Meaning of cost of currency hedging
Hi,
I have often heard discussion around certain emerging markets currencies are too expensive to hedge. However, I have never been able to fully comprehend what this actually means.
Can somebody explain, in layman terms, what this actually means and how this is quantified, perhaps by way of example?
When you do financial transactions for assets denominated in a foreign currency, let's say BRL for Brazil, there's an inherent risk that when you convert that money back to USD you will lose some of that value if USD appreciates against BRL, because the USD is now more expensive to buy with BRL. To protect yourself from losing money, you hedge perhaps with an FX derivative like an FX swap.
For major currencies like EUR, the amount of market participants trading EURUSD swaps is very high, and you can easily find a counterparty willing to sell you USD for EUR, so the spread will be tight and you pay a smaller cost for the trade. For emerging markets currencies, the market is less liquid and so spreads will be wider, thus harder and more costly to get the trade done.
Basically this can mean several things, either:
1. The instrument you would use to hedge the EM currency doesn't actually exist, or is not easily available meaning that an OTC instrument needs to be created which can be expensive since the seller of this instrument (likely a bank) will build in alot of edge/profit from their side
2. The hedging instrument has a super wide bid/ask spread, so when you actually go to the market to buy the hedging instrument, you'll have to pay a high price since the instrument is not very liquid and there are not many people quoting it
3. Finally, even if you do the above, maybe the actual transaction fee of executing the trade can be high (this fee is usually paid to an exchange)
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