Foreign exchange hedging in Chile Jorge A. Chan-Lau International Monetary Fund, 700 19th St NW, Washington, DC 20431, USA. E-mail: [email protected] Received (in revised form): 10th October, 2006 Dr Jorge A. Chan-Lau is a senior economist in the Monetary and Capital Markets Department of the International Monetary Fund. He holds MPhil and PhD degrees in Economics and Finance from the Graduate School of Business, Columbia University, and a BS in Civil Engineering from Pontificia Universidad Cato´ lica del Peru´ . He currently works on credit risk, financial markets, and financial stability, and has published work on contagion, financial crisis, credit derivatives, corporate restructuring, and institutional investors’ asset allocation. Abstract if a country accumulates reserves to ‘bail out’ Policy makers have expressed interest in fostering the private institutions in case of adverse exchange development of local foreign exchange derivatives markets rate movements, the country is essentially with a view to reducing risks arising from currency subsidising foreign exchange hedging at the mismatches between assets and liabilities in the corporate expense of depressed investment and sector. This paper assesses foreign exchange exposure in consumption. Arguably, then, the provision of the corporate sector in Chile, analyses the current state of foreign exchange hedging will be better the foreign exchange derivatives market in Chile, and undertaken if done by the private sector rather argues that liquid and developed foreign exchange than by the government. derivatives markets can help promote financial stability. This paper explores the following questions Derivatives Use, Trading & Regulation (2006) 12, about the market for foreign exchange hedging in 250–267. doi:10.1057/palgrave.dutr.1850045 Chile: (i) the foreign exchange exposure of the Chilean corporate sector; (ii) the determinants of Keywords: Chile; derivatives market; forward the demand and supply of foreign exchange contracts; currency options hedging; (iii) the instruments available for hedging foreign exchange risk; (iv) the impact of the regulatory framework and market structure on the INTRODUCTION growth of the foreign exchange derivatives A market for foreign exchange hedging market;and,finally,(v)thedegreetowhich instruments can help domestic corporations to foreign exchange risk hedging reduces systemic manage currency mismatches between assets and vulnerabilities to financial crises. liabilities. In the absence of markets for foreign exchange hedging, currency mismatches can be FOREIGN EXCHANGE EXPOSURE IN Derivatives Use, Trading & Regulation, hedged if governments accumulate large foreign CHILE Vol. 12 No. 3, 2006, pp. 250–267 reserves. Accumulating reserves, though, may In Chile, systemic risk from currency r 2006 Palgrave 1,2 Macmillan Ltd have substantial opportunity costs. In addition, mismatches in corporate balance-sheets appears 1357-0927/06 $30.00 250 Derivatives Use, Trading & Regulation Volume 12 Number 3 2006 www.palgrave-journals.com/dutr to be low, as foreign exchange exposure in Chile Table 1: Firm and industry level foreign is low compared with other developed and exchange exposure emerging market countries. Caballero et al.3 Firm level Industry level report that the mean and median share of foreign exposure, exposure, currency liabilities in Chile are approximately 28 in per cent in per cent and 5 per cent, compared with more than 50 and 60 per cent, respectively, in Argentina, Peru, and Chile 13.6 17.4 Uruguay. These authors also note that foreign France 18.9 17.1 exchange liabilities appear to be concentrated Germany 20.6 64.7 mainly in the tradable sector, a sector that may Italy 26.3 32.3 be able to withstand adverse exchange rate Japan 31.1 59.5 movements better than other industrial sectors. Netherlands 26.3 40.0 Central Bank figures also indicate that 84 per Thailand 21.3 25.0 cent of the total external debt in the non- United Kingdom 18.8 46.2 financial private sector, standing at $24.9 billion or 34 per cent of GDP by end-2003, is tilted Source: Dominguez and Tesar (2001). towards medium and long-term maturities. The relatively long maturity profile reduces corporate sector vulnerabilities to adverse exchange rate (FSAP) suggest that banks in Chile hedge movements. Finally, findings by Dominguez and between 90 and 100 per cent of their net foreign Tesar4 suggest that foreign exchange exposure is exchange positions (Mendelson and Glaessner8). significant only for 13 per cent of publicly listed Foreign exchange hedging, however, does not firms. At the industry level, the exposure only imply that banks’ equity returns should be affects 17 per cent of all industries. Foreign insensitive to exchange rate movements. For exchange exposure in the Chilean corporate instance, exchange rate movements may have an sector is thus significantly lower than in other impact on interest rates, and, hence, affect the countries (Table 1). profitability of the floating rate loan portfolio. Factor analysis suggests the financial sector has been the most exposed to foreign exchange risk 5–7 (Box 1). Table 2 shows the sensitivity of THE MARKET OF FOREIGN EXCHANGE equity returns in different industrial sectors to DERIVATIVES exchange rate changes after controlling for movements in the overall stock market. A higher Demand and supply coefficient associated to the exchange rate Foreign exchange derivatives in Chile are traded changes indicates higher exposure. Clearly, the mainly in the over-the-counter market where financial sector has been the most exposed banks have a major role as market-makers.9 before and after the abandonment of the floating Domestic banks and financial institutions can band in September 1999. Interestingly, the write a variety of derivatives instruments, and are exposure has increased although data compiled responsible for matching corporate end-users by the Financial Sector Assessment Programme and institutional investors’ needs to cover Foreign exchange hedging in Chile 251 Box 1: Assessing foreign exchange exposure using factor analysis The foreign exchange exposure of a particular firm or industrial sector can be assessed approximately using factor analysis (Jorion5). The method consists of regressing the stock market return of the particular industry or firm analysed on exchange rate changes while controlling for overall stock market movements. The econometric model specification used in the analysis is: Ri;t ¼ a0 þ a1Rs;t þ a2Rm;t þ i;t ð1Þ where Ri,t is the stock market return of firm or industry i in period t, Rs,t is the rate of change of the Chilean peso exchange rate vis-a`-vis the US dollar, Rm,t is the rate of the return of the Chilean stock market, and ei,t is an independent and identically distributed error. The coefficient associated to changes of the exchange rate, a1, measures the foreign exchange exposure of firm or industry i, or equivalently, the elasticity of its stock returns to changes in exchange rates. Two caveats about factor analysis should be borne in mind. First, as noted by Adler and Dumas,6 factor analysis is equivalent to a statistical decomposition of stock market returns and does not necessarily imply a causal relationship between returns and exchange rate changes. Second, the empirical method cannot explain how changes on firms’ operating procedures affect their exchange rate exposure. If the coefficient a1 is not different from zero, it does not necessarily imply negligible foreign exchange exposure. For instance, the firm may be hedging actively its foreign exchange exposure using derivatives or other operational techniques. Therefore, the firm offsets any impact exchange rate movements have on its stock market return. The analysis includes the following sectors: consumer discretionary goods, consumer staples, financials, health care, industrials, materials, telecommunications, and utilities. Morgan Stanley Capital Indices (MSCI) for each sector and the overall market are used to calculate monthly stock market returns. The sample period analysed is January 1995–April 2004. Equation (1) was estimated for the full sample period as well as for two subperiods, January 1995–December 1999, and January 2000–April 2004 using Ordinary Least Squares and correcting for serial correlation of the error term. Dividing the sample in two subsamples helps assessing changes in foreign exchange exposure that may be attributed to increased management of exchange rate risk at the sectoral level. It also allows examining the impact on foreign exchange rate exposure of the abandonment of the floating band in September 1999. exchange rate risk.10,11 Commercial banks are they have the resources and skills to implement allowed to take positions on foreign futures foreign exchange hedging programmes. In contracts on foreign currency and interest rates, consequence, they participate actively in the and on exchange-traded options on foreign foreign exchange derivatives market. Small and currency and interest rate futures. Thus, medium enterprises, however, seldom hedge commercial banks that act as market-makers in their foreign exchange exposures because of lack the local market can hedge their net positions of knowledge about the benefits of hedging offshore if needed. using financial instruments. Currently, local Demand for foreign exchange hedging comes banks are organising seminars to educate end- mainly from large corporations, mostly because users in the small and medium enterprise sector 252 Chan-Lau Table 2: Chile: