Adapt or fail

Since October last year, ructions in South Africa's foreign exchange rate have caused offshore hedge funds to exit the market, while dealers have been reluctant to take on risk. Those that remain active have had to adapt their behaviour as a result. By Mark Pengelly

Market turbulence has left a lasting imprint on the South African rand. The bankruptcy of Lehman Brothers on September 15 last year, combined with a chronic liquidity crisis and continued losses on subprime mortgage portfolios, caused a widespread bout of risk aversion in global markets. Amid an unwinding of the carry trade, international banks and hedge funds have pulled back from the South African currency - in turn, having an effect on the behaviour of those remaining in the market, as well as the country's corporate hedgers.

"We're going back to basics again, and now people are trading on real flow from corporate interest, not hedge fund flow and offshore investors that previously traded emerging markets. The risk appetite from offshore counterparties has diminished significantly," says Brigid Taylor, head of international sales for fixed income, currencies and commodities at Rand Merchant Bank (RMB) in Johannesburg.

The carry trade has been a key strategy for many hedge funds, and involves borrowing in a currency with a low interest rate and investing in another, higher-yielding currency. Investors profit from the interest rate differential between the two currencies, as long as exchange rates do not move against the trade.

Popular funding currencies have included the Japanese yen and Swiss franc, while the South African rand has been a common target currency, with the country's main interest rate set at 11.5% as of early February. But, in the weeks immediately following Lehman's demise, acute risk aversion saw hedge funds exit the trade in droves, causing the rand to fall precipitously. Between September 15 and October 22, the South African currency plummeted by 41.19%, to reach R11.37 to the dollar.

"That was definitely the carry unwind. There was a massive rush for the exits and it just shows you how much leverage there was in the system," says David Gracey, Johannesburg-based head of foreign exchange and fixed-income trading and sales at Nedbank Capital.

The pullback of hedge funds and other offshore investors contributed to a sharp decline in liquidity - in turn, exacerbating the magnitude of the currency moves. Ten-day historical volatility for the rand against the US dollar shot up from 24.16% on September 15 to peak at 77.27% on October 23, according to Bloomberg.

By October 29, the rand had whipped back to R9.87 against the dollar, before strengthening further to R9.65 on November 4. "There were times when the rand was moving 10 or 15 cents in a matter of minutes and it made it really difficult to manage any exposures," says Gracey.

Conditions have begun to normalise since November. As of February 3, the South African currency was at R10.14 to the dollar, while 10-day historical volatility against the dollar had receded to 19.64%. However, uncertainty continues to linger over the market. "Volatility increased significantly in September and October. Just like in the rest of the world, volatility has subsequently reduced somewhat, but people are still very nervous and volatility is expected to continue," says John Cairns, currency strategist at RMB in Johannesburg.

Liquidity also remains thin, as investors continue to shun emerging markets in general. "There's a bit of a feedback loop in that volatility has caused liquidity in the rand to dry up somewhat," adds Cairns.

Hedge funds are not the only ones to have pulled out of the market. Some international banks have also reduced market-making activity, and are reluctant to take risk onto their balance sheets, participants say. "Since pre-October, there's been a huge change in terms of the number of players and those willing to make markets, and spreads are pretty wide," says Andre van der Merwe, head of global currency options at Standard Bank in Johannesburg. Whereas simple three-month dollar forwards might have had a bid/offer spread of 10 basis points before October, this has now risen to 50bps, he says. "It's important to have good relationships with those who are willing to make markets, because liquidity is not always freely available."

For their part, end-users have become more aware of counterparty risk in the wake of Lehman's collapse, encouraging some to turn to the exchange-traded market. Indeed, the Johannesburg Stock Exchange saw its biggest ever month of trading for rand-based currency futures in October 2008 (see box).

For those still active in the over-the-counter market, the focus is now very much on short-dated trades, with the average duration of trades now inside three months, notes Nedbank Capital's Gracey. "Liquidity has definitely improved - players have come back into the market - but nothing on a long-term basis. People are very short term in the decisions they make." Currency forwards had always been a relatively developed market in South Africa; but even here, there is little interest beyond the one-year time frame, Gracey adds.

Meanwhile, options pricing has also suffered from heightened volatility expectations. In September, one-week at-the-money volatility implied by dollar/rand options prices was at 21.50%, but this has now risen to 30.50%, according to Standard Bank. Three-month at-the-money implied volatility has also increased, from 20.25% to 30%.

The change in market conditions has had an effect on corporate hedging activity. In recent years, a greater proportion of South African firms have employed complex strategies designed to cheapen the cost of their currency hedges - in some cases, incorporating directional views on the rand.

With the recent tumult, however, Standard Bank's van der Merwe says interest in more exotic structures has receded. "With the volatility we're experiencing, interest from guys looking at structured deals has reduced," he says. With the rand trading in a relatively wide range, there is a greater risk of barriers or triggers being hit, he points out. Instead, corporates are opting for simpler, more vanilla hedges. "They're treading the more conservative route and maybe just looking at forward exchange contracts. Alternatively, if their commitments are very short-dated, they are trying to take advantage of the spot moves in the range that we're in," he says.

With the cost of options rising in line with increased volatility, many corporates are most interested in creating certainty by fixing their exposures as expeditiously as possible. "What you're finding is that, due to the recent turmoil, corporates are much more price-sensitive. What people are trying to do is budget correctly and attempt to remain competitive," says RMB's Taylor.

That is not to say plain vanilla options are being totally shunned. Since the collapse of Lehman Brothers, dealers are increasingly pricing counterparty credit risk into foreign exchange transactions - and with credit spreads widening and volatility in the foreign exchange market increasing, this has significantly added to the cost of simple forwards (see pages 21-23). As such, options can still provide an effective means of protection, say some dealers.

"What strategies people use will be driven by prevailing levels of volatility. You might find people prefer to do more spot foreign exchange or forwards at certain times and more options-based strategies at certain times," says Temisan Ofong, Johannesburg-based head of foreign exchange and commodities sales and structuring at Absa Capital.

Local bankers say one thing is certain: currency movements have increased the importance of forex hedging for the country's corporates, particularly importers. "Given what they've seen in the past few months in the macro environment, we think corporates will be looking to manage more of their risk - not less of it - because they have such fine margins to protect," says Ofong.

Such concern may well continue, with the potential for further rand weakness against the dollar, analysts say. Many point to uncertainty over the outcome of parliamentary elections in April as weighing on the rand, in addition to unease about corruption charges that continue to hang over Jacob Zuma, leader of the African National Congress.

At a global level, conditions will not improve until more international players are prepared to re-enter the market, says Nedbank Capital's Gracey. This hinges on how global turmoil lasts. "I don't think things will sort themselves out overnight," he adds.

Not everyone is as pessimistic about the rand, however. The South African currency kept within a rough range of R9.80-R10.20 against the dollar between late January and early February, notes Taylor at RMB. This compares favourably with many other emerging market currencies, she believes. "From an emerging markets perspective, I think the rand has performed well and it has behaved relatively well, trading conservatively within certain ranges. We've had volatility - but that's to be expected," she says.

Futures gain currency

Global currency market volatility has been making its presence felt in South Africa through both the over-the-counter market and the Johannesburg Stock Exchange (JSE).

In June 2007, the country's first currency futures contracts launched on the JSE's Yield-X interest rate trading platform. With market volatility spiking, volumes increased markedly in the latter half of 2008, says Warren Geers, general manager of the JSE's trading division. "Currency futures were actually one of our star products from June last year to early December. The liquidity and the volatility on the underlying currency created great demand for products linked to the rand," he says.

The cash-settled products, which have special dispensation from the South African Reserve Bank despite exchange controls, are linked to the euro, sterling and Australian and US dollars. In September 2008, the value of currency futures traded on the exchange leapt to R8.82 billion, more than double any previous month. During October, this figure nearly doubled again, to R16.16 billion. "October was the biggest month ever," says Geers. October also saw the launch of currency options on the JSE - although these have yet to rival the interest in the futures contracts, he adds.

Brigid Taylor, head of international sales for fixed income, currencies and commodities at Rand Merchant Bank in Johannesburg, says the bank has seen interest in the product from a range of local clients. "We've seen a lot of interest in it, mainly from hedge funds and larger, top-end corporates," she says.

Although previously restricted to retail clients, the country's central bank allowed so-called corporate entities to trade in February 2008 - a distinction that includes ordinary businesses, pension funds and asset managers. Such entities have quickly upped their participation in the product, and now account for around 95% of the value of contracts traded on the exchange. Although the futures bear the obvious setback of not being deliverable in foreign currency, pricing and liquidity was constant throughout last year's market upset, notes the JSE's Geers.