• Paul Stafford

Currency Impact on Investment in LATAM

Updated: Nov 20, 2020

LATAM economic growth is expected to regain momentum in 2020. Accelerating investment in Brazil, Chile, Mexico and even Peru is expected. Inflation is easing: Chile´s central bank slashed its benchmark interest rate to 1.75% from 2% on October 23rd, its third major rate cut since June; and Brazil’s central bank cut rates for the third time in as many months. Interestingly, Fintech startups are fueling part of this growth with cross-border investments from both outside and within the region. Huawei, Amazon and Stripe represent some of the former, and Alaya and IOVLAbs represent examples of the latter.

What all of these cross-border investments have in common is currency risk. When an investor or firm acquires an interest in a LATAM entity, the investor's home currency is converted to the local currency. Subsequent growth, revenue and dividends are valued in local currency during the investment period. At the end of the investment term, the value is converted back to the investors home currency. If the spot rate has moved adversely during this period, gains can easily be swamped by currency losses. LATAM currencies are particularly vulnerable to this effect - of the top seven most volatile currencies against the USD, five are LATAM (ARS, COP, BRL, and CLP). Here are the historical spot rates of the most common target investment currencies- they exhibit heightened volatility and trending depreciation:

10 year volatility charts for USD/CLP, USD/BRL, USD/COP and USD/MXN

An investment made with USD into Mexico in 2014 (spot rate 14) and redeemed in 2019 five years later (spot rate 19) has a 35% deficit to make up, reducing ROI by an annualized 6.2%. This high volatility creates significant risk that needs to be managed if investment goals are to be realized.

The classical tools for managing foreign exchange risk are forward contracts. These lock in a future conversion rate, eliminating risk. So far, so good...However, the forward rate is based upon differential interest rates (to prevent arbitrage) . This often means the forward rate is often worse than the current spot rate (3-4%/yr for COP, BRL), but sometimes is a few percent in the hedgers favor (CLP). Thus, picking a hedge ratio is an exercise in optimization.

Given the expense of this insurance for some currency pairs, alternatives are sometimes employed. Proxy hedging - the use of a basket of more liquid currency forwards that track the target currency closely -is one common solution. Choosing the basket and the hedge ratios of its components is now done using machine-learning enhanced techniques to avoid the many pitfalls of linear regression.

Proxy vs Actual hedging chart for CLP

Forwards are a safe and assured for managing predictable cash flows (dividends, interest rate payments on debt, corporate earnings). What happens if the cash flows are not at all assured? For example, the Uruguayan firm IOVLabs recently announced the acquisition of Taringa, an Argentine social media platform. Usually, during acquisitions, there is a due diligence period which may last 3-6 months. During that time the UYU/ARS spot may (will!) move significantly, representing a large valuation risk. Forwards are not an alternative for deal-contingent hedging because if the deal unwinds, the hedge must as well; and forward contracts are not able to be cancelled.

Options might be a choice if both currencies are liquid/fungible; not exactly the case here. In situations like this, using a basket of currencies that has been selected to minimize volatility between the two target currencies (buyer and seller) may be an alternative. The buyer exchanges the purchase price into the basket of currencies. At the end of the due diligence period the buyer has a choice- they may convert the basket to the seller's currency and complete the deal; OR if the deal has unwound, they can convert back into their home currency. Conversion optionality over a lengthy and uncertain due diligence period can be achieved. Again, machine learning and constrained optimization techniques may be used to select the minimal volatility basket.

Taking advantage of LATAM's accelerating growth and abating inflation makes sense for investors within and outside of the region. Chile, Columbia and Peru all are expecting GDP growth of nearly 3%, and Bolivia nearing 3.7%. However, currency fluctuations pose one of the larger risks to such cross-border investment.

Fortunately, many tools are available to the investor to manage this risk: forward contracts where reasonable, proxy baskets otherwise. Contingent deal risk - always a challenge - is also manageable without going to the expense of options. Advances in algorithms, machine learning and AI have enhanced the ability of hedgers to manage risk and enjoy safe returns from investing in LATAM.

If you would like to learn more about how Deaglo Partners can assist you, then please reach out and set up some time with one of our team today.

11 views0 comments
Deaglo white logo.png
  • LinkedIn - White Circle

All statements of opinion and/or belief contained in this website and all views expressed represent Deaglo Partners LLC's “Deaglo” own assessment and interpretation of information available to it at the date of this website. The information contained in this website is based on publicly available information only, from third-party sources. Deaglo does not represent that it is accurate, timely, comprehensive or complete and it should not be relied upon as such, nor has it been independently verified. No reliance may be placed for any purposes whatsoever on the information contained in this website. Under no circumstances should the information provided in this website be considered as investment or trading advice, or as a sufficient basis on which to make any investment or trading decisions and is provided to you for information purposes only. Whilst this website has been prepared in good faith, Deaglo and its group undertakings, members and employees from time to time (“Affiliates”) do not make and are not authorized to make any representation, warranty, or undertaking, express or implied, with respect to the information or opinions contained in it and no responsibility or liability is accepted by any of them as to the accuracy, completeness or reasonableness of such information or opinions or any other written or oral information made available to you. Without prejudice to the foregoing and to the fullest extent permitted by law, Deaglo and its Affiliates do not accept any liability whatsoever for any loss however arising, directly or indirectly, from use of this website or otherwise arising in connection therewith. Nothing herein shall not exclude any liability for, or remedy in respect of, fraud or fraudulent misrepresentation. Our professionals may provide oral or written market commentary or trading strategies to our clients. Deaglo will not treat recipients as clients by virtue of their receiving this report. Data may be subject to updates and corrections without notice. No part of this material may be (i) copied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Deaglo.