Euro weakness drives Asian exporters to pay for protection

David Naville, an FX structurer at Barclays Capital, talks to FinanceAsia about the challenges facing Asian companies exporting to Europe.

The euro’s recent wild ride has left many Asian exporters with little choice but to buy protection in the form of put options. But David Naville, director of foreign exchange structuring at Barclays Capital, explained to FinanceAsia recently that there are some simple structures that can help to offset the cost of protection.

The euro has looked dangerously weak at times this year. How has this affected Asian companies trying to hedge their euro earnings?
The second quarter of 2010 was really at an extreme, from a directional and dynamics point of view. The euro, which moved somewhat steadily upwards during the past decade -- apart from the second half of 2008 -- witnessed one of its biggest drops, in magnitude and speed, of its 11-year existence. On top of this, FX volumes across Asia have increased over the years in step with the rising level of trade -- and, in particular, exports to Europe. When you have moves of 15% or 20% on the downside in euro-dollar, that directly threatens the profit margin of Asian companies doing business there. That shift in behaviour in euro-dollar has triggered both stronger need and willingness to hedge euro receivables compared to the past.

In response, are clients now more willing to consider derivatives solutions again?
Last year, clients were less receptive to derivatives ideas, but in retrospect that was a normal reaction to the credit crunch of 2007 and 2008. It is interesting to see that there has now been a change in psychology towards foreign exchange markets. Typically, it is not straightforward in the first place to convince a client to pay a premium for an option. This year, however, people are more willing to pay the price for hedging.

What is the most common hedge against the euro?
Typically a euro put struck at $1.20, or some variation around an absolute level at which the client is guaranteed to be hedged. That is very common because at that level many Asian exporters into Europe start to become unprofitable.

The euro has been even lower than $1.20 this year, was there any sense of panic?
The all-time low in the euro was $0.83 and the high was $1.60. In other words, the two biggest economies in the world have a fluctuation in their exchange rate that has been from one to two over a decade -- and this year we saw a USD appreciation of 15%-20% over a five-month period.  In 2007, when the euro moved from $1.30 to $1.45, people were calling for it to trade up to $2. It didn’t go there. It went to $1.60 and traded back down in 2008. This year, we heard about euro-dollar going to parity rapidly, then it traded back up above $1.30. The move down in euro-dollar surely created a lot of nervousness, but I don’t think we got into panic mode as far as hedging is concerned.

Is there demand for more complex strategies now?
We don’t sell complex products these days. We structure fairly straightforward payouts and use the technology we have to create an option with features that clients can benefit from at the minimum premium possible. A vanilla option might cost $1, but you can however look at a product that costs $1.30 that has a potential return that is two or three times the vanilla. If clients can see the value in paying $1.30, they will consider it.

The euro has now reversed some of its losses. To what extent is volatility itself a concern, in addition to the downside risk in the spot rate?
That’s an area where structuring and structured sales are putting in a lot of focus. We explain to clients that when they are hedging, volatility is something they need to track almost as closely as spot. Look at one-month volatility on the Aussie dollar for instance -- the volatility dynamic is itself pretty volatile, and that has a strong impact on the pricing of derivatives and insurance premiums. On top of that, spot and volatility are not independent from each other. They tend to move together to some extent. Depending on the currency pair, that correlation can be pretty strong.

A very good example in Asia is dollar/Korea. When the won appreciates, volatility goes down. And vice versa. Spot and volatility go hand in hand, in a way. It’s not two variables, it’s one-point-something. When you look at hedging, you need to be very much aware of this correlation and this interdependence. In euro-dollar, there has been a significant increase in that relationship, which makes the price of downside insurance more expensive in both delta terms as well as volatility pricing input -- in sympathy with the spot move.

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