Deutsche Uses Credit Derivatives To Manage Emerging Markets Risk

SINGAPORE--Deutsche Bank is using credit derivatives to manage risks arising from potential inconvertibility of certain emerging market currencies, particularly those of Asian countries.

The Asian economic crisis has increased industry concerns over convertibility risk--the risk that a government will impose exchange controls, resulting in counterparty default on foreign exchange transactions in those currencies.

Troy Bowler, head of fixed income research for non-Japan Asia at Deutsche's Singapore office, says the most common form of credit derivative used to hedge convertibility risk is the default swap--a currency swap that only kicks in if the currency becomes inconvertible.

For example, current government regulations on the Korean won restrict the buying and selling of the currency on a capital account. The regulations state that an offshore investor can only trade won for hedging purposes, not speculation.

Should the Korean government decide to impose exchange controls to protect against a weakening of the currency, institutions left holding won would be unable to exchange their positions for another currency.

A default swap acts as insurance against the possibility of inconvertibility, says Bowler. It requires the counterparty to absorb the won position in return for a specified amount of another currency.

Bowler adds that the credit derivatives used to hedge convertibility risks are sold over the counter at a high premium. Quantitative risk analysis of these instruments is immature, he says, due to the fact that no historical information exists for convertibility risk.

"Banks come out with these beautiful models based on loads of macroeconomic data," says Bowler. "But these models are spurious because there is no historical data set to play with. It's really a trading market based on a market clearing approach."

Bowler compares the reliance on intuition for managing convertibility risks in emerging market currencies to the fledgling options market of the early 1980s before the industry acceptance of the Black-Scholes model. "It works just because traders understand how the market works," he says.

Robust legal documentation is particularly crucial to managing convertibility risk, adds Bowler.

There is a concern that forex obligations transacted in potentially inconvertible currencies will not be honoured, he says, with governments supporting counterparty default.

Bowler cites the example of recent lawsuits between JP Morgan and Korean firms, in which Korean courts have found in favour of the defaulting counterparties (Risk Management Operations, February 23).

The major banks offering credit derivatives to hedge convertibility risk include Deutsche, JP Morgan, Goldman Sachs and Merrill Lynch, says Bowler.

Second-tier banks are also entering the market, he adds, though Bowler warns that inconvertibility is not yet accurately reflected in the prices offered by these institutions.

The legal, political and economic turbulence surrounding the recent Asian currency crisis highlights the increased likelihood that a government will suddenly make its currency inconvertible, says Bowler.

He predicts increased trading of credit derivatives to hedge against such risks, especially amongst commercial banks.