Emerging Markets Derivatives

Some insight into pricing and hedging emerging market derivative products.

Emerging Markets as Asset Class

Emerging markets can be thought of as a cross section of other assets in that it requires knowledge of many different asset classes. Let's illustrate this using a vanilla cross currency swap. When dealing with a cross currency swap in emerging markets, one must worry about many subtle differences from developed markets. For one, rates curves construction with special conventions (ACT/360, 30/360, etc). In addition, most emerging foreign exchange currencies are not deliverable. Lastly, there is an embedded credit exposure related to the cross currency basis swap.

Even within emerging markets, there are some regional differences. In Latin America, there is high product sophistication and strong external regulators. In Brazil, there is a large scope of exchange traded products. In the regional comprising of Middle East, North Africa, and Central Asia, one must consider special requirements, low products sophistication, and energy based economies. Lastly, Central and Eastern Europe is almost G10, yet still lack certain characteristics of developed markets.

Products to Model

There are many nuances in modeling different derivatives in emerging markets. Even in interest rate flow products, different conventions might throw off traders. While most traders in the United States are familiar with a 12 month calendar and intuitive conventions such as Actual/365 or 30/360, Mexican rate conventions required new calendars in risk systems. For example, the Mexican Basis Swap is quoted as 28 day basis vs. 1m USD Libor + Spread. Also, Real Rates UDI are quoted as UDI Fixed vs 6m USD Libor. In addition, Brazilian Interest rates are only calculated on business days. Interest only accrues on weekdays not weekends. This convention developed historically because Brazil rates were high and banks did not want to pay interest when they were not working. Also, one must consider other issues such as using DI Futures as the main IR curve building instrument or requiring model dependent Convexity Adjustment for Brazil CDI Participation swaps. In emerging foreign exchange markets, traders must be wary of extremely high volatility and cash settlement. Higher implied volatilities create challenges when calibrating models. In addition. onshore and offshore foreign exchange markets are related but not the same. Furthermore, certain currencies are pegged currency; the 2001 Argentine Default tested market models of pegged currencies. Lastly, inflation derivatives are special for most of Latin American countries as no such instruments similar to TIPS (Treasury Inflation Protected Securities) exist. Instead, the market CPI is implied by a discount factor on bonds.

Commentary

A former Latin America equity derivatives exotics summed up emerging markets with this thought: because the standards and practices of pricing derivatives in developed markets may not apply to Latin America, one must understand even the most basic pricing parameters. For example, in emerging markets, stocks may be difficult to short while at the same time difficult to also fund. Black Scholes assumes one can short assets and borrow cash at the same interest rate, but this spread between the rate of funding and rate of short borrow (repo) could be very wide on a Brazilian share. Therefore, the ability to manage the most basic functions such as funding and stock loan makes a large difference in managing exotic derivative positions in emerging markets. For example, the profit from trading exotic structures such as down-and-in puts can actually come from smart collateral management instead of smart risk taking on volatility.

Also, one must be careful when calibrating unusually high volatilities or extreme interest rates from market. In one experience I had, our firm modeled interest rates as continuous and represented them using an exponential function. While the daily compounded interest rate and the continuous interest rate are similar for normal interest rate levels, for unusually large interest rates, the daily compounded interest rate and continuous rate start to differ by a wide gap. During an unusual rate environment, the continuous interest rate implied by our model did not represent correctly the actual overnight rate to fund an instrument. Hence, for both developed and emerging markets, it is essential to firmly understand the mathematics behind pricing models and to question outputs which are out of line.