If you’ve looked at the markets in the past week, you may be experiencing some uncertainty or may be nervous about the volatility caused by the events happening in Ukraine.
Because of this, we have put together key information regarding market volatility including:
How and why currencies move in times of crisis
What today’s events mean for currencies
What today’s events mean for you and your cross border transactions
What you can do to manage volatility and risk
Why do currencies move?
In simple terms, it is a flight to safety. The key to understanding volatility is understanding how markets move in the first place. Conventionally, there are two types of market regimes.
The first is called risk-on and happens when economies are thriving. During times like this, there is plenty of investment activity, often in riskier geographies or assets.
The second is called risk-off. This is the opposite of risk-on and happens when investors become conservative in investing in order to preserve their assets.
The risk-off regime can be triggered by different events such as financial meltdowns (e.g. Lehman Brothers), pandemics, and wars. This is when Investors tend to move funds into safe-haven currencies. The USD is the world's reserve currency and the depth of its markets is unmatched due to its high liquidity.
As a result, investors tend to move funds out of riskier assets into USD-based instruments in times of crisis. However, due to a desire for diversity, other risk-off currencies such as CHF and JPY as well as traditional hard assets such as gold and silver are also used.
The Dollar index tends to rise in risk-off, see Fig 1. Volatility indices such as the VIX will also rise during risk-off.
Figure 1. Dollar Index
What this means right now
Global Equity markets will sell off, especially in neighboring countries as well as any countries that trade heavily or are allied with Russia. The EU buys a large fraction of its energy from Russia but could get cut off. The UK also receives a significant amount of Russian oligarch investments in normal times that are likely to be cut off as well.
Commodities usually suffer in risk-off too, although with Russia being the number two producer/exporter of oil and gas, those have risen in price (Brent broached $100, see Fig. 2).
Figure 2. Brent Oil
As a result, we have seen a rapid sell-off in EUR, GBP, CAD, and AUD currencies in the last week.
See Fig 3 for EUR selloff.
Figure 3. EURUSD
These funds traditionally go into treasuries, bond markets, or assets in the risk-off regions listed above.
The chart in Fig 4 shows the relative changes in currencies in the last two weeks vs USD. JPY has risen slightly, CHF only a slight drop. EUR and GBP are down 2.5%, and RUB has fallen 17%!
Figure 4. Currencies against USD
Digital assets have long been touted as a potential safe haven away from the USD, but that supposition has proved very wrong. Bitcoin has dropped 25% in value since Feb 15, and almost 50% since November. So much for BTC as an asset class.
What does this mean to me and my cross-border transactions?
Case 1: A USD fund invests in foreign-denominated assets in LATAM has an expected holding period of 3 to 5 years. Currency fluctuations over that time horizon can be significant and may cause a material drag on Fund total return.
Challenge
International investors allocate capital to the Fund in order to gain exposure to LATAM investments, exposing them to currency risk. The emerging currencies continue to stand out for its volatility.
The Solution/Approach:
● The client offered unhedged and hedged share classes, providing investors with different investment alternatives.
● Deaglo designed a hedging strategy of the hedged share class hedging both deployment and harvesting phases looking to net out the cost of hedging.
● Deaglo assisted the client to consolidate the client’s PPM to include hedged share class and supported the fundraising exercise of the client, solving any direct inquiries from investors, prospects, and placement agents.
● The client oversubscribed its USD hedged share class.
Case 2. Global companies, particularly in the mining (heavy equipment), transportation, infrastructure, non-durable consumer goods, agro-chemicals sectors have significantly increased their borrowing in USD enjoying the period of ultra-loose US monetary policy.
Challenge: Non-intercompany debt in foreign currency is financed at long maturities mainly by banks. These credit providers understand that the company is exposed to FX fluctuations which might push the borrower to default. The bank required the client to hedge against these risks in order to get comfortable with the approval of the loan.
The Solution/Approach:
● Deaglo designed a hedging strategy to mitigate FX currency gains and losses for each notional borrowed. The change in the value of the hedge offsets the change in the value of the loan (except for forward points).
● Deaglo helped the client to document its official hedging policy in order to demonstrate the proactive approach to its FX exposures.
● Balance sheet hedges were implemented for each of its non-intercompany loan payables to eliminate the related FX noise.
What are the outcomes?
Your bottom line and IRR may have changed substantially for better or for worse.
Hedging costs will change. Volatility increases option pricing and interest rates may be on the move again this will affect hedging costs either positively or negatively depending on what side you are on.
You may need to post margin or more margin to cover a negative movement in your hedging contracts.
Investors will be interested in what you do next
Bombardment of opinions. You are going to get a lot of information thrown at you.
What can I do now?
1. Know your risk (VaR). Quantify what this move has done to your bottom line/IRR.
2. Look at your options. Did your current strategy hold up? Is it time to review?
3. Negotiate with your bank. Can you improve margin terms? Our margin simulator can show you the likelihood of a margin call.
4. Showcase how the strategy is performing and gain their confidence by showing that you are looking at alternatives.
5. Don't panic, read neutral news from unbiased news outlets and focus on the facts.
Although this is only the beginning and no one knows what will happen next, our team has solutions to help prevent volatility. Reach out to us here or send us an email.
Want to learn more? We’ve got you covered:
Benefits of Layered hedging