Removing a Risk: Hedging with NDFs and NDOs in Emerging Markets

By Ogden, Joan | Global Finance, February 1997 | Go to article overview
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Removing a Risk: Hedging with NDFs and NDOs in Emerging Markets


Ogden, Joan, Global Finance


Most developing countries' central banks require documentation to bring foreign exchange into the country. Some, Brazil among them, levy a tax-Brazil's is 7%-on such transactions. Emerging markets are also subject to convertibility risk, the possibility that a central bank will suddenly not allow its currency to be exchanged at all, as happened in Mexico in 1982. All this has made hedging emerging market currency exposure difficult, expensive, and sometimes downright impossible. But now, thanks to a growing market in nondelivery forwards (NDFs) and options (NDOs), companies are finding it increasingly easier and cheaper to protect themselves from emerging market currency risk. If they're actually hedging a loan, an NDF or NDO may also achieve a lower cost of funding.

Take a European company exporting to Argentina and expecting payment in Argentine pesos 180 days from the date of sale. Rather than selling pesos for dollars six months forward, the company simply enters into a contract with its bank to settle in dollars the difference between an agreed upon peso/dollar exchange rate and the average rate at which pesos happen to be trading in the spot market in six months. At that time, if this so-called reference rate is weaker than the contract rate, the bank will pay the exporter the difference in dollars. If it's stronger, the exporter will pay the bank the difference-again, in dollars. Then the exporter can buy Argentine pesos in the spot market.

James Kemp, managing director of foreign exchange at Citibank, estimates that NDFs in the more liquid currencies, such as the Mexican peso and the Brazilian real, have grown by 25-50% over the past year. The market appears set to grow even more rapidly in the year ahead. Peter Ellsworth, managing director for foreign exchange sales at BankBoston, reckons that inquiries in NDFs have "at least quadrupled" over the past year. In Mexico, where foreign exchange controls have been removed, NDFs are making dramatic inroads on the older and larger cobertura market, where forwards require an up-front premium and settle in pesos.

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