), local restrictions have been put in place by local governments, the currency is not traded outside the country...
In consequence, it is usually much more expensive to cover this non-deliverable currencies.
Regards
You didn’t indicate if you were long or short these currencies but given that you are concerned about expense I will assume you are selling these currencies forward. Because you are paying for the privilege to hedge this my first step would be to assure myself that my exposures were “economic”, not just coming from an intercompany account that may never pay down. If it is an intercompany receivable and not going to be repaid any time soon determine if it meets the ASC 830 criteria for a long term investment treatment (start treating it like equity). If you are expecting the funds from the intercompany or a 3rd party one alternative is to look for “natural hedges”: can you factor/sell the receivable into the local market. If you are a borrower, can you borrow some of the funds in these currencies: please note that the borrowing rates will likely be much higher than your US borrowing costs—but that is part of what is reflected in the forward point costs. One thing of critical importance is that the folks making pricing decisions for sales into these economies should be made aware of the “cost” of hedging these receivables. Another way to make the hedging cheaper is to go farther out on the yield curve. I just took a quick look out on Bloomberg and PHP 1 month forwards were by far the most expensive. If you took that hedge and rolled it 12 times it would cost 3 times more than a one year contract. I don’t know how accurate that pricing is but you should definitely review your hedge tenors. There is really no need to roll a hedge every month. Determine your cash inflows/outflows and hedge accordingly. You do not need to be precise: you can still roll small amounts to balance. One last thought: Look at how much the forward cover costs and consider self insurance. If it costs 15% a year to protect a position consider 1) how likely is the currency to move more than 15% and 2) can you stand the P&L volatility if it moved the whole 15% in one month.
The 'expense' of a non deliverable forward really breaks down into two pieces.
1) The expense of what would otherwise be a deliverable forward - based in the interest rate differentials between the two currencies.
2) The 'extra' expense associated with the speculative nature of some currencies - where offshore supply / demand dynamics can lead to a deviation between the deliverable and non deliverable prices. (e.g. USD CNY)
If you are contemplating a currency such as Brazil, the on shore (deliverable) and the off shore prices are very similar and you'd be probably better off IN ANY CASE by using a off shore NDF (to avoid the onerous documentation process that is required for on shore contracts). (if you need to deliver the currency at some point, you can do a off shore / on shore spot trade to prevent 'slippage' in the rate - ask me as an aside what this entails)
If, however, you are contemplating a currency such as Chinese Reminbi (CNY), the off shore and on shore markets tend to be quite different because there is high demand from speculators for the forward purchase of CNY. This results in the purchase of CNY forward to be MUCH more expensive off shore and thus you'd want to purchase the currency on shore if you have a legitimate commercial purpose. If you want to SELL CNY forward, the off shore market presents a better opportunity from a pricing perspective.
Lots of moving pieces to this - happy to discuss off line.
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Cash Management