Large PE firm uses Deaglo's FX strategy when purchasing a portfolio of Latam assets
Deaglo designed a hedging strategy for the acquisition of a Latam portfolio asset with five different currency exposures for a Brazilian PE firm.
Benefits for the client of working with Deaglo
The client was able to get comfortable with five different exposures over a three year hold in the same portfolio
The PE client is able to take advantage of multi-currency accounts.
The new account was used to pool funds from numerous different countries and was held in local currency until the PE firm had completed due diligence
The client was looking to develop and implement a flexible FX hedging strategy to protect the acquisition of a LatAm Asset portfolio with multiple currencies risk, including COP, MXN, UYU, BRL, and PEN.
The client was going to be moving the acquisition funds from their BRL fund to a new offshore SPV (exposure A) that would complete the acquisition of the Latam portfolio using U.S. dollars and be sold after three years (exposure B). The client would then move the proceeds from the sale back into BRL (exposure C); this US entity would also be used to place any hedging contracts.
Deaglo put together an analysis for each of the 15 exposures the client had. This involved running multiple strategies through a number of Monte Carlo skews in order to find the best combination of structures for the entire portfolio.
As it was an FX exposure involving currencies from emerging countries, the availability of derivatives and their respective liquidity was a relevant issue before starting the simulations. Deaglo, through its extensive network of relationships with banks, Money Service Business (MSB), and brokers, consulted the availability of each product; NDF, and Options (vanilla and exotic) for each currency.
Deaglo created an FX forward curve (fig. 1) visualisation of each currency in order to understand whether entering into an FX forward for that currency pair would be a cost or a gain compared to the current spot rate.
Figure 1. Forward Points Annualized (%) for each currency against the USD.Source: Bloomberg
Figure 1 shows that all curves are upward sloping (fwd points positive), which meant local deposit rates were higher in those countries relative to the U.S. Therefore, for the exposures A (Capital Call Risk) and B (Asset Exposure Risk), the forward points were against the hedging. For exposure C (USD investment back to BRL Risk), the forward points favored hedging.
A. Short-term Hedging – Capital Call Risk
Description: hedging $41.24M BRL to USD, with tenor equal to 30 days (funds to SPV for deployment).
Deaglo modeled the following five hedging strategies: Forward Contract, 25% participating forward, Collar, Knock-out and an OTM call option. The period volatility modeled was 20%, with zero skew (no market trend), and a trading spread of 0 bps. The reference spot was 5.31, and all option premiums were obtained from Bloomberg on 05/19/21.
Figure 2 shows the base case results for the 30-day period exposure. The main objective of the hedging is to reduce downside risk, whilst allowing participation in the potential upside. The forward has the least variability; however, it does not allow the participation of any potential upside movement. The OTM Call was the worst-performing of all these strategies. While it preserved the most upside, there was an expensive upfront premium. The Collar was a zero-cost strategy, but it’s limits were so narrow and the potential upside participation was similar to 25 Par Fwd. The Knock-out (KO) had no hope of competing as the Median was worse than the unhedged exposure.
Thus, for the 30-day exposure, the Forward Contract and 25 Par Fwd performed well.
Figure 2. Strategy comparison results
B. Long-term Hedging – Asset Exposure Risk
Description: Hedges back to USD from Local Currency.
In this case, Deaglo followed the same methodology described above, carrying out different simulations for each of the 13 assets exposed to exchange rate fluctuations.
Unlike case A, many of the assets were exposed to a tenor of more than 18 months, which made the selection of a single strategy to protect the entire period unfeasible due to the cost of hedging and the availability of products for the long term.
In this way, the study of future curves was essential to optimize and design the hedging strategies.
To highlight the challenge, let’s pick the BRL exposure as an example. As we can see in figure 1, the annualized rates for the USD/BRL is nearly 5%, which has a substantial impact on the forward rates, leveraging it but acting against the hedging strategy. Therefore, Deaglo suggested two hedging alternative strategies in order to minimize this effect.
Hedging Alternative Strategies
a) Roll Forwards
The forward curve is strongly upward-curving (2nd order coefficient positive and large). This favors 1 or 2-month rolls.
Figure 3. USD/BRL forward points and curve
b) Roll Options
Option premia are driven mainly by tenor and the resulting implied volatility. Figure 4 illustrates the vol surface for USDBRL out 2 years. Along the expiry axis, vols are relatively flat until 9 months, where they start to rise rapidly. Along the Delta axis (in or out of the money puts and calls), far OTM puts are quite cheap (demand for USD downside protection is low); the implied vol is about 15%. At the other end, far OTM calls show a marked demand for BRL downside protection - the implied vol is 21%!
Figure 4. Volatility surface for the USD/BRL pair. Source: Bloomberg
Therefore, rolling tenors should be kept to 3, 4 or 6 months to minimize premia. Going forward OTM calls should therefore be avoided due to their exorbitant costs.
Another example is for the Mexican Peso asset, where we also analyzed in detail the forward curve’s structure and the volatility surface for the USD/MXN pair.
As we can see in Figure 1, the forward rates for MXN are very expensive (5%/year)! Therefore, we needed to look at options alternatives.
For that, we also needed to look at the vol. surface for MXN (Figure 5). When reviewing the vol. curve, unlike the BRL, there is no “smile” USD calls/MXN puts are much higher with an implied vol. (16% vs 10%). The tenor component is flat from 1 month to a year but rises steeply thereafter. Like BRL, this means we can't use a single strategy for the entire 2.5 yr tenor but will roll shorter hedges. However, we can use 12 months (because the tenor component for 12 months is flat), not 6 (as with BRL), so there's less exposure to market risk.
Figure 5. Volatility surface for the USD/MXN pair. Source: Bloomberg
c. Long-term hedging - USD investment back to BRL Risk
As mentioned earlier, the USD capital from the exit will be moved back to BRL. Thus, the client was exposed to BRL fluctuations against the USD over the long term as the capital must return to the Brazilian entities. Therefore, the offshore SPV will also place hedges to protect the USD investment back to BRL.
Also from figure 1, we can see that the Forward curve for the USD/BRL is strongly upward-curving, which now benefits the hedging direction (selling USD and buying BRL). This makes 12-month rolls the best alternative.
Nonetheless, this relationship needs to be monitored frequently, as the inflection and level can change quickly as a result of either the Federal Reserve’s or Brazil’s Central Bank interest rate decisions.
Understanding the dynamics of the forward curve has a fundamental role in the elaboration of hedging strategies since it optimizes the cost-effectiveness ratio.
By creating a bespoke risk model (using Monte Carlo techniques to model the range of outcomes) Deaglo helped the client visualize and understand why the strategies selected could perform well in the current market environment.
Finally, the identification of the counterparties for the execution is a fundamental part, since it allows the client to execute the pre-selected strategies. Furthermore, this advisory service reduced the client's efforts in finding counterparties, which saved time and resources.