FinClient

FX hedging costs are on the up again for the Turkish Lira. This will be an info-dump covering the last 12- months of data for this currency.

Firstly, it is getting hard to now manage currency risk on lira-denominated assets. In the past, we always hedged by selling the lira through FX forward contracts, but that only works when you can hedge over a duration over
six months, and thanks to the extreme volatility in the lira, the cost hedging that far out is now too high to make sense. Bid offer spreads have also exploded, a few thousand percent. This begs the question; how do you maintain exposure to Turkey while mitigating the risks? Some
are cutting local assets and still running exposure in forwards. Others have kept the assets but adjusted forward hedges as risk changes. But even
remaining neutral to the benchmark carries risks, so whichever
the way you look at it, Turkey poses a challenge.

Liquidity in the current spot market is down considerably; most investors are really on the sidelines. The average daily trading volume at EBS Direct for spot is down -40%. While the platform is not the main venue to trade the pair, the change in liquidity conditions is striking. Even when taking into account the various liquidity providers, you now have a choice of around 50% less. The price of lira-linked FX derivatives also soared through this period. FX forwards and swaps-the hedging instrument most popular with asset managers and corporates also have seen huge price rises. One measure is to look at the implied yield — effectively how much higher the forward rate is versus the spot level at the time-which is driven by a combination of interest rate differentials and demand.

Trying to put on forwards when the yield is high is fraught with danger. As a result, managers have taken a variety of approaches to managing the positions. Looking at US mutual funds in aggregate, the main theme has been a reduction in net Turkey risk. Currently there’s a big discrepancy between the bond and forward figures, more than likely due to funds heavy preference for replicating their benchmark lira exposures in forwards instead of bonds. Not holding Turkish government bonds has been an advantage, instead of hedging half of the Turkish exposure in benchmarks solely through FX forwards, running a small net short position on the lira since 2020 has performed very well. The advantage of forwards is they are still an active market and consist of bilateral contracts with a dealer, meaning significantly less risk compared to government bonds, which settle onshore and would be impossible to sell if capital controls are introduced.

However, getting in and out of forward positions isn’t cheap, the liquidity is down, and bid/offer spreads have ballooned. PGIM, one of the biggest users of USD/TRY options among US mutual funds has dropped their notional options by 7% since 21. We noticed that they were buying call spreads, where they would purchase the USD/TRY option at io, for example, and sell calls at a higher strike price, such as ii. These positions would only gain if the rate depreciated up to ii, but anything beyond that was capped. The high carry cost made outright calls at 9 s too expensive at the time, and many thought it wouldn’t depreciate as much as it did. But as the volume on these options rose as high as 60%, calls spread were no longer a viable strategy. At this point, it would be worth noting that the smart money has been taking advantage of these elevated volatility levels by selling out of the money puts. In other words, we think that at a certain strike price, the Turkish lira is likely to appreciate over the coming months or so.

Consider those rolling FX forwards at its custodian base; often they are done ahead of the settlement date of the original trade. In that case, where the custodian sees that the manager is due to receive a currency and pay it out on the same day, it would net the two off and be done. This is effectively an intraday credit line given to the trader. But with the lira’s volatility, many custodians have become wary of giving out this credit now. With any heightened risk of a failed settlement on the Lira, credit has all but dried up. So even if you have two offsetting lira payments due to settle on the same day, the bank will only process the short trade if they have already processed the long. In the event of new lines of credit reopening, you must take this as a positive for the Lira, this would actually be considered a bullish signal for the FX. Currently, because of the shortfall, Lira needs to be settled in custody accounts the day before any short settling. This reluctance stems from any lack of clarity around lira flows and has really made it quite a simple short trade. As this is no longer a two-way flow and has become sporadic, things have become unpredictable. Now we are at a trade-by-trade decision, meaning the trades need to be properly analysed when looking at things like size and tenor. Until this workload slows down when looking at the other side of the trade, regardless of direction, the bears are very much in charge.

This brings us onto corporates, who redoubtably have a tougher job in managing their FX risk. . Simply using FX forwards to lock in a rate to sell lira and buy USD has become expensive. Currently, the one year outright FX forward price in USD/TRY is about 30% higher than today’s spot rate. That’s huge. Do I want to pay 30% to guarantee that rate, or should I take a more active approach? That means weighing up the costs of hedging lira on an ongoing basis and the risks associated with not doing so compared to other currencies they have exposure in. Recently, for example, we are seeing more liquidity trading lira against the euro than the dollar. Some corporations are even looking at changing the form in which they get their lira exposure to generate natural offsets. Going forward, these are the scenarios that traders will need to take into account when trading the Lira FX.