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4.2.2 Maturity

The second characteristic that greatly differs between developed and emerging markets is the maturity of traded instruments.

From what we might know already and from what we have hitherto said, emerging markets are associated with a feeling of uncertainty and risk. The fact that someone might be unwilling to enter into too long a contract in an uncertain environment results in the maturities of financial instruments being considerably shorter in emerging markets.

In developed markets such as USD or EUR we can have swaps going up to maturities as long as 40 or even 50 years. This is very different from a situation such as the one in Figure 4.3b, which shows quotes for FX forwards for a collection of African currencies. These currencies belong to countries that are even less developed than the one appearing in Figure 4.2b: only FX forwards are traded and we can see that the bid-offer is extremely wide. For example, if we try to imply a one-year zero rate for Ghanian Cedi (GHS), we obtain a bid-offer larger than 300 bps; for three year it is greater than 500 bps! The argument on the width of the bid-offer is not only to continue the discussion on liquidity started in the previous section, it is to show that at such wide bid-offers, the actual bulk of trades will be conducted at much shorter maturities.[1]

The attentive reader might argue that we have seen that in emerging markets, FX forwards are the most common instruments traded, we have seen that FX forwards are essentially fully collateralized, so where is the risk involved? Why can't we trade longer maturities? This is an interesting point that begs for some further explanation. We shall enter into greater detail in the following chapters but we can now ask the question, why do people enter into financial transactions of the type shown here as examples?

A commonly held view (and a view that the great recession has done nothing but strengthen) is that all financial transactions of derivative instruments are carried out as a form of betting and/or speculation. While certainly this is true of some of them, this view ignores or forgets that derivatives are meant to constitute an insurance against the sensitivity to some market parameter of a primary investment or economic activity.

While it is true that many market participants use FX forwards to speculate on the vagaries of an exchange rate, it is also true that FX forwards are used for the purpose they were intended: to convert future cashhows in foreign currencies at an exchange rate agreed today, something that retrospectively might result in a loss but that eliminates uncertainty from the primary activity (the one whose cash flows we are hedging). This means that the FX forwards shown in Figure 4.3b are most probably used as a hedging tool for some other activity, which can be a private investment in some concrete economic activity returning a profit in local currency or to hedge the cash flows of a bond in local currency.

Let us imagine we purchase a bond in Ghanian Cedi (GHS) maturing at time T. As a U.S. investor, the present value will be given by

where FXt is the FX rate today, is the principal in Cedi, C is the coupon, andare the Cedi discount factors. The present value will be very sensitive to the forward FX rates since these are the main drivers of the foreign discount factors. An alternative would be, for each cash flow, to enter into an FX forward so that each cash flow is a USD amount, in practice

By doing so we have eliminated any sensitivity to the Cedi market and we only have USD interest rate risk. This means that (it might be an obvious statement but it is perhaps worth making anyway), like in all forms of hedging, we might end up worse off than if we hadn't done anything: the only certain thing is that we have eliminated a form of uncertainty. Because of the risk involved in either activity (economic investment or bond buying), neither is likely to be entered for too long a period. As a consequence, the financial market will match fairly closely those maturities.

The above should be seen also in the context of what we discussed in the chapter about curve construction. It is important when making decisions about pricing (curve construction should be considered pricing) to observe what actually takes place in the market and what is the biggest picture we can consider at once. We could have simply looked at the GHS bond and discounted it on the GHS curve. By asking ourselves what is the actual activity taking place (the hedging of the bond), we see that it can be priced in a completely different way by discounting it on the USD curve.[2]

  • [1] The type of quotes shown in Figure 4.3b are what brokers call indicative levels: they are not actual trades. This means that we cannot know at which maturity the majority of trades take place: a fair guess would be in the less than one year region.
  • [2] In some cases, we shall discuss nondeliverability. In Section 4.2.4, we have no choice and we have to convert all cash flows in USD as the country does not allow foreign investors to deal in local currency.
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