The use of market based risk management instruments has been growing in industrial countries. Now indebted developing countries may be able to use some of these techniques
A notable characteristic of the past ten years has been the historically high volatility of short-term international interest rates. For example, the six-month London Interbank Offered Rate (LIBOR) fell from 18 percent in 1981 to 9 percent in 1983. It then rose to 12 percent in 1984, only to fall to 6 percent by 1986; it currently stands at 11 percent. Prior to the mid-1970s, interest rate variability had relatively little effect on the debt-service payments of developing countries, both because conditions in the international credit markets were relatively stable and because a large proportion of outstanding debt, particularly for the low-income countries, had been contracted from official sources at fixed rates and on concessionary terms. By the late 1970s, this picture had changed sharply. Developing countries became much more dependent on private external financing as both the public sector and private residents borrowed heavily in world capital markets. There was a marked shift from nondebt-creating flows—official transfers and private direct investment—to debt-creating, interest-sensitive borrowing in world capital markets. As a result, the share of total external debt that was subject to floating interest rates increased from one quarter in 1973 to more than three quarters in 1985.
Since fluctuations in international asset prices can potentially have a strong impact on the economic performance of indebted developing countries, periods of increased international price variability have often created difficulties for the formulation and implementation of adjustment policies. Recent experience with Fund-supported adjustment programs suggests that such variability is more likely to have an impact on an adjustment program as the time horizon of adjustment programs is extended to the medium term. Further, interest rate volatility assumes an added dimension when the indebted developing country faces the possibility of illiquidity or insolvency in the event of very unfavorable movements in interest rates.
The uncertainties created by the increased interest rate volatility have spawned new official and private sector arrangements for dealing with the associated risks. In industrial countries, active risk management has generally become an important element of financial management. Participants (i.e., private and central banks) in the major financial markets have resorted to a large variety of hedging instruments and techniques, most notably financial futures, options, and interest rate swaps (see glossary). In light of the positive experience of industrial countries, this article examines the possibilities for indebted developing countries to make use of similar market-based hedging instruments.
Market based hedging
The increase in interest rate volatility of the 1970s stimulated the search for new instruments and techniques to transform and reallocate financial risks. This search was facilitated by the more general process of financial innovation and liberalization (see box), the weakening or elimination of capital controls among the major industrial countries, and the emergence of global trading of some of the more liquid financial assets, as well as advances in information and communications technology.
A basic instrument for dealing with interest rate variability is the refinancing of floating rate debt in the international fixed rate debt markets. However, concerns about the creditworthiness of indebted developing countries, particularly countries with rescheduled debt, have meant that such countries do not generally have access to the international fixed interest rate debt markets and thus are denied the possibility of lowering their exposure to international interest rate volatility through a lengthening of the interest rate reset period, that is, the period during which the interest rate remains fixed.
For a detailed discussion of developments in global financial markets, see International Capital Markets: Development and Prospects, 1988, by M. Watson, D. Mathieson, R. Kincaid, C. Atkinson, E. Kalter, and D. Folkerts-Landau, International Monetary Fund. Price $7.50, and “Marked-to-Market Swaps” by D. Folkerts-Landau in Analytical Issues in Debt by Jacob A. Frenkel (editor), International Monetary Fund, 1989, forthcoming. Available from Publication Services, IMF, Washington, DC 20431 USA.
The search for more flexible instruments and techniques of interest rate risk management has produced three instruments.
Interest rate cap. Medium-term protection against a rise in short-term interest rates may be gained by purchasing an interest rate cap. These are currently provided by several major international banks and securities houses. If the market interest rate exceeds the cap, then the writer of the cap will reimburse the holder for the difference. The purchaser of the cap pays a premium related to the level at which the interest rate is capped, the length of time over which the cap is in effect, and the expected volatility of the capped rate.
An important advantage offered by caps is that they can provide protection for up to ten years, though liquidity in the market for caps with a maturity of over five years is limited. The use of caps provides some flexibility in the amounts of protection needed for a range of interest rate values. For example, an indebted country may seek only partial interest rate protection for interest rate values between 10 and 13 percent; and be willing to forgo protection when rates exceed 13 percent, as the cost of interest rate caps increases with the length of the coverage and the difference between the interest rate cap and the actual rate.
Caps allow a country to benefit from a decline in rates, while limiting the upward movement of rates. However, a lack of sufficient foreign exchange reserves has generally made developing countries unable or unwilling to purchase this method of interest rate protection.
Interest rate swaps. In such an arrangement, the indebted developing country would pay fixed rate interest payments to a counterparty, usually a bank, and receive in return a stream of floating rate payments over an agreed time period. No actual principal would be exchanged either at the beginning or at the termination of the contract. For example, at current swap rates (i.e., the fixed interest rate payments payable in exchange for variable interest payments at LIBOR), the country would have to pay a fixed 10.5 percent on a notional principal of, say, $100 million for five years and receive in return six-month LIBOR payments based on the same notional principal. A floating-rate borrower can thus achieve any desired medium-term lengthening of his interest rate period through the use of an interest rate swap. The conventional interest rate swap market has become one of the most successful markets for interest rate risk management with a total amount of notional principal outstanding in excess of $1 trillion.
A swap is an effective hedging instrument only if each counterparty fulfills its debt-servicing obligations. Since in a typical interest rate swap the developing country commits itself to make future fixed interest payments at regular settlement dates, up to a specified maturity date, the counterparty incurs credit risk. The swap participant’s credit risk depends on the potential movement of interest rates over the period of the swap, and on the likelihood of a failure by the country to make its fixed swap payments as a result of other causes. Most borrowers, therefore, will engage in a swap only when credit risk is perceived as low. As a result, indebted developing countries with debt-servicing difficulties have not had access to this market.
Financial futures contract. Since much of the floating interest rate debt of the indebted developing countries denominated in US dollars is indexed to LIBOR, the Eurodollar futures contract is the most useful of several futures contracts available. The Eurodollar futures contract represents an obligation to buy or sell at a predetermined price on a specified future date a Eurodollar time deposit with a maturity of three months which is indexed to the three-month LIBOR. It has a face value of $1 million. The position of the holder of the contract is considered “long” because the contract implies that he will buy a Eurodollar time deposit at some point in the future. The position of the writer of the contract is “short” because he has sold a Eurodollar time deposit, which he may not yet own, with delivery occurring at some future date.
Using Eurodollar futures contracts to hedge (guard) against an unanticipated change in LIBOR prior to the next date on which the interest rate on a country’s external debt is to be reset would involve writing an appropriate number of Eurodollar futures contracts. In this way, any increase in interest rates that resulted in higher debt-servicing payments would also generate offsetting profits on the country’s futures position. However, writing Eurodollar futures contracts also means that a decline in LIBOR, which would reduce debt service payments, would also generate losses on the country’s future position. As a result, lower interest cost would be offset by losses on the futures contract thereby keeping the total cost of Eurodollar funds equal to the interest rate contracted for in the futures contract. A futures hedge has the advantage of requiring no premia to be paid in advance. It locks in a given cost of funds no matter which way interest rates move; that is, it is a symmetric hedging instrument.
The credit risk associated with the obligation to make future delivery under futures contracts has successfully been minimized through institutional features, such as daily resettlement, margin requirements, and futures clearing houses. Any gains or losses that arise on the futures contract because of changes in the price of the contract are realized the next morning through cash settlements among the contracting parties, and the futures price is marked-to-market.
For example, assume a country sells 1,000 contracts ($1 million per contract) for delivery of three-month Eurodollar deposits at a specified future date at 92 cents per dollar. If on the next day the futures interest rate on the three-month Eurodollar deposits has decreased by five hundredths of a percentage point, then the country will have suffered a $125,000 loss on its short futures position. The resettlement procedure provides for the $125,000 to be paid to the holder of the contracts and for the interest rate at which the Eurodollar deposits will be supplied to be adjusted upward by five basis points. Thus, the performance period has been reduced to one day.
In addition, market participants are required to post margins in the form of a performance bond related to the volatility of intraday futures prices to cover any intraday losses. Thus, the incentive to renege on the futures contract has been virtually eliminated. Also, a clearing house interposes itself between transacting parties in all contracts, such that all contracts have the clearing house as counterparty, which further reduces the risk of nonperformance.
The futures market is most liquid in the contracts for delivery of three-month Eurodollars up to one year and would be able to accommodate substantial participation by indebted developing countries. However, the markets for longer-dated contracts or for contracts for future delivery of six-month or one-year Eurodollars are not sufficiently liquid to accommodate substantial participation by indebted developing countries.
Interest hedging with Eurodollar futures beyond 12 months is, therefore, not yet generally effective on a large scale. In addition, the hedging of interest rate risk with shorter-term financial futures requires continuous adjustment in contract positions. Such activity requires skilled personnel capable of dealing in wholesale hedging markets on a continuous basis. While these risk management services can to some extent be purchased from various financial institutions, even the evaluation of the quality and cost of these services requires considerable knowledge of market instruments and techniques. A further problem arises in designing and implementing an internal control mechanism that effectively limits the activities of risk managers to legitimate hedging operations. Recent experience in some financial firms has shown that inadequate internal controls could result in potentially large trading losses. For this reason, indebted developing countries have been cautious in using this market for hedging interest rate risk of the near term. A recent example of the use of the financial futures to hedge an interest rate exposure arising from floating rate external US dollar liabilities is the hedging program undertaken by Chile. Using various hedging techniques, an effective rate of 7.3 percent was locked in by this operation, thereby eliminating interest rate uncertainty for 1988. The central bank is currently engaged in a new hedging operation aimed at reducing the uncertainty of the LIBOR rates prevailing at the 1989 reset dates.
Appropriate instruments for LDCs
The special circumstances of indebted developing countries, particularly those with rescheduled debt, demand that an interest rate risk management tool satisfy a number of conditions before it can be used successfully. First, access to the risk-management tool should not be influenced by the markets’ perception of the creditworthiness of the country. Second, the instrument should provide cover over the medium term (e.g., from two to five years). Its use would add certainty to medium-term financial programs, as well as smoothing out cyclical movements in interest rates. Third, the use of the risk management instrument should not require significant fees to be paid up-front. Fourth, the risk management technique must be easy to use and not require active management of contract positions or monitoring of delegated trading activity. Lastly, the market for the risk management product must be sufficiently deep to allow large-scale participation by indebted developing countries.
From the earlier discussion, it is apparent that none of the existing risk management techniques satisfies these five requirements simultaneously. Hence, indebted developing countries have made limited use of them so far. Instead, a recent innovation taking the form of a modified interest rate swap contract appears to be more suitable to the special circumstances of these countries. The swap market possesses the necessary depth over the medium term to accommodate substantial participation by indebted developing countries. Further, entering into a medium-term swap contract does not require an advance premium and can be done in a single transaction without a need for continuous monitoring. However, indebted developing countries have not yet gained access to the conventional swap market because of the reluctance of participants to expose themselves to the greater performance risks of such countries over the medium term.
Recent experience in the US dollar markets has shown, however, that an identification of the gains and losses occurring in swap contracts due to changes in the swap rate makes it possible to transfer such changes in the swap’s value from the losers to the gainers followed by a “marking-to-market” of the swap interest rate. This mechanism, which is analogous to that employed in the futures market, is a way to greatly reduce the credit risk from the swap contract. By making such transfers of the previously unrealized changes in the value of the swap contract at the beginning of each interest rate period, and by resetting (i.e., “marking”) the original swap rate to the then prevailing market rate, it is possible to reduce the size of losses to changes in the swap’s market value occurring during a single interest rate reset period. While the practice of periodic resettlement and marking-to-market of swap rates may expose the indebted developing country to potentially large variations in cash flows, such flows occur in the opposite direction to interest rate movements. As rates rise, the country receives payments, and as they decline, the country makes payments. Further, the internal rate of return of the net payments of the fixed-rate payor remains equal to the initial swap rate (i.e., the fixed interest rate payable). Since indebted developing countries have generally made interest payments on their external obligations, there would appear to be scope for facilitating the solution of the technical problems associated with the cash-flow management generated by converting floating rate payment into fixed-rate payment through a marked-to-market interest rate swap.
Over the medium term, high variability of external interest rates makes the financing gap less predictable and can make the design and implementation of adjustment programs more difficult. In such circumstances, obtaining some degree of insurance before the fact against interest rate volatility through the use of market-related hedging instruments can make an important contribution to the continuity of the adjustment effort.
Some creditor banks have also argued that the use of hedging instruments by indebted developing countries could potentially help forestall the need to reopen restructuring agreements in the event of unanticipated movements in the LIBOR index. Having bank creditors supply interest rate hedges in the form of LIBOR caps as part of restructuring agreements has also been seen by some as an attractive addition to the menu of techniques for resolving debt problems. Such a step could be part of a more general approach to structuring loan (or rescheduling) agreements to allow for more adequate hedging of financial risks.
Finally, while the use of financial hedging markets would not directly increase the scale of financing available to indebted developing countries, it would be analogous to restoring some access to international capital markets for debt management purposes. In particular, a country could regain some influence over the proportions of its external liabilities with either floating or fixed (or capped) interest rates.
An exchange-traded contract generally calling for delivery of a specified amount of a particular grade of commodity or financial instrument at a fixed date in the future. Contracts are highly standardized and traders need only agree on the price and number of contracts traded. Traders’ positions are maintained at the exchange’s clearing house, which becomes a “counterparty” (i.e., a participant) to each trade once the trade has been cleared at the end of each day’s trading session.
The buyer pays a fee or premium to obtain protection against a rise in a particular interest rate above a certain level.
A transaction in which two counterparties exchange interest payment streams of differing character based on an underlying notional principal amount. The three main types are coupon swaps (fixed rate to floating rate in the same currency), basis swaps (one floating rate index to another floating rate index in the same currency), and cross-currency interest rate swaps (fixed rate in one currency to floating rate in another).
(1) In the futures market, the position of a trader on the buying side of an open futures contract; (2) in the options market, the position of a trader who has purchased an option regardless of whether it is a put (right to sell) or a call (right to buy). A participant with a long call-option position can profit from a rise in the price of the underlying instrument, while a trader with a long put option can profit from a fall in the price of the underlying instrument.
An amount of money deposited by both buyers and sellers for futures contracts to ensure performance of the terms of the contract. Margin in futures markets is not a payment of equity or down payment on the commodity itself but rather is in the nature of a performance bond or security deposit.
A hypothetical amount on which swap payments are based. The notional principal in an interest rate swap is never paid or received.
The contractual right, but not the obligation, to buy or sell a specified amount of a given financial instrument at a fixed price before or at a designated future date. A call option confers on the holder the right to buy the financial instrument. A put option involves the right to sell the financial instrument.
A market commitment. For example, one who has bought futures contracts is said to have a long position, and conversely, a seller of futures contracts is said to have a short position.
(1) In the futures market, the position of a trader on the selling side of an open futures contract; and (2) in the options market, the position of a trader who has sold or written an option regardless of whether it is a put or a call. The writer’s maximum potential profit is the premium received.
The designated financial instruments which must be delivered in completion of an option contract or a futures contract. For example, the underlying instrument may be fixed-income securities, foreign exchange, equities, or futures contracts (in the case of futures option).
The price “variability” of the instrument underlying an option contract, and defined as the standard deviation in the logarithm of the price of the underlying instrument expressed at an annual rate. Expected volatility is a variable used in pricing options.
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