Currency Derivatives

Most of the currency derivatives trading around the world takes place through the overthe-counter (OTC) markets, with foreign exchange swaps accounting for more than two-thirds of the turnover. In emerging markets, the most liquid OTC currency derivative markets are in Hong Kong SAR, Singapore, and South Africa, where average daily turnover significantly exceeds the spot market turnover. By contrast, a significant share of the foreign exchange derivative trading in Brazil takes place at the organized exchange—Bolsa de Mercadorias & Futuros of Sao Paulo, or BM&F (see Box 4.1). According to the Bank for International Settlements (BIS), the global market activity in currency derivatives has been on a declining trend since 1998, with the average daily turnover in the global OTC currency derivatives markets falling to $853 billion in April 2001 from $959 billion in April 1998, in parallel with the contraction of the global spot market activity. The latter is generally attributed to the introduction of the euro, expansion of E-broking, and banking sector consolidation. By contrast, the turnover in the emerging foreign exchange spot markets increased, with the share of emerging market currencies (including the Hong Kong SAR and Singapore dollars) in global foreign exchange turnover rising from 5.5 percent in April 1998 to 8.6 percent in April 2001. Turnover of currency derivatives in emerging markets remained roughly stable (see Table 4.2).

Table 4.2.

Average Daily Turnover in the Over-the-Counter Derivatives Markets

(In billions of U.S. dollars)

Source: Bank for International Settlements, Triennial Central Bank Survey 2001. Note: Turnover is defined as the absolute gross value of all new deals entered into during the month of April. No distinction is made between sales and purchases. The basis for reporting is the location of the office where any given deal was struck, so transactions concluded abroad were not reported by the country of location of the head office.

Table 4.2.

Average Daily Turnover in the Over-the-Counter Derivatives Markets

(In billions of U.S. dollars)

	Total			Foreign Exchange			Interest Rate
	April 1998	April 2001		April 1998	April 2001		April 1998	April 2001
Brazil	…	2.1		…	1.9		…	0.3
Chile	0.5	0.6		0.5	0.6		—	—
China	…	—		…	—		…	—
Czech Republic	3	1.4		3	1.2		—	0.2
Hong Kong SAR	51.4	52.0		48.9	49.4		2.4	2.6
Hungary	0.5	0.2		0.5	0.2		—	—
India	1.3	2		1.3	1.8		—	0.1
Indonesia	1	0.5		1	0.5		—	—
Korea	1.1	4		1	3.9		—	0.1
Malaysia	0.8	0.9		0.8	0.9		—	—
Mexico	2.6	4.6		2.4	4.2		0.2	0.4
Philippines	0.4	0.6		0.4	0.6		—	—
Poland	0.5	3.8		0.5	3.3		…	0.5
Russia	0.9	0.2		0.9	0.2		—	—
Singapore	90.7	72.5		85.4	69.3		5.3	3.2
South Africa	6	8.4		5.2	7.9		0.8	0.6
Taiwan Province of China	1.6	1.8		1.5	1.7		0.1	0.1
Thailand	2.2	1.3		2.2	1.3		—	—
Turkey	…	0.7		…	0.7		…	—
Total	164.5	157.6		155.5	149.6		8.8	8.1

Source: Bank for International Settlements, Triennial Central Bank Survey 2001. Note: Turnover is defined as the absolute gross value of all new deals entered into during the month of April. No distinction is made between sales and purchases. The basis for reporting is the location of the office where any given deal was struck, so transactions concluded abroad were not reported by the country of location of the head office.

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Table 4.2.

Average Daily Turnover in the Over-the-Counter Derivatives Markets

(In billions of U.S. dollars)

	Total			Foreign Exchange			Interest Rate
	April 1998	April 2001		April 1998	April 2001		April 1998	April 2001
Brazil	…	2.1		…	1.9		…	0.3
Chile	0.5	0.6		0.5	0.6		—	—
China	…	—		…	—		…	—
Czech Republic	3	1.4		3	1.2		—	0.2
Hong Kong SAR	51.4	52.0		48.9	49.4		2.4	2.6
Hungary	0.5	0.2		0.5	0.2		—	—
India	1.3	2		1.3	1.8		—	0.1
Indonesia	1	0.5		1	0.5		—	—
Korea	1.1	4		1	3.9		—	0.1
Malaysia	0.8	0.9		0.8	0.9		—	—
Mexico	2.6	4.6		2.4	4.2		0.2	0.4
Philippines	0.4	0.6		0.4	0.6		—	—
Poland	0.5	3.8		0.5	3.3		…	0.5
Russia	0.9	0.2		0.9	0.2		—	—
Singapore	90.7	72.5		85.4	69.3		5.3	3.2
South Africa	6	8.4		5.2	7.9		0.8	0.6
Taiwan Province of China	1.6	1.8		1.5	1.7		0.1	0.1
Thailand	2.2	1.3		2.2	1.3		—	—
Turkey	…	0.7		…	0.7		…	—
Total	164.5	157.6		155.5	149.6		8.8	8.1

Source: Bank for International Settlements, Triennial Central Bank Survey 2001. Note: Turnover is defined as the absolute gross value of all new deals entered into during the month of April. No distinction is made between sales and purchases. The basis for reporting is the location of the office where any given deal was struck, so transactions concluded abroad were not reported by the country of location of the head office.

Among the emerging markets of Asia, Singapore has the largest foreign exchange derivatives market. A notable pickup in cross-currency swaps occurred after 1998, when the government allowed foreign entities to issue Singapore dollar bonds and to swap the proceeds into foreign currency for use outside the country. In Korea, the development of the onshore currency derivatives market was constrained by a legal requirement that any forward transaction had to be certified as a hedge against future current account flows (the so-called “real demand principle”), which also spurred the development of a liquid offshore “nondeliverable” forward (NDF) market in the Korean won. In 1999, this restriction was lifted and a lot of activity moved onshore, leading to the convergence of the offshore and onshore prices.

Generally, the NDF contracts are the principal instruments in the offshore derivatives markets for emerging market currencies and are often preferred by foreign investors who have restricted access to the onshore market and want to avoid potential costs of delivering local currencies or to reduce their counterparty credit risk exposure. In most cases, NDF markets trade at a premium to local markets because offshore financial institutions have limited access to local funding. In Taiwan Province of China, for example, the average implied one-year NDF yields were around 150 basis points higher than onshore rates during 2001–02. In some cases, however, offshore markets perform functions that are not performed by onshore markets. For example, while both onshore and offshore forward markets in Korea are most liquid in maturities of up to one year, the NDFs and swaps can be structured in tenors of up to 10 years in the offshore market.

In Latin America, the most active foreign exchange derivatives markets are in Brazil and Mexico (see Table 4.2). The recent expansion of currency derivatives in Brazil was stimulated by the flotation of the real in early 1999 and regulatory authorization for OTC derivatives on foreign exchange, interest rates, and price indexes. The change in the exchange rate regime coincided with sharply higher volatility in both the real-dollar rate and Brazilian interest rates, contributing to the creation of a “hedge culture.” At present, trading in currency derivatives is much higher than that in the cash market: daily currency derivatives turnover is more than $5 billion compared with a little over $1 billion in the spot market. Most of the derivatives contracts are “nondeliverable” because, historically, the BM&F did not want local derivatives markets to be limited either by less than free convertibility of the real or by the size of the cash market, with the latter also being susceptible to short squeezes. In contrast with many other derivatives markets, a significant part of the trading in currency derivatives in Brazil takes place at the BM&F. Besides certain features of the country’s legal framework that had hampered the development of the OTC market, the BM&F itself was actively trying to absorb part of the OTC business (see Box 4.1). In contrast to the rapid growth of derivatives markets in Brazil, the development of exchanges in Mexico has been slower, primarily because the exchanges in Chicago (which are in the same time zone) have launched numerous derivative products based on Mexican underlying assets.

In emerging Europe, Middle East, and Africa (EMEA), the most liquid OTC forward foreign exchange market is in South Africa, where daily turnover significantly exceeds turnover in the spot market (see Table 4.2). By contrast, the liquidity of the Central European derivatives markets remains limited. Hungary has seen a strong pickup in currency derivatives trading since the move to greater exchange rate flexibility and removal of capital controls, but, compared to Poland, liquidity is still low (see Tables 4.1 and 4.2). The relatively limited development of onshore derivatives in the Central and Eastern European (CEE) countries is due to some extent to restrictions on derivatives trading, including regulatory constraints on the use of hedging instruments by local corporates and pension funds. Many of the derivatives linked to the Central European currencies are reportedly traded offshore, mainly out of London.

Fixed-Income Derivatives

In contrast to recent trends in markets for currency derivatives, global fixed-income derivatives activity surged over the past few years, with daily average turnover in the global OTC interest rate derivatives market rising from $265 billion in April 1998 to $489 billion in April 2001, according to the BIS. Interest rate swaps constitute the largest (around 70 percent of total turnover) and the fastest growing segment of the market. The rapid expansion of the interest rate swaps was triggered by the liquidity crunch in the cash and exchange-traded derivatives markets during the Russia/Long-Term Capital Management crisis and the reduction in the U.S. government bond market liquidity due to the planned debt repayments, which forced market participants to look for alternative hedging and benchmark instruments and encouraged the shift into the OTC swaps market (see Schinasi and others,2001). As in the case of currency derivatives, the OTC segment of the global fixed-income derivatives market is significantly larger (when measured in terms of the outstanding notionals) than the exchange-traded derivatives segment, although the average daily turnover in the latter is higher, possibly due to the shorter maturity of the exchange-traded instruments.

In emerging markets, the most deep and liquid fixed-income derivatives markets are in Singapore, Brazil, and South Africa (see Tables 4.1, 4.2, and 4.3). In terms of the outstanding notional of the exchange-traded fixed income derivatives, the Singapore Exchange (SGX) is far ahead of all other emerging markets, with most traded contracts including Euroyen LIBOR, Euroyen TIBOR, and Eurodollar futures and options.

Table 4.3.

Exchange-Traded Options and Futures Contract Trading Volume,2001

Sources: International Federation of Stock Exchanges (FIBV); and FOW TRADEdata.

Table 4.3.

Exchange-Traded Options and Futures Contract Trading Volume,2001

		Stock	Equity Index	Government Debt	Interest Rate	Foreign Exchange
Latin America
Brazil		69,065,436	6,713,344	3,012	88,626,322	24,869,397
Mexico		…	34,478	958,908	16,813,830	205,068
Asia
Singapore		6,575	9,349,788	624,435	21,008,786	…
Hong Kong SAR		4,010,411	5,889,934	1,175	643,806	4,226
Korea		…	855,257,564	9,323,430	1,410	1,681,677
Taiwan Province of China		…	4,351,390	…	…	…
Malaysia		…	288,092	…	54,914	…
Europe, Middle East, and Africa
South Africa		6,517,235	28,798,060	14,072	…	…
Hungary		879,049	1,245,481	1,800	7,585	2,750,373
Poland		60,557	…	…	…	14,325

Sources: International Federation of Stock Exchanges (FIBV); and FOW TRADEdata.

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Table 4.3.

Exchange-Traded Options and Futures Contract Trading Volume,2001

		Stock	Equity Index	Government Debt	Interest Rate	Foreign Exchange
Latin America
Brazil		69,065,436	6,713,344	3,012	88,626,322	24,869,397
Mexico		…	34,478	958,908	16,813,830	205,068
Asia
Singapore		6,575	9,349,788	624,435	21,008,786	…
Hong Kong SAR		4,010,411	5,889,934	1,175	643,806	4,226
Korea		…	855,257,564	9,323,430	1,410	1,681,677
Taiwan Province of China		…	4,351,390	…	…	…
Malaysia		…	288,092	…	54,914	…
Europe, Middle East, and Africa
South Africa		6,517,235	28,798,060	14,072	…	…
Hungary		879,049	1,245,481	1,800	7,585	2,750,373
Poland		60,557	…	…	…	14,325

Sources: International Federation of Stock Exchanges (FIBV); and FOW TRADEdata.

Over the past two years, falling interest rates and increased local bond issuance in emerging Asia spurred the expansion of the interest rate swaps market, which significantly outpaced the growth in cross-currency swaps.¹ The onshore derivatives markets in Singapore and Korea, which were deregulated more extensively than other regional markets, experienced the fastest growth. As equity prices remained volatile and interest rates continued to decline throughout Asia, many investors shifted from stocks to bonds, turning to the bond futures and interest rate swaps markets either in search of yield or to hedge their bond exposures. For example, in Korea, the increase in the fixed-income derivatives trading volume clearly mirrored the performance of the underlying cash market (see Figure 4.1).

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Korea: Three-Year Government Bond and Bond Futures

Sources: Bloomberg L.P.; and FOW TRADE data.

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Abundant local liquidity and an increasingly sophisticated institutional investor base also contributed to the rapid pickup of the fixed-income derivatives activity in Asia. One of the key drivers behind the growth of the interest rate swaps market in Korea was the entry of the investment trust companies that were allowed to hedge up to 5 percent of total assets using local derivatives. In Singapore, insurance companies, which form the core of the local institutional investor base, increased their participation in the longer-dated bond futures market as well. Similarly, in Taiwan Province of China, pension and insurance companies have become more active users of debt-related derivatives, following their shift toward fixed-income investments and away from equity and real estate.

The recent efforts by several Asian governments to extend the government bond yield curve played an important role in lengthening maturities of the interest rate swap contracts. However, the improvement in liquidity of longer-tenor bond futures has been uneven. For example, the daily volume on the three-year government bond future contract traded on the Korean Futures Exchange (Kofex) grew from 27,000 contracts in July 2001 to 66,000 contracts in July 2002. By contrast, the liquidity of the future contract on the five-year Singapore government bond launched in July 2001 declined markedly, with the average daily volume falling from 878 contracts in July 2001 to 351 contracts in July 2002, partly due to weak activity in the underlying cash market.

In some emerging market economies, most notably in Brazil and Hong Kong SAR, the interest rate swap market is more liquid than the underlying cash market and as a result performs functions that are typically provided by cash markets, such as price discovery and provision of benchmarks. For example, in Brazil, the local swap curve is the benchmark yield curve for maturities beyond one year. In Hong Kong SAR, because the small size of Exchange Fund bonds limits the liquidity of the secondary market, the swap market is more liquid and, therefore, drives the pricing of local bonds.

Equity-Linked Derivatives

Compared with global currency and fixed-income derivatives, the equity-based derivative products represent a much smaller part of the global market, with most of the activity concentrated at the organized exchanges. This reflects in part the diminishing role of local equity markets as a source of funding for local entities. As of June 2001, the outstanding notional of equity-based options and futures was only 3 percent of the global outstanding notional of all types of derivatives (see Table 4.1). While the increased volatility in global equity markets over the past years led more participants to use equity derivatives, the volume of exchange-traded equity futures and options in most mature markets nonetheless rose fairly modestly.

In contrast, the Korean Stock Exchange experienced exceptionally strong growth in equity options and futures trading on the back of increased participation by individual investors (see Figure 4.2), with the average daily volume of Kospi200 options and futures reaching 3.5 million contracts in June 2002 compared to only about 400,000 contracts in June 2000. As a result, the Korean equity index derivatives market has become the second most active in the world after that of the United States. The Hong Kong Exchanges and Clearing Company (HKE) has also been very active in introducing new equity-linked derivative products, such as equity-linked notes and small-sized equity index option contracts, aimed at attracting retail investors. The Taiwan Futures Exchange (Taifex) launched similar instruments to increase retail investor participation. The average daily volume of index futures and options traded at Taifex rose from 2,000 contracts in July 2000 to almost 6,000 in July 2002, with around 90 percent of futures markets reportedly being represented by retail investors.²

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Kospi 200 Index Futures: Cumulative Net Purchases

(In millions of U.S. dollars)

Source: Bloomberg L.P.

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In Latin America, the trading volume of stock options at the Brazilian Bovespa is the highest in the region. In EMEA, South Africa has a fairly well developed equity index futures and options market, with the outstanding notional exceeding that of the Korean market in June 2001 (see Table 4.1). By contrast with index options and futures, the activity in derivatives based on individual emerging market stocks is much lower.

Credit Derivatives

Although the global credit derivatives market is still a very small part of the global derivatives markets, it remains one of its fastest-growing segments despite several major credit events that shook the market over the past few years (for example, defaults by Russia and Argentina, and the collapse of Enron). The data collected as part of the BIS Triennial Survey showed that positions in the global credit derivatives market rose to $693 billion at the end of June 2001 from $118 billion at the end of June 1998.³

The market for credit derivatives in emerging markets mainly consists of credit protection instruments on external sovereign bonds that are traded offshore. Size estimates of this market range from $40 billion for the outstanding notional as of mid-2001, according to Risk survey, to $200–300 billion suggested by Deutsche Bank.⁴ The most commonly used credit derivatives in emerging markets are credit default swaps (CDSs), credit-linked notes (CLNs), and collateralized debt obligations (CDOs).⁵ The sovereign CDSs are the most liquid instruments in emerging market credit derivatives, accounting for around 85 percent of the total outstanding notional. The most actively traded contracts reference the external sovereign bonds issued by Brazil, Russia, Mexico, Turkey, and Venezuela. A relatively few top tier corporate credits (in Latin America, these include mainly Mexican names, such as Telmex and Cemex) are also traded in the CDS market, but these instruments are considerably less liquid and account for less than 5 percent of the emerging CDS market, excluding Asia. Market participants use credit default swaps as a tool for hedging against (or gaining exposure to) changes in credit spreads and default risk. Compared with cash instruments, the CDSs have several advantages: (1) they allow positions in maturities for which the cash instruments are illiquid or unavailable; (2) they require no collateral or upfront cash payment, subject to the counterparty’s decision; and (3) they provide investors with an opportunity to take a short position vis-à-vis a particular credit for a longer term than in the repo market, in which positions typically have to be rolled over every one-to-three months.⁶ Thus, emerging market credit default swaps are often used to take exposure to sovereigns for maturities shorter than those corresponding to outstanding bonds and to express views on sovereign default risk and on cross-country relative values (see Box 4.2).

Box 4.2.

Credit Default Swap Spreads in Emerging Markets

The credit default swap curve, a plot of credit default swap spreads for different maturities, conveys useful information about market views on a sovereign’s ability to honor its external debt, as well as the recovery value bond investors can obtain in case of debt default. The credit default swap curve is normally upward sloping because credit deterioration is more likely in the medium and long term than in the short term. If the sovereign is able to meet its debt repayments in the short term, changes in market perception about debt sustainability would likely result into parallel or steepening movements of the credit default swap curve. In contrast, problems associated to short-term financing needs would lead to a flattening of the credit default swap curve, as short-term spreads widen to compensate protection sellers for the increase in short-term risk. During periods of market stress, the credit default swap curve can become inverted, as in the case of Argentina during the second half of 2001, and more recently, of Brazil since June 2002.

Further information on default probabilities for a sovereign for different time horizons can be extracted using standard credit default swap valuation models. The figure shows the evolution of one-year and two-year default probabilities for Argentina between January 1990 and December 2001.¹ The approval of an IMF package for Argentina at the end of 2000 contributed to soothe investors’ sentiment and reversed a sharp spike in default probabilities experienced in November 2000. However, increased concerns about the ability of Argentina to meet its debt payments amid continued deterioration of the country’s fiscal position, together with an uncertain political climate, caused default probabilities to creep upwards during 2001. By the end of the second half of 2001, default probabilities reached levels not observed ever before. As it became clear that no further external aid was forthcoming and that the government would refrain from implementing significant fiscal measures, default probabilities increased significantly at the end of the third quarter of 2001. By mid-December 2001, trading on Argentina default swaps stopped completely as no participant was willing to take a long position on Argentina credit risk, a position validated by Argentina’s default in December 2001.

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Sovereign Credit Default Probability and EMBI+ Spread for Argentina

Sources: J.P. Morgan Chase; and IMF staff estimates.

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Credit default swaps are not the only financial instruments that contain useful information about sovereign risk, as sovereign bond spreads are also useful indicators of sovereign debt solvency. Indeed, the figure shows the high correlation between the default probabilities implied by credit default swaps and the EMBI+ spread for Argentina.² However, liquidity in the cash market is more likely to dry out during periods of stress than in the credit default swap markets. In fact, there is anecdotal evidence that following the serious disruptions in the cash market clearing mechanisms in the aftermath of the events of September 11, 2001, price discovery migrated from the cash market to the credit derivatives market.

¹ Default probabilities were estimated using the credit derivatives pricing model described in Duffle (1999) and assuming a 25 percent recovery rate in case of default. ² A detailed analysis of different sovereign risk measures for emerging markets, including implied default probabilities from credit default swaps and sovereign bond yields, is provided in Chan-Lau and Sy (forthcoming).

Compared with other regions, credit default swaps activity in emerging Asia has been limited by the relatively small size of external sovereign bond market. However, the CDSs are rapidly gaining popularity, as they often provide higher market liquidity, higher returns, and longer yield curves than the U.S. dollar-denominated sovereign bonds. In some cases, the CDS market is more liquid than the underlying bond market. According to market sources, the average daily trading volume in the Asian CDS market rose to $200 million in 2002 from $100–150 million in 2001. In Korea, the onshore investors with excess cash reserves have reportedly been very active in the CDS market this year, buying credit protection in anticipation of widening spreads on Korean bonds on the back of increased new issuance.

Some emerging markets, most notably Brazil and South Africa, have recently experienced a pickup in local credit derivatives activity. In Brazil, the government has made the first steps toward developing the onshore credit derivatives markets by allowing local banks to trade credit risk. In South Africa, trading in credit derivatives grew rapidly in 2001 on the back of a strong local demand for higher-yielding paper, amid a general shortage of government bonds and with bond yields hovering at all-time lows. However, in both countries, the local bond markets are fairly small and illiquid, limiting the CDS growth.⁷ As a result, local banks tend to structure CLNs, which reference corporate bonds and promissory notes that are unlisted but traded over-the-counter. Nevertheless, many market analysts are optimistic and foresee the local credit derivatives market providing price discovery for the cash market and, thus, encouraging securitization in the medium term.

Local Participation

Local entities with foreign exchange exposures are among the most active participants in the local derivatives markets. The relative importance of derivatives for local entities’ fundraising in international markets varies across emerging market economies, depending on their net external borrowing needs as well as on the relative maturity of the local derivatives markets. In the emerging markets in Europe and Asia, the link between fundraising in international markets and derivatives activity is not as strong as in Latin America. Following the Asian crisis, many emerging market countries in Asia began to rely more on local currency financing. In addition, many of these countries are running significant current account surpluses, and thus do not have positive net external financing requirements. In emerging Europe, local entities have gained access to the international capital markets only a few years ago and are still facing regulatory restrictions on the use of derivatives.

By contrast, in Brazil, the link between fundraising in international markets and derivatives activity has been particularly strong (see Figure 4.3). Virtually all local companies that have access to international financial markets raise U.S. dollar-denominated funds and then turn to the local derivatives market to swap the external financing obligations into reals with an interest rate indexed to the overnight (CDI) rate. Historically, the cost of U.S. dollar hedges in Brazil was fairly high due to the shortage of hedge provision, as most domestic institutional investors did not have foreign currency positions (in sharp contrast to the Chilean pension funds) and many exporters with U.S. dollar receivables nonetheless typically had overall net short U.S. dollar positions. As a result, Brazilian corporates tended to invest part of their cash reserves in U.S. dollar-denominated securities in order to provide at least partial protection against an adverse exchange rate move. In 1999, the Brazilian central bank stepped in as the main provider of the currency hedge to the market through the issuance of U.S. dollar-linked securities. Furthermore, in March 2002, the Brazilian central bank decided to split the exchange rate linked instruments into real-denominated bonds and foreign-exchange swaps in order to lower its debt rollover costs and also to reduce the cost of currency hedging for local entities.⁸

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Brazil: International Bond and Loan Issuance and Derivatives Trading Volume

Sources: Bloomberg L.P.; and FOW TRADE data.

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Local market participants can also play a key role in the development of a local credit derivatives market, which can facilitate a more accurate pricing of corporate credit risk and help attract capital flows going forward. Many analysts believe that since local players are more familiar with local credit risk and less concerned about market liquidity than foreign investors, they are natural sellers of credit protection on emerging market corporate risk. On the other hand, local financial institutions that have exposure to local corporate credit risk (in the form of bonds, loans, receivables) are in a good position to structure products that match local investors’ preferences for credit risk exposure. Currently, the market for corporate credit risk protection remains very illiquid in most emerging market economies, mainly due to the lack of a well developed local corporate bond market. However, local institutional investors, particularly pension funds and insurance companies in Latin America, have become more active users of credit derivatives over the past year. In emerging Asia, banks and insurance companies were also reported to have been actively buying CDSs and CLNs to boost yields in a low interest rate environment.

Foreign Participation

Foreign investors in emerging markets generally include banks, corporates, “real money” accounts (both dedicated and crossover investment funds), and speculative money accounts (hedge funds and proprietary trading desks of investment and commercial banks). Compared with local entities, foreign investors’ participation in the local derivatives exchanges is fairly limited. Mexico, Hungary, Poland, and the Czech Republic have recently seen a considerable demand by international investors for long-term interest rate and local currency exposures that has been driven in part by the so-called “convergence trades,” with exposures established both in cash and derivatives markets.⁹ As far as the OTC markets are concerned, the extent of foreign investor participation (both as final users of the derivative products as well as intermediaries) varies. In some countries, such as Singapore, Hong Kong SAR, and South Africa, foreign dealers account for the bulk of the turnover in the OTC markets, while in other countries, most of the trading goes through domestic dealers.

Both anecdotal evidence and industry surveys suggest that “real money” funds hedge relatively little of their risk exposures in emerging markets, either because of internal restrictions on leveraged positions or because these risk exposures are desirable. A survey of derivatives usage by U.S. institutional investors conducted in 1998 by the Stern School of Business at New York University (Hayt and Levich, 1999) showed that only 46 percent of respondents were permitted to use derivatives by their investment mandate, and only 27 percent of respondents had open derivative positions at the time of the survey. Because many emerging market countries maintain various restrictions on foreign participation in local derivatives markets, one would expect that the percentage of the dedicated emerging market funds using local derivatives to hedge various risk exposures is even lower. Separately, our analysis of foreign institutional investors’ purchases of stocks in Brazil, Korea, Taiwan Province of China, and South Africa and the trading volumes in these economies’ currency and equity derivatives markets suggests that there is no statistically significant relationship between foreign purchases of cash instruments and the level of activity in local derivatives markets.¹⁰ It should be noted, however, that in some emerging markets, local equities are a “natural hedge” against the foreign exchange risk (e.g., in South Africa, the share prices of companies with significant dollar receivables are often referred to as “rand hedges”). Also, in some emerging markets, foreign investors prefer to hedge their local bond market exposure via the repo market rather than by using currency derivatives.

In contrast with the “real money” accounts, speculative investors can use derivatives freely either for hedging risks associated with their cash market positions or for gaining leveraged returns or for exploiting relative value opportunities between the cash and derivatives markets. However, according to the Credit Suisse First Boston/Tremont, the leading provider of the hedge fund indices, emerging market hedge funds often employ a long-only strategy because “many emerging markets do not allow short selling, nor offer viable futures or other derivative products with which to hedge.”¹¹

Both leveraged investors and dedicated emerging market debt funds are active participants in the credit derivatives markets for emerging market U.S. dollar-denominated bonds. The main protection sellers in credit derivatives markets are the major internationally active banks. Hedge funds have been the most active users of emerging market credit derivatives over the past year, mainly focusing on trading the basis between default swaps and bonds amid increased volatility in emerging debt markets.¹² The “convertible arbitrage” funds have also been among the active buyers of credit protection, using the CDSs to strip the credit component from the equity option of convertible bonds. The main features of credit derivatives that make them particularly attractive for hedge funds are: they provide an efficient way to short a credit with a relatively low risk of a short squeeze, and they are better instruments for structuring any relative value trading strategies than cash bonds because they allow better alignment between maturities of different credit exposures. However, for “real money” accounts, CLNs represent a more viable investment alternative than CDSs, since these funds are typically allowed to invest only in cash instruments.¹³ Since the ability of foreign investors to manage the emerging market corporate default risk remains limited (due to the relatively underdeveloped state of the corporate credit default market), many emerging market borrowers are forced to issue bonds with various credit enhancements, particularly when the perceived credit risk rises (see Chapter V, in the March issue of the Global Financial Stability Report; IMF,2002a).

The Mexican Crisis, 1994

In the early 1990s, the recently privatized Mexican banks engaged in an aggressive building up of their on- and off-balance sheet positions, which led to an increase of their credit and market risk exposures well beyond prudential limits. In particular, they used various derivatives in order to achieve leveraged returns. One of the popular instruments that allowed local banks to leverage their holdings of the exchange rate linked treasury bills (the Tesobonos) was a tesobono swap (Garber, 1998). In a tesobono swap, a Mexican bank received the tesobono yield and paid U.S. dollar LIBOR plus X basis points to an offshore counterparty, which in turn hedged its swap position by purchasing tesobonos in the spot market. The only transactions that were recorded in the balance of payments were: (1) an outflow of bank deposits related to the payment of collateral by the Mexican bank, and (2) a U.S. dollar inflow related to the purchase of tesobonos by the foreign investor. Thus, traditional balance of payments accounting provided a misguided representation of capital flows and associated risks—that is, although it appeared that the foreign investor had a long position in government bonds, it was in fact the local bank that bore the tesobono risk, while the foreign investor was effectively providing a short-term dollar loan. Tesobono swaps were not the only instruments that allowed local banks to establish leveraged positions financed by short-term U.S. dollar loans from their offshore counterparties; other instruments included various structured notes and equity swaps.¹⁴

At the onset of the crisis and in the face of rising political uncertainty and weakening fundamentals that ultimately forced the authorities to float the peso, the tesobono yields jumped from 8 percent to 24 percent. As a result, the U.S. dollar value of the collateral fell, triggering margin calls on Mexican banks. Quoting market sources, Garber (1998) suggested that the total of margin calls on tesobono and total return swaps was about $4 billion, adding to the pressure on the Mexican peso foreign exchange market.¹⁵

The Asian Crises,1997–98

As in the Mexican crisis, unhedged currency and interest rate exposures were key determinants of the severity and scope of the Asian crises (see IMF,1998). Banks and nonfinancial corporations in Asia left their exposures unhedged because (1) domestic interest rates were higher than foreign interest rates, (2) the pegged exchange rates were generally perceived as stable, and (3) domestic hedging products were underdeveloped, while offshore hedges were expensive. Foreign banks were eager to lend to East Asian banks that tried to capture carry profits on the interest rate differentials. However, local prudential regulations, such as restrictions on the net open foreign exchange exposures and risk-to-capital ratios, limited the amount of profitable arbitrage trade. Therefore, Asian financial institutions turned to derivatives “to avoid prudential regulations by taking their carry positions off balance sheet” (Dodd, 2001, p. 10).

According to market sources, the majority of losses reported by both U.S. and European banks on their Asian lending were listed as due to swaps contracts, with the latter presumably including both total return swaps and currency swaps (Kregel, 1998). In a total return swap, one counterparty paid the other the cash flows (both capital appreciation and interest payments computed on a mark-to-market basis) generated by some underlying asset (equity, bond, or loan) in exchange for dollar LIBOR plus X basis points. Thus, the flows between Asian financial institutions and foreign counterparties were similar to those in the tesobono swap described above. As in the case of tesobono swaps, offshore counter-parties were buying the underlying assets to hedge their swaps positions, while local banks were left with short U.S. dollar positions. After weakening fundamentals led to a collapse of the exchange rate peg and domestic interest rates rose, both counterparties had incentives to either unwind the swaps or hedge their foreign exchange exposures, which exacerbated the selloff in Asian assets and currencies.¹⁶

Russia’s Default and Devaluation, 1998

Although the poor state of Russia’s fiscal accounts was well-known by mid-1998, the announcement of a 90-day moratorium on external debt payments on August 17, 1998 caught most market participants by surprise. At the time of the default and devaluation, the estimates of the outstanding notionals of the U.S. dollar-ruble NDF contracts ranged from $10 billion to $100 billion, and the total foreign exposure to the domestic bond market (GKO/OFZs) was around $20 billion. According to market sources, the U.S. dollar-ruble foreign exchange forwards with Russian firms as counterparties were the largest source of credit losses by major swap dealers during 1997–98, exceeding the losses made on their Asian lending. The events in Russia highlighted the presence of convertibility risk even when local currency positions in emerging markets were hedged, and raised the issue of the NDF valuation when an official rate was not available. In addition, Russia’s default sent shock-waves through the credit-derivatives markets, with the cost of protection increasing in all sectors, including the investment grade segment. Ambiguous and often misleading definitions of reference obligations, credit events, and settlement mechanics made it very difficult for protection buyers to enforce the contracts. According to dealers, many CDS contracts were initially triggered under “failure to pay” clauses, but the attempts to enforce the contracts under such clauses were often frustrated by other credit events that appeared more significant and, therefore, had to carry more weight under contractual law. In order to address the legal issues highlighted during the Russian crisis, the International Swaps and Derivatives Association (ISDA) issued new credit derivative documentation guidelines in 1999.¹⁷

Argentina’s Default and Devaluation,2001–02

In contrast with the Russian crisis, the Argentine default and devaluation in December 2001 were widely anticipated and occurred at a time when the credit derivatives market was relatively more mature. The protracted recession and gradual deterioration of the sovereign’s credit quality gave market participants sufficient time to exit the bond and credit protection markets and also allowed the main sellers of credit protection on Argentine sovereign bonds (broker-dealers) to hedge their books in the repo market. According to market sources, liquidity in the Argentine CDS market dried up in August-September 2001, following a bout of volatility in July. The announcement of the moratorium on all debt payments on December 23,2001 was unanimously accepted as a “repudiation/moratorium” credit event consistent with the ISDA definitions. There were, reportedly, some disputes as to which bonds could be considered as “deliverable,” but they have been resolved fairly quickly. According to market sources, 95 percent of all CDSs were settled by mid-February 2002 and there were no reported failures to deliver, with the total sum of contingent payments from the protection sellers to the protection buyers estimated at $7 billion (Ranciere, 2002).