China's capitalists are getting a lesson in the law of supply and demand. As they scramble to hedge exposure to dollars following the yuan's devaluation, chief financial officers from Shanghai to Shenzhen are finding the costs have gone up.
For some, the price has been too high. Modern Land China hasn’t used swap markets to protect against currency risks because of the expense, Faye Fang, a Hong Kong-based investor relations officer at the Beijing-based developer, told Bloomberg News. The yuan has depreciated about 4.2 percent against the dollar and 6.5 percent against the euro in the past 12 months. With China's currency no longer seen as a one-way bet on appreciation, there's been a rush to protect against further declines.
The higher cost of hedging has affected investors as well as companies. Pimco's Luke Spajic told Bloomberg News that one hurdle for investing in China's local bond market right now is the cost of immunizing portfolios against currency volatility.
One of the cheapest ways of hedging against currency exposure is to use options. Among the principal measures of option costs is implied volatility, which reflects what kind of swings investors expect in the underlying security. That gauge has surged for the yuan since China's unexpected devaluation on Aug. 11. Three-month implied yuan volatility hit 9.6 percent on Feb. 3, the highest since December 2008 and six times the level it was at in April.
Option prices have increased in response to higher demand for dollar-yuan calls, which rise in value as the Chinese currency depreciates (a call option gives the right but not the obligation to buy an asset at a certain price within a set time frame). The one-month risk reversal, a measure of the premium paid for calls over puts (the right to sell), hit the highest in almost 26 years on Aug. 12.
Buying options is the cheapest way to hedge foreign currency exposure, but not the best. Among their limitations: While options are more liquid, they have short tenors. Maturities longer than a year are expensive and hard to find. That means that every so often the hedge has to be rolled over and if that need comes just as there is a jump in volatility, the costs increase.
The more conservative chief financial officers in the emerging world usually enter into a basis swap that hedges the entire cash flow of their bond throughout the life of the security. That increases the costs of selling bonds offshore but significantly reduces headaches and surprises.
Perhaps investment bankers are now adding a bit of hedging education to their bond-sale pitches in China. They might take a leaf from the insurance salesman's book: It's best to buy protection before you actually need it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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