Jittery ringgit spurs options growth in Malaysia

Local corporates seek new hedging tools, but longer-term options liquidity lacking

Companies in Malaysia are looking to use foreign exchange options as a cheaper way of hedging currency exposure, dealers say. The move follows a surge in US dollar/Malaysian ringgit volatility.

“Before the beginning of the year there was no volatility in the market and so there was not much upside in doing an option,” says Ina Ibrahim, regional head of corporate sales at CIMB. “It is only in the past three months that we have started to see a huge pick-up in option activity because of the high levels of volatility.”

During March, volatility in USD/MYR reached levels not seen since 2016, when the central bank cracked down on offshore non-deliverable forward trading, pushing out speculators and crimping exchange rate variability.

Since the start of the year, daily close-close volatility has doubled from the levels seen between 2017 to 2019. This has led to a growth in interest from local corporates to use combinations of options to hedge the resurgent FX risk.

Four banks with a large presence in Malaysia report that they have seen a 10–15% increase in currency options trades with a tenor of less than six months compared to the same period last year. When combined in certain structures, options hedges canoffer users an improved strike versus forwards.

“When the currency is stable corporate treasurers either just transact in the FX spot market – i.e. they don’t hedge – or they do simple forwards to lock in the cost,” says Sylvia Wong, head of financial markets for Malaysia at Standard Chartered.

“But because of the current volatility we have seen an increase in the number of requests from corporate clients asking us how they can reduce forward hedging costs.”

 

 

In a typical options strategy, the corporate uses combinations of bought and sold options to achieve a hedging goal – most commonly, an improved strike. The rising volatility in USD/MYR means there is now enough premium available from selling options to improve the strike to a level that makes the structures economically attractive versus regular forwards.

One example of a structure is a target redemption forward, or Tarf. Here, a corporate buys or sells a set amount of currency at a fixed, improved level – made possible by selling options – on a regular basis over the course of a contract, which knocks out when a target profit level has been reached. The combination of puts and calls means the upfront premium is typically zero.

If the currency strengthens, the seller’s profits roll in every month and the product expires early when a target amount of profit is reached. However, if the opposite happens, the sold options mean corporates can be locked into selling at a worse rate until expiry. Leveraged versions could see companies locked into selling twice as much at the worse rate. The product has caught out investors and dealers in countries such as Taiwan, Korea and Brazil in previous years.

Options can also be used to construct an array of hedges that, for example, give buyers full protection from adverse rate movements but the ability to make some profit from beneficial moves as well. They can be useful, too, for corporates looking to limit credit line usage compared to regular forwards.

Shorter-dated options

Dealers say most of these options are being used by local family-run businesses and small and medium-sized enterprises to hedge the currency exposure of the import and export side of their businesses.

“These are the clients that don’t have to go through multiple layers of approval: where the decision makers and the business owners are the same,” says Ibrahim at CIMB.

Option structures typically reference the USD/MYR cross, since this is the pair that most corporates are most exposed to. Even where corporates have exposures to other G10 currencies, many of them choose to use the US dollar as a proxy hedge, since these structures are the cheapest to put on.

But recent volatility has also been driving interest in other crosses, such as Australian dollar/Malaysian ringgit, says Selene Chong, head of global FX and commodities for Asia at HSBC in Hong Kong.

“People are realising that if they have a G10 currency exposure, they can’t simply use the US dollar any more as a hedge and run the basis currency risk – which a lot of them were doing in the past – because vols are ticking up and the currency is moving more,” she says.

The tendency towards the shorter end of the hedging spectrum is partly a legacy of how Malaysia’s hedging regulation has evolved. Until recently, corporates that wanted to put on a hedge longer than six months had to seek prior approval from the central bank. Bank Negara – something that few of the smaller corporates could spare the resources to do.

This has since changed. In May 2019, Bank Negara extended the tenor limit up to 12 months and in April this year it was scrapped altogether.

Bank Negara Malaysia relaxed the regulatory regime for FX options in April 2020

This means corporates are now able to put on options hedges of any tenor without going to the central bank first, providing they have the underlying currency exposure. Despite this change, though, firms are yet to move away from the six-month hedging cycle that they are comfortable with. Ibrahim says it may take a little longer to change this hedging mindset.

“We do see some clients asking about longer-dated hedging, but it’s going to be a step-by-step process to increase the tenor,” she says. “Typically when they go beyond a year they need to mark the hedge to market, and this hits their P&L, so from what I see their behaviour is very much to try and match the tenor before year-end.”

The propensity towards shorter-dated options structures means liquidity is hard to come by at the longer end of the curve. Consequently, those with longer-term currency exposure are often unable to find option structures to match. Ibrahim says options liquidity is available up to about two years, but beyond that rapidly falls away, making it difficult for banks to offer longer-dated Tarfs.

Dealers claim their warehousing capabilities can push the structures available on the market out to five years or even, some say, beyond 10 years. However, the longer-dated structures can increase dealers’ sensitivity to movements in volatility, known as vega, which needs to be hedged or reduced.

“You can structure the product in such a way that you have less vega or where the vega is weighted towards the shorter tenor. There are always ways,” says Chong.

Hedge accounting

Despite efforts to extend the tenor of instruments, long-term corporate needs are still not being met on the Malaysian market. One large domestic corporate owes billions of US dollars for overseas purchases that it has made, which is to be paid over the next 10 to 15 years. Most of the hedging for this liability is done via a combination of forwards and cross-currency interest rate swaps, but the corporate has recently been engaging with banks to try and reduce the hedging cost. Putting on long-dated options could be one avenue.

“Our liability is huge and to a very long tenor so we wanted to see if there was any more suitable structure we could use to hedge it,” says the head of treasury at the corporate. “We talked to the banks but it became complicated and we had to speak to our auditor about how we could translate this into the accounts.”

The treasurer says the company is sticking with its current hedging approach for now, since “other hedging options are not quite there yet”.

Previously the accounting rules were too prescriptive. Under IFRS 9, it is now easier to achieve hedge accounting

Prakash Arikrishnan, PwC

Other corporates are even more conservative, and the heads of treasury aren’t prepared to start discussing new hedging structures, even as the hedging cost continues to rise, since they know they won’t be able to convince the board to accept them.

“We don’t want to do anything more sophisticated than a forward because it’s difficult to understand how we can account for it,” says the head of treasury at another publicly listed firm. “Anything more fancy and we just don’t know if the pricing is correct. There’s no standardisation and, unless we can find a homogenous structure that we can refer to, like a forward contract, we’re going to be cautious.”

The recent change in the way financial instruments are accounted for – under IFRS 9 – has simplified hedge accounting and is improving appetite among corporates for longer-dated hedges in Asia.

“Previously the accounting rules were too prescriptive. You needed to meet a certain hedging effectiveness and you couldn’t roll things forward if the hedge structure didn’t match,” says Prakash Arikrishnan, a director within the treasury advisory services of PwC in Malaysia. “Under IFRS 9 a lot of these restrictions have gone away and it is now easier to achieve hedge accounting even for dynamic hedging, which gives people more comfort with putting on longer-dated hedges.”

Editing by Alex Krohn