Are Currency Forwards Effective in Volatile Market Conditions? an Emerging Market Perspective

ABSTRACT. Firms in emerging markets use forward contracts to hedge currency risk. Financial theory points to the usefulness of these contracts in 'locking in' the price payable/receivable in future, thus ensuring stable cash flows. The paper revisits these findings in the context of hedging long term currency exposure. Since forward contracts are mainly short-term instruments with maximum liquidity concentrated in one, three and six month segments, single exposures in the distant future would require roll-over of short-term contracts. While they may normally serve the purpose, emerging currencies tend to exhibit high volatility during periods of macroeconomic stress. The resulting volatility clusters stretch over long periods, making roll-over unattractive. Using forward contracts to manage multi-period exposure, as in external debt service payments, face similar problem because volatile market conditions transfer spot volatility to future earnings by way of derived volatility in forward rates. Entering into multi-period contracts in the beginning, to avoid volatility clusters, is also not possible as long term forward contracts are not available. Focus therefore, has to be on innovative currency/commodity swaps and building natural hedges to lower currency risks.JEL Classification: G11, G13, G15, G32Keywords: risk hedging, futures market, derivatives, currency markets and financial risk1. IntroductionVolatility in exchange rates has been a characteristic of crises. The subprime crisis that transformed into a global crisis only emphasised this point. Emerging markets, that had erstwhile faced a surge of capital flows seeking higher returns, were suddenly subject to 'reversal' as Dollar's role as a 'safe haven' gained ground. A number of firms were caught on the wrong foot with many facing bankruptcy. Forward currency contracts have been widely used by importers/exporters to hedge against currency risk. Their ability to safeguard firms against currency volatility however, has been found wanting. The paper explores the reasons for the same using the Indian experience as a backdrop.An importer faces the risk of domestic currency depreciation (US $ appreciation). A fall in value of the same necessitates larger payment in local currency terms for buying the same amount of foreign currency. In the early years, when the domestic currencies in developing countries were, in general, under pressure to depreciate, forward contracts were extensively used by importers to minimize currency risk. For an exporter on the other hand, the risk is that of local currency appreciation (US $ depreciation) resulting in lower realization in domestic currency terms. In the years preceding the global crisis, emerging market economies faced huge capital inflows, leading to appreciation of domestic exchange rates. Exporters faced the risk of loss due to lower realization on account of appreciating local currency.Forwards, being single period contracts however could not provide longterm hedge in the face of sustained volatility. In a scenario of continuously appreciating/depreciating domestic exchange rates, forward contacts failed to mitigate long term exchange risk since the forward rate is a function of continuously appreciating/depreciating domestic spot rate. Against these developments, the paper seeks to explore and test the hypothesis that forward rates failed to hedge currency risks of an exporter in an environment of high and sustained local currency volatility.Section II highlights derivatives usage in emerging markets to gauge the volume of activity and reasons out the dominance of foreign exchange derivatives in emerging markets. While Section III underpins the basic premise of illiquid long-term contracts, Section IV provides evidence on the existence of volatility clusters and analyses the behaviour of forward premia during periods of high volatility. Section V looks at the earnings volatility in case of multi-period exposure when using forwards. …