Currency Management for Emerging Market Currencies

Managing emerging market currency risk presents a unique set of challenges, with two key considerations at the forefront:

1. Higher trading costs: Many emerging market currencies have thin trading volumes. These occasions increase transaction costs due to broader bid-offer spreads. Additionally, the limited availability of standardized derivatives products means that banks often need to create custom solutions for their clients, resulting in higher markups due to the exotic nature of these products.
2. Increased likelihood of spikes in volatility: Thinly traded currency pairs pose a higher risk of elevated transaction costs. For instance, an investor in Mexico (using the Mexican peso, currency code MXN) seeking investments denominated in the Thai baht (THB) may face challenges as the MXN/THB cross is likely to have limited trading activity due to insufficient trade or capital flows between the two countries. Consequently, major intermediary currencies such as the USD are often employed to facilitate transactions. However, this may lead to more frequent trades and, consequently, higher transaction costs.

Moreover, excess carry trades can exacerbate the issue of thinly traded currencies, resulting in crowded markets. While this may make it easier to enter foreign currency positions, it complicates unwinding these positions when conditions change.

Another critical factor is the non-normal distribution of return probabilities for currency trades with relatively frequent extreme events. Using risk measurement and control tools such as Value at Risk (VaR) that rely on normal distributions can be misleading, substantially underestimating the portfolio’s actual risks.

Furthermore, government involvement can impact currency management in thinly traded markets. This involvement may manifest through foreign exchange market intervention, capital controls, or pegged exchange rates. However, these interventions are often driven by political considerations rather than economic fundamentals or sound financial principles, leading to unpredictability in emerging markets.

Non-Deliverable Forwards (“NDFs”)

Non-deliverable forwards (NDFs) serve as a solution for traders aiming to manage currency risk in tightly controlled currencies, where capital controls restrict traditional approaches. These NDFs are similar to regular forward contracts, but have one crucial difference. They are cash-settled in a freely traded currency within the currency pair, instead of being physically settled. As a result, the controlled currency is neither delivered nor received at the contract’s maturity. The common choice for the freely traded currency in NDFs is usually the USD or another major currency.

Below is a partial list of some significant currencies for which NDFs are available:

• Chinese yuan (CNY).
• Korean won (KRW).
• Russian ruble (RUB).
• Indian rupee (INR).
• Brazilian real (BRL).

NDFs (Non-Deliverable Forwards) serve as cash-settled “bets” on the future movement of the spot rate for the specified currencies. Traders use NDFs to mitigate risks in restricted currency environments and effectively manage their exposure to fluctuations in these controlled currencies. 

Question

An investor from Barbados, who deals with the Barbadian Dollar, has recently invested in a group of resorts in Anguilla, which operates with the East Caribbean Dollar. Assuming all other factors remain constant, what is the most likely outcome for a thinly traded currency pair?

1. The pair will have tighter bid-ask spreads.
2. The pair will exhibit normal distributions of returns.
3. The pair will rely on an intermediary cross-currency.

Solution

The correct answer is C:

Due to its proximity, the thinly traded currency pair between the Barbadian and East Caribbean Dollar will likely be traded through the US dollar. However, this introduces additional transaction costs, involving at least one more bid/ask spread, and possibly extra markups.

A is incorrect. Tighter bid-ask spreads are associated with less costly trading, typically accurate for major currency pairs like USD/EUR.

B is incorrect. Thinly traded currencies and their pairs display higher volatility and risk levels. Consequently, this alteration in risk characteristics leads to a change in the distribution of returns, shifting away from the normal distribution and instead favoring distributions with fatter tails. These fatter tails indicate a higher frequency of extreme events or collapses.

Derivatives and Risk Management: Learning Module 3: Currency Management: An Introduction; Los 3(i) Discuss challenges for managing emerging market currency exposures.