Asian companies get smart about derivatives: Part I

Corporate use of derivatives has risen sharply over the last five years. Is Asia Inc now fully hedged or do some areas of risk remain? Part one of a two part article.

For many corporates in Asia, risk management has become more than a department; it has become a business plan. Companies have been ravaged by the financial crisis; enticed by the tech boom; dashed by the tech collapse; and are now hurting from decreased margins. Doing business in Asia has never been so volatile.

Within this overall matrix of risk, corporate treasurers and CFOs are increasingly turning to their banks to provide them with the financial insurance they need to be able to sleep at night. Derivatives are now big business for banks operating in Asia and the main reason is that many of their corporate clients have bought into the derivative buzz.

"Asian corporates are much more hedged than they have ever been," says Goetz Eggelhoefer, head of global markets for Asia at Bank of America in Singapore. "The pendulum has swung fully the other way from the bad old days before the crisis."

All of the banks interviewed for this article attest to the fact that they are doing significantly more derivatives business with corporate clients than they have ever done before. Although financial institutions remain the biggest buyers and users of derivatives, corporations now make up a significant part of the market.

At the most simplistic level, it is easy to see why Asian companies are using derivatives in their treasuries. They got burnt in the crisis - badly. Indeed the shocks and volatilities of the last five years have made many Asian companies incredibly risk averse. "Since the crisis, there are very few companies in the region that are prepared and willing to keep their exposures unhedged," says Ivan Wong, head of risk management advisory for Asia-Pacific at HSBC's Treasury and Capital Markets division in Hong Kong.

The crisis and subsequent volatilities have taught many companies to keep their financial houses in better shape. As a result companies are focusing on issues such as liability management and risk controls and using derivatives to help them in their quest for financial rectitude.

A corollary of this demand for product has been the development of the supply side of the equation. One of the biggest trends in the international markets over the last few years has been the amalgamation of universal banks' debt and derivative teams. Institutions such as Citigroup, Deutsche Bank and HSBC now ensure that their debt product people work very closely with the derivative people. This ensure that their corporate clients get advice specific to them, rather than just individual products pushed at them.

This development stems from a desire on the part of corporates to reduce the number of banks with whom they have relationships. "Companies in Asia are reducing the number of banks they are dealing with because they really do want to do one stop shopping," says Paul Hand, head of sales for Asia-Pacific at HSBC's Treasury and Capital Markets division in Hong Kong. "Before the crisis, many companies had counterparty relationships with over 40 banks. Now it is down to an average of about five."

Other bankers agree that Asian companies are doing more work with fewer banks, and in the process they are using derivatives far more than they used to. "Companies are taking a more integrated approach to their overall risk management," says Loh Boon Chye, managing director and head of global markets, Asia at Deutsche Bank in Singapore. "As a result of the universal banking now offered by some banks, clients are leveraging their traditional banking relationship into areas such as derivatives."

Matched to the new desire for derivatives from the users, and the amalgamation of the providers, has been a concomitant increase in the actual products. According to the head of derivatives at one international investment bank speaking off the record, derivatives in Asia can be as sophisticated as anywhere else in the world.

The first generation of OTC derivatives - asset swaps, default swaps and CLNs - has been succeeded by the second generation of yield enhancing structures such as 1st to Nth default swaps. The banker now believes that Asia is embarking on the third generation products such as collateralized debt obligations and synthetic LBO structures. The primary driver for the development of these products, he believes, is that big investors are cash rich and hungry for yield.

Over the past few years, governments have been running surpluses, diminishing the amount of government bond paper in the market. Furthermore with a 500 basis point reduction in the Fed funds rate and a near three-year bear market in equities, the credit derivative market has mushroomed as one of the only places that investors can get yield. As a result bankers report that much of the development of the OTC derivative market in Asia has been driven by reverse enquiries, as investors and asset managers seek exposure to companies through their derivative and structured products rather than in traditional ways.

Another aspect of this investor driven trend is that many companies are turning into investors as well. They are retaining their cash flows and not investing in their businesses due to the uncertain economic environment. And the cash that is sitting on their books is being put to use in the same way that dedicated investors are using their cash. The treasury departments of some companies are even being turned into profit centers.

On the exchange traded derivative side the key products at the moment surround interest rates, according to all the bankers interviewed for this article. Interest rates around the region and across the world are at historically very low levels. However the yield curves of many local currencies are quite steep. Therefore many companies are seeking to lock in short term cheap rates or swap their existing long term fixed rate debt into short term floating rate products - even though these types of swaps are quite expensive at present.

There is however a certain amount of discrepancy among the bankers as to which is the best strategy for companies to follow, when it comes to managing their interest rate exposure. Some bankers believe that companies do not need to hurry into locking themselves into current interest rates. "We are advising our clients that there is no rush to lock in their interest rates because, on the balance of probabilities, interest rates are probably going to continue to go down," says Wong at HSBC.

Others however, believe that companies should take the low interest rates now on offer and not waste time scrabbling about for one or two more interest rate cuts. "I think more companies should do their best to lock themselves in to these low interest rates now," says the banker speaking off the record. "Corporates are being greedy and stupid not locking in these rates now."

Whatever turns out to be the right advice, only time - and Mr Greenspan - will tell. However what is not in question is the general availability of exchange-traded derivatives, which will enable companies to lock in their rates. A look at Table 1 shows the general availability of interest rate swaps and options in local currencies throughout Asia. Interest rate futures remain only partially available, but their effect can be synthetically manufactured by a combined swaps and option strategy.

In the currency arena, many companies are now fully hedged. During the crisis period, wild currency swings did huge damage to many companies' balance sheets, as their debts did not match their cash flows. This lesson has now been learnt and due to the development of local currency debt markets, many companies now have much better asset/liability matching.

Where discrepancies remain, derivative are being used to hedge out the mismatches. In particular, currency options are proving to be the most popular among corporate treasurers. "By and large we are seeing much more utilization of foreign exchange options strategies by companies keen to minimize their FX volatility," says Deutsche Bank's Loh. "Companies are now willing to pay for optionality."

(See tomorrow for Part II of this article)

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