## _wp0537

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---

### I. Introduction
- A market for foreign exchange hedging instruments enables domestic corporations to manage currency mismatches between assets and liabilities.
- In the absence of hedging markets, governments can accumulate foreign reserves to hedge currency mismatches; Edison (2003) estimates that it costs 1 percent of GDP to increase reserves by 10 percent of GDP.
- Paper objectives:
  - (i) the foreign exchange exposure of the Chilean corporate sector;
  - (ii) the determinants of the demand and supply of foreign exchange hedging;
  - (iii) the instruments available for hedging foreign exchange risk;
  - (iv) the impact of the regulatory framework and market structure on the growth of the foreign exchange derivatives market;
  - (v) the degree to which foreign exchange risk hedging reduces systemic vulnerabilities to financial crises.

### II. Foreign Exchange Exposure in Chile
- Overall assessment:
  - Systemic risk from currency mismatches in corporate balance-sheets appears to be low in Chile relative to other developed and emerging market countries.
- Key comparative statistics (Caballero, Kowan, and Kearns (2004)):
  - Mean and median share of foreign currency liabilities in Chile: approximately 28 percent and 5 percent.
  - Argentina, Peru, and Uruguay: mean and median foreign currency liabilities reported as more than 50 percent and 60 percent respectively.
- External debt and maturity profile:
  - Total external debt in the non-financial private sector: $24.9 billion or 34 percent of GDP by end-2003.
  - 84 percent of that external debt is tilted towards medium and long-term maturities.
- Firm- and industry-level exposure (Dominguez and Tesar (2001)):
  - Firm level exposure (percent): Chile 13.6; France 18.9; Germany 20.6; Italy 26.3; Japan 31.1; Netherlands 26.3; Thailand 21.3; United Kingdom 18.8.
  - Industry level exposure (percent): Chile 17.4; France 17.1; Germany 64.7; Italy 32.3; Japan 59.5; Netherlands 40.0; Thailand 25.0; United Kingdom 46.2.
- Sectoral findings:
  - Foreign exchange exposure is significant for 13 percent of publicly listed firms and affects 17 percent of industries.
  - The financial sector has been the most exposed to foreign exchange risk.
  - Banks hedge between 90 to 100 percent of their net foreign exchange positions (Mendelson and Glaessner, 2004).
  - An FSAP mission concluded solvency ratios would not be seriously affected in the event of devaluation even if combined with increases in interest rates and deteriorating credit quality (Gutierrez, 2004).
- Empirical sample periods reported:
  - January 1995 - April 2004.
  - January 1995 - December 1999.
- Additional statistic:
  - 0.1 percent of total assets in the financial system.

### III. The Market of Foreign Exchange Derivatives — Demand and Supply
- Market structure and participants:
  - Foreign exchange derivatives in Chile are traded mainly in the over-the-counter market, with banks as major market makers.
  - Domestic banks and financial institutions write a variety of derivative instruments and match corporate end-users and institutional investors’ hedging needs.
  - Banks acting as market makers can hedge net positions offshore if needed.
- Demand drivers:
  - Demand primarily from large corporations; small and medium enterprises seldom hedge due to lack of knowledge and costs.
  - Some firms avoid hedging because it requires sacrificing the option to prepay dollar liabilities.
  - Empirical evidence from small industrialized countries: financial distress (higher leverage, lower credit rating) explains greater derivatives usage.
  - Financial distress may be the main determinant of hedging in Chile; testable using FECUS data.
- Hedging practices and magnitudes:
  - Banks hedge 90 to 100 percent of their exposure; corporations hedge only 40 percent (IMF and World Bank, 2004).
  - Pension funds as suppliers:
    - As of end-December 2003, pension funds held 24 percent of their assets, or $11.9 billion, in foreign assets (mostly U.S. dollars).
    - Sizable foreign asset holdings of pension funds equal 14 percent of GDP.
    - By end-December 2003, institutional investors had an outstanding dollar-paying position of $7.7 billion compared to the outstanding dollar-buying position of $2.9 billion of corporations (Alarcón, Selaive, and Villena, 2004).
  - Exporters and pension funds:
    - Exporters’ foreign-currency paying positions amounted to $4.8 billion or close to 28 percent of the total amount of foreign-currency paying positions in the domestic derivatives market in 2003.
- Maturities and supply concentration:
  - Supply concentrated in short maturity contracts (three months or less).
  - Pension funds and exporters typically take foreign currency-paying positions in short-maturity contracts.
  - Banks supply hedging for maturities of one year and above, hedging long-term forward contracts with dollar and dollar-linked bonds issued by the Central Bank.
  - Market analysts estimate outstanding forward contracts with maturities above one year exceed banks’ holdings of dollar and dollar-linked instruments by 50 percent, implying banks carry an unhedged position in Chilean pesos; these long-maturity contracts account for 1 percent of the forward market.
  - Back-of-the-envelope calculation suggests banks’ exposure from unhedged long-maturity forward contracts amounts only to $50-60 million.

### IV. Instruments: Forwards and Options
- Forwards:
  - Forward contracts can be written onshore or offshore.
  - Onshore: can be written for Chilean pesos and Unidades de Fomento against the U.S. dollar; Chilean pesos are preferred. Nine out of ten onshore contracts are non-deliverable (Moguillansky, 2002).
  - Offshore: forward contracts are non-deliverable and written only for Chilean pesos.
  - Onshore market liquidity and size:
    - Average face value of a forward contract is $5 million.
    - Market analysts estimate daily turnover at $100 million; Central Bank data estimate daily turnover at $625 million in 2001; another cited figure is $600 million.
    - Onshore forward market is quite liquid for contracts with maturities of three months or less.
  - Maturity breakdown of onshore forward contracts:
    - Chile: 21 percent (one week and less); 78 percent (7 days to one year); 1 percent (one year and above).
    - Australia: 61 percent (1 week or less); 31 percent (over 1 week and less than 1 year); 8 percent (over 1 year).
    - New Zealand: 41 percent (1 week or less); 58 percent (over 1 week and less than 1 year); 1 percent (over 1 year).
  - Transaction costs and opportunity costs:
    - Bid-ask spread (percent of forward rate) for one-month contracts: Chile 8 basis points; Brazil 15 basis points; South Korea 8 basis points; New Zealand 4 basis points; Australia 2 basis points.
    - Opportunity cost of hedging with 3-month forward contracts (percent of forward rate, April 2001 to April 2004):
      - Average: CLP 4.68; AUD 4.76; NZD 5.69.
      - Maximum: CLP 13.20; AUD 16.11; NZD 15.99.
      - Minimum: CLP 0.00; AUD 0.00; NZD 0.01.
      - Volatility: CLP 2.90; AUD 3.78; NZD 4.11.
    - Conclusion: opportunity costs in Chile are slightly lower than in Australia and New Zealand; Chile performed better with respect to maximum gain foregone during the examined period.
  - Collateral and credit lines:
    - Typical collateral requirements for corporate forward contracts:
      - Maturities less than 30 days: 5 percent of the nominal value.
      - Maturities over 30 days and up to 180 days: 7 percent to 10 percent.
      - Maturities over 180 days and up to 360 days: 15 percent.
    - Even firms meeting bank credit rating requirements must obtain approval of a credit line; the cost of tying up the bank’s economic capital is passed on via less favorable forward rates.
    - Only 40 percent of foreign exchange liabilities were hedged using forwards (Mendelson and Glaessner, 2004).
    - SMEs face access constraints due to counterparty credit risk and lack of sophistication.
- Offshore currency options:
  - Implied volatilities (at-the-money forward, September 2000–April 2004) — selected statistics:
    - 1-month contract (Average; Maximum; Minimum; Standard Deviation): CLP 10.67 / 17.33 / 6.00 / 2.23; AUD 11.45 / 17.34 / 7.09 / 2.22; NZD 12.65 / 19.11 / 8.45 / 2.41.
    - 12-month contract (Average; Maximum; Minimum; Standard Deviation): CLP 12.00 / 18.17 / 9.00 / 1.60; AUD 11.21 / 13.91 / 9.43 / 1.19; NZD 12.44 / 15.83 / 10.10 / 1.48.
  - Option premium (offshore U.S. dollar calls) as percent of spot rate:
    - 3 month maturity: Average — Chilean Peso 2.20; Australian Dollar 1.98; New Zealand Dollar 2.22. Maximum — Chilean Peso 2.88; Australian Dollar 2.42; New Zealand Dollar 2.89. Minimum — Chilean Peso 1.68; Australian Dollar 1.81; New Zealand Dollar 1.88. Volatility — Chilean Peso 0.38; Australian Dollar 0.13; New Zealand Dollar 0.24.
    - 6 month maturity: Average — Chilean Peso 3.11; Australian Dollar 2.08; New Zealand Dollar 2.98. Maximum — Chilean Peso 3.97; Australian Dollar 2.68; New Zealand Dollar 3.67. Minimum — Chilean Peso 2.50; Australian Dollar 1.84; New Zealand Dollar 2.59. Volatility — Chilean Peso 0.45; Australian Dollar 0.17; New Zealand Dollar 0.25.
  - Observations:
    - Volatility of the USD-CLP option premium is roughly twice that of Australian and New Zealand dollar options.
    - USD-CLP options offshore are less liquid than USD-AUD and USD-NZD options; USD-AUD options had a daily average traded outstanding notional amount of $40 billion in 2001 (BIS, 2002). No offshore USD-CLP volume figures provided.
- Onshore currency options:
  - Growth constrained by regulation that prevents banks from offering option contracts directly; banks use affiliates or “sociedades de inversion” to offer contracts.
  - Customer base composed of large corporations; corporate demand is low because:
    - Option premium must be paid upfront.
    - Perception that currency options may be “illegal” since banks cannot offer them directly.
  - Onshore daily average volume: $2.5 million.
  - Onshore option premia (percent of spot rate): 3-month contract: 3 percent; 6-month contract: 4 percent.
  - Comparison: offshore premia April 2003–April 2004 were 2.2 percent (3-month) and 3.11 percent (6-month); onshore premia are higher.

### V. Policy Measures to Foster Derivatives Market Growth and Risks
- Key prerequisites for development:
  - Modernize clearing and settlement systems and address legal/operational voids (especially netting of positions).
  - Continue implementation of market-friendly policies.
- Potential policy options:
  - Remove restrictions on derivatives trading for pension funds and insurance companies.
  - Foster development of derivatives exchanges as a complement to the over-the-counter market.
- Rationale for exchanges and centralized clearing-houses:
  - Decentralize risk, reduce counterparty risk and associated costs, facilitate price discovery, and allow access to risk-sharing instruments for small corporations.
  - Centralized clearing-houses act as sole counterparty to exchange members, net aggregate positions, reduce systemic risk from a failing market maker, and concentrate information for monitoring and regulation.
- Risks during financial crises:
  - Derivatives availability may exacerbate systemic risk if markets become one-sided and market makers hedge by selling domestic currency in the spot market, weakening the domestic currency, raising interest rates, increasing volatility, and deteriorating corporate solvency.
  - Dynamic hedging and delta hedging by option sellers can amplify depreciation pressures on the domestic currency.
  - Cross-border transmission risk: increased volatility in Chile in the second half of 2001 was attributed to multinational firms hedging Argentine peso exposures using Chilean derivatives.
- Mitigation:
  - Exchanges and centralized clearing-houses reduce systemic risk from concentrated market-making and improve regulatory monitoring.

### VI. Conclusions and Sectoral Exposure
- Foreign exchange exposure in Chile is lower than in other countries in the region and similar to small industrialized countries.
- Most exposed sector: the financial sector; banks hedge between 90 to 100 percent of net foreign exchange positions and are assessed as able to withstand severe exchange and interest rate shocks.
- Forward market:
  - Has facilitated managing currency risk and currently meets domestic users’ hedging needs through pension funds and exporters.
  - Liquidity (bid-ask spreads) is lower than in most emerging markets but deemed satisfactory by market participants.
- Constraints to wider hedging uptake:
  - Counterparty credit risk and lack of sophistication prevent SMEs from accessing forward and options markets.
  - Regulatory constraints limit growth in currency options; allowing banks and pension funds to underwrite currency options could foster market development.
- Caveat:
  - While derivatives provide risk transfer benefits and can reduce exchange rate volatility, they can increase instability during financial turmoil; authorities should weigh these risks when fostering market development.

### Box 2 — What Factors Determine the Demand for Foreign Exchange Hedging
- Purposes and value:
  - Hedging is part of overall risk management; valuable if it reduces costs of financial distress, decreases taxes, or avoids bad investment decisions from agency costs.
- Financial distress channel:
  - Hedging reduces volatility of foreign currency-denominated cash flows, lowering probability and costs (direct and indirect) of financial distress.
- Tax-smoothing channel:
  - Hedging can decrease tax payments if the tax schedule is convex or when tax preference items create convexity.
- Agency costs and capital structure channel:
  - Hedging attenuates conflicts among stakeholders, can increase leverage by reducing borrowing costs, and helps achieve optimal capital structure.
- How derivatives can destabilize exchange rates during distress:
  - Market makers hedging forward positions synthetically in the money market can put downward pressure on the domestic currency and upward pressure on interest rates during panics.
  - Option-selling and delta hedging: as the domestic currency depreciates, deltas increase, forcing market makers to buy larger amounts of foreign currency, amplifying depreciation.
- Historical example:
  - Brazil in mid-2002 — uncertainty boosted demand for forward hedging; substantial selling pressure in the spot market drove the Brazilian real and domestic interest rates to all-time highs.

*Source: _wp0537 (excerpted content from the provided PDF).*

### References..............................................................................................................

### _wp0537 - References.................................................................................................................. 22

### I. Introduction
- A market for foreign exchange hedging instruments enables domestic corporations to manage currency mismatches between assets and liabilities.
- In the absence of hedging markets, governments can accumulate foreign reserves to hedge currency mismatches, but reserve accumulation has substantial opportunity costs. Edison (2003) estimates that it costs 1 percent of GDP to increase reserves by 10 percent of GDP.
- The paper explores:
  - (i) the foreign exchange exposure of the Chilean corporate sector;
  - (ii) the determinants of the demand and supply of foreign exchange hedging;
  - (iii) the instruments available for hedging foreign exchange risk;
  - (iv) the impact of the regulatory framework and market structure on the growth of the foreign exchange derivatives market;
  - (v) the degree to which foreign exchange risk hedging reduces systemic vulnerabilities to financial crises.

### II. Foreign Exchange Exposure in Chile
- Overall assessment:
  - Systemic risk from currency mismatches in corporate balance-sheets appears to be low in Chile relative to other developed and emerging market countries.
- Key comparative statistics (from Caballero, Kowan, and Kearns (2004)):
  - Mean and median share of foreign currency liabilities in Chile: approximately 28 percent and 5 percent.
  - By contrast, in Argentina, Peru, and Uruguay mean and median foreign currency liabilities are reported as more than 50 percent and 60 percent respectively.
- External debt and maturity profile:
  - Total external debt in the non-financial private sector: $24.9 billion or 34 percent of GDP by end-2003.
  - 84 percent of that external debt is tilted towards medium and long-term maturities.
  - The relatively long maturity profile reduces corporate sector vulnerabilities to adverse exchange rate movements.
- Firm- and industry-level exposure (Table 1, Dominguez and Tesar (2001)):
  - Firm level exposure, in percent:
    - Chile 13.6
    - France 18.9
    - Germany 20.6
    - Italy 26.3
    - Japan 31.1
    - Netherlands 26.3
    - Thailand 21.3
    - United Kingdom 18.8
  - Industry level exposure, in percent:
    - Chile 17.4
    - France 17.1
    - Germany 64.7
    - Italy 32.3
    - Japan 59.5
    - Netherlands 40.0
    - Thailand 25.0
    - United Kingdom 46.2
- Sectoral findings:
  - Dominguez and Tesar (2001) suggest foreign exchange exposure is significant for 13 percent of publicly listed firms and affects 17 percent of industries.
  - Factor analysis indicates the financial sector has been the most exposed to foreign exchange risk (see Table 2).
  - FSAP findings: banks in Chile hedge between 90 to 100 percent of their net foreign exchange positions (Mendelson and Glaessner, 2004), and an FSAP mission concluded solvency ratios would not be seriously affected in the event of devaluation even if combined with increases in interest rates and deteriorating credit quality (Gutierrez, 2004).
- Empirical specifications and sample periods (Table 2):
  - Sample period: January 1995 - April 2004
  - Sample period: January 1995 - December 1999
  - Bold fonts indicate coefficient is statistically significant at the 10 percent level at least; t-statistics in italics.

### III. The Market of Foreign Exchange Derivatives
#### A. Demand and supply
- Market structure:
  - Foreign exchange derivatives in Chile are traded mainly in the over-the-counter market, with banks playing a major role as market makers.
  - Domestic banks and financial institutions can write a variety of derivatives instruments and are responsible for matching corporate end-users and institutional investors’ hedging needs.
  - Commercial banks may take positions on foreign futures contracts on foreign currency and interest rates, and on exchange-traded options on foreign currency and interest rate futures; banks acting as market makers can hedge net positions offshore if needed.
- Demand drivers:
  - Demand for hedging primarily comes from large corporations, which have the resources and skills to implement hedging programs; small and medium enterprises seldom hedge due to lack of knowledge.
  - Some firms avoid hedging because it requires sacrificing the option to prepay dollar liabilities.
  - Empirical evidence from small industrialized countries suggests financial distress is often the main driver of corporate hedging; proxies for costs of financial distress (higher leverage, lower credit rating) explain greater derivatives usage in Canada, Australia, Finland, Sweden (Jalilvand (1999); Nguyen and Faff (2002); Hakkrainen et al (1998); Hagelin (2003)).
  - Financial distress may be the main determinant of hedging in Chile, potentially testable using FECUS data (Box 2).
- Hedging practices and magnitudes:
  - Banks hedge 90 to 100 percent of their exposure; corporations hedge only 40 percent (IMF and World Bank, 2004).
  - Pension funds as suppliers:
    - As of end-December 2003, pension funds held 24 percent of their assets, or $11.9 billion, in foreign assets, mostly denominated in U.S. dollars (Table 3).
    - Sizable foreign asset holdings of pension funds equal 14 percent of GDP.
    - By end-December 2003, institutional investors had an outstanding dollar-paying position of $ 7.7 billion compared to the outstanding dollar-buying position of $ 2.9 billion of corporations (Alarcón, Selaive, and Villena, 2004).
  - Pension funds’ and exporters’ roles:
    - Pension funds are natural providers of foreign currency hedging because minimum coverage requirements of foreign assets give them incentive to take the foreign currency-paying leg of derivatives transactions.
    - Exporters also take foreign currency-paying positions; foreign-currency paying positions of corporate end-users, mainly exporters, amounted to $4.8 billion or close to 28 percent of the total amount of foreign-currency paying positions in the domestic derivatives market in 2003 (Alarcón, Selaive, and Villena, 2004).
- Maturities and supply concentration:
  - The supply of foreign exchange hedging is concentrated in short maturity contracts (three months or less); pension funds and exporters typically take foreign currency paying positions in these short-maturity contracts.
  - Pension fund managers sometimes do not fully cover long foreign currency positions because carrying naked dollar positions during periods of dollar appreciation is profitable.
  - Banks supply hedging for maturities of one year and above, hedging long-term forward contracts with dollar and dollar-linked bonds issued by the Central Bank.
  - Market analysts estimate outstanding forward contracts with maturities above one year exceed banks’ holdings of dollar and dollar-linked instruments by 50 percent, implying banks carry an unhedged position in Chilean pesos; these long-maturity contracts account for 1 percent of the forward market.
  - A back-of-the-envelope calculation using Alarcón, Selaive, and Villena (2004) and opportunity cost details suggests banks’ exposure from unhedged long-maturity forward contracts amounts only to $50-60 million.

#### B. Instruments
- Forwards:
  - Forward contracts can be written onshore or offshore.
  - Onshore: contracts can be written for Chilean pesos and Unidades de Fomento against the U.S. dollar; Chilean pesos are preferred. Nine out of ten onshore contracts are non-deliverable (Moguillansky, 2002).
  - Offshore: forward contracts are non-deliverable and written only for Chilean pesos.
  - Market use:
    - Domestic corporations generally find the onshore market more advantageous for hedging exposure.
    - The offshore market is used mainly by leveraged foreign investors.
  - Average daily volume for the past three years has been in the range reported in the source tables and figures.

*Source: _wp0537 - References (excerpted content from the provided PDF).*

### 0.1 percent of total assets in the financial system.

### _wp0537 - 0.1 percent of total assets in the financial system.

### Onshore forward market: size, average contract, and turnover
- Average face value of a forward contract is $5 million.
- Market analysts estimate daily turnover at $100 million dollars; Central bank data estimate daily turnover at $625 million in 2001; another cited figure is $600 million.
- The onshore forward market is described as quite liquid for contracts with maturities of three months or less.
- The forward market for contracts with maturities of one year or less is a two-way market: demand from corporations with short dollar positions is mostly met by supply from institutions with long dollar positions such as exporters and pension funds.

### Maturity breakdown of onshore forward contracts
- Chile: 21 percent of contracts are for maturities of one week and less; 78 percent for maturities between 7 days and one year; 1 percent for maturities of one year and above.
- Australia: 61 percent (1 week or less); 31 percent (over 1 week and less than 1 year); 8 percent (over 1 year).
- New Zealand: 41 percent (1 week or less); 58 percent (over 1 week and less than 1 year); 1 percent (over 1 year).
- Implication: majority of contracts have very short maturities, so hedging in the forward market may not contribute much to reduce cash flow volatility.

### Transaction costs and opportunity costs for forwards
- Bid-ask spread (as percent of forward rate) for one-month contracts:
  - Chile: 8 basis points.
  - Brazil: 15 basis points.
  - South Korea: 8 basis points.
  - New Zealand: 4 basis points.
  - Australia: 2 basis points.
- Opportunity cost of hedging with 3-month forward contracts (measured as percent of forward rate at inception) for period April 2001 to April 2004:
  - Average: CLP 4.68; AUD 4.76; NZD 5.69.
  - Maximum: CLP 13.20; AUD 16.11; NZD 15.99.
  - Minimum: CLP 0.00; AUD 0.00; NZD 0.01.
  - Volatility: CLP 2.90; AUD 3.78; NZD 4.11.
- Conclusion: opportunity costs in Chile are slightly lower than in Australia and New Zealand; Chile performed better with respect to maximum gain foregone during the examined period.

### Collateral, credit lines, and uptake by corporates
- Typical collateral requirements for corporate forward contracts:
  - Maturities less than 30 days: 5 percent of the nominal value of the contract.
  - Maturities over 30 days and up to 180 days: 7 percent to 10 percent.
  - Maturities over 180 days and up to 360 days: 15 percent.
- Even firms meeting bank credit rating requirements must obtain approval of a credit line; the credit line ties up the bank’s economic capital and its cost is passed on to end-users via less favorable forward rates.
- Only 40 percent of foreign exchange liabilities were hedged using forwards (Mendelson and Glaessner, 2004).
- Comparison: a 1999 survey showed New Zealand used financial contracts to hedge 64 percent of foreign currency denominated liabilities.
- Result: counterparty credit risk and lack of sophistication limit SMEs' access to forward markets; collateral and credit-line costs likely contribute to low hedge ratios in the corporate sector.

### Offshore currency options: implied volatilities and premia
- Implied volatility (at-the-money forward) comparability (September 2000–April 2004): USD-CLP, USD-AUD, and USD-NZD show similar average implied volatilities.
- Implied volatility statistics for offshore OTC currency options:
  - 1-month contract (Average; Maximum; Minimum; Standard Deviation): CLP 10.67 / 17.33 / 6.00 / 2.23; AUD 11.45 / 17.34 / 7.09 / 2.22; NZD 12.65 / 19.11 / 8.45 / 2.41.
  - 3-month contract (Average; Maximum; Minimum; Standard Deviation): CLP 10.67 / 17.33 / 6.00 / 2.23; AUD 11.45 / 17.34 / 7.09 / 2.22; NZD 12.65 / 19.11 / 8.45 / 2.41.
  - 12-month contract (Average; Maximum; Minimum; Standard Deviation): CLP 12.00 / 18.17 / 9.00 / 1.60; AUD 11.21 / 13.91 / 9.43 / 1.19; NZD 12.44 / 15.83 / 10.10 / 1.48.
- Option premium (offshore U.S. dollar calls) descriptive statistics (in percent of spot rate):
  - 3 month maturity: Average — Chilean Peso 2.20; Australian Dollar 1.98; New Zealand Dollar 2.22. Maximum — Chilean Peso 2.88; Australian Dollar 2.42; New Zealand Dollar 2.89. Minimum — Chilean Peso 1.68; Australian Dollar 1.81; New Zealand Dollar 1.88. Volatility — Chilean Peso 0.38; Australian Dollar 0.13; New Zealand Dollar 0.24.
  - 6 month maturity: Average — Chilean Peso 3.11; Australian Dollar 2.08; New Zealand Dollar 2.98. Maximum — Chilean Peso 3.97; Australian Dollar 2.68; New Zealand Dollar 3.67. Minimum — Chilean Peso 2.50; Australian Dollar 1.84; New Zealand Dollar 2.59. Volatility — Chilean Peso 0.45; Australian Dollar 0.17; New Zealand Dollar 0.25.
- Observation: the volatility of the USD-CLP option premium is roughly twice that of Australian and New Zealand dollar options.
- Liquidity: USD-CLP options offshore are less liquid than USD-AUD and USD-NZD options; USD-AUD options had a daily average traded outstanding notional amount of $40 billion in 2001 (BIS, 2002). No offshore USD-CLP volume figures provided; implied volatilities change less frequently for USD-CLP.

### Onshore currency options: regulation, volumes, and premia
- Onshore OTC currency options market growth constrained by regulation that prevents banks from offering option contracts directly; banks have used affiliates or “sociedades de inversion” to offer contracts.
- Customer base is composed of large corporations; corporate demand is low because:
  - Option premium must be paid upfront, perceived as a cost rather than insurance.
  - Perception that currency options may be “illegal” since banks cannot offer them directly.
- Onshore daily average volume: $2.5 million.
- Onshore option premia quoted as percent of spot rate:
  - 3-month contract: 3 percent.
  - 6-month contract: 4 percent.
- Comparison: average offshore premia April 2003–April 2004 were 2.2 percent for the 3-month contract and 3.11 percent for the 6-month contract; onshore premia are higher.

### Policy measures to foster derivatives market growth
- Key prerequisites for development:
  - Modernize clearing and settlement systems and address legal/operational voids, especially those related to netting of positions.
  - Continue implementation of market-friendly policies.
- Potential policy options:
  - Remove restrictions on derivatives trading for pension funds and insurance companies.
  - Foster the development of derivatives exchanges as a complement to the over-the-counter market.
- Rationale for exchanges:
  - Decentralize risk, reduce counterparty risk and associated costs, facilitate price discovery, and allow access to risk-sharing instruments for small corporations.
- Advantages of centralized clearing-houses:
  - Act as sole counterparty to exchange members, net aggregate positions across members, reduce systemic risk from a failing market maker, and concentrate information for monitoring and regulation.

### Risks of derivatives markets during financial crises
- During extreme financial distress, derivatives availability may exacerbate systemic risk:
  - Markets can become one-sided as firms hedge foreign currency exposures using short-term instruments; lack of counterparties forces market makers to hedge by short-selling domestic currency in the spot market, weakening the domestic currency, raising domestic interest rates, increasing volatility, and deteriorating corporate solvency.
  - Dynamic hedging can amplify market movements; speculators can take large positions in forward and swap markets that reduce central bank intervention effectiveness.
- Cross-border transmission risk:
  - Example: increased volatility in the Chilean foreign exchange market in the second half of 2001 attributed to multinational firms hedging Argentine peso exposures using Chilean market derivatives.
- Mitigation:
  - Derivatives exchanges and centralized clearing-houses reduce systemic risk from concentrated market-making and improve regulatory monitoring.

### Conclusions and sectoral exposure
- Foreign exchange exposure in Chile is lower than in other countries in the region and similar to small industrialized countries.
- Most exposed sector: the financial sector; however, recent assessments suggest banks can withstand severe exchange and interest rate shocks successfully.
- Forward market has facilitated managing currency risk and currently meets domestic users’ hedging needs through pension funds and exporters; this situation is likely to continue as the pension fund industry grows.
- Liquidity in the forward market (bid-ask spreads) is lower than in most emerging markets and deemed satisfactory by market participants.
- Constraints identified:
  - Counterparty credit risk and lack of sophistication prevent SMEs from accessing forward and options markets.
  - Growth in currency options has been constrained by regulation; allowing banks and pension funds to underwrite currency options could foster market development.
- Caveat: while derivatives provide benefits (risk transfer, better investment decisions, lower exchange rate volatility), they can increase instability during financial turmoil; authorities should weigh these risks when fostering market development.

*Source: _wp0537 - 0.1 percent of total assets in the financial system.*

### Box 2. What Factors Determine the Demand for Foreign Exchange Hedging

### Box 2. What Factors Determine the Demand for Foreign Exchange Hedging

### Purposes and value of foreign exchange hedging
- Hedging foreign exchange risk is one component of a firm’s overall risk management program.
- Hedging is valuable if it helps reduce the costs of financial distress, decrease taxes, or avoid bad investment decisions arising from agency costs (Smith and Stulz, 1985).

### Financial distress channel
- Financial distress happens when a firm’s income cannot cover its fixed expenses.
- Direct costs: those linked to default, bankruptcy, reorganization, and/or liquidation.
- Indirect costs: operating effects even if no default occurs (for example, borrowing costs increase to compensate for increased probability of default; customer loyalty may decline causing sales, and hence, income to decline).
- Hedging reduces the likelihood of financial distress by reducing the volatility of foreign currency-denominated cash flows.

### Tax-smoothing channel
- Foreign exchange hedging can decrease tax payments if the tax schedule is a convex function of income; smoothing pre-tax income lowers the average tax burden.
- Even where the tax schedule is flat, tax preference items such as tax loss carry-forwards and investment tax credits create convexity, and hence, an incentive to hedge.

### Agency costs and capital structure channel
- Conflicting objectives among stakeholders (shareholders, debt-holders, and managers) may lead to sub-optimal investment decisions.
- Managers’ compensation largely depends on firm performance; managers may demand a premium or bypass projects they deem too risky.
- Hedging attenuates these problems and helps firms increase leverage by reducing borrowing costs, as it assures potential bondholders of a reduced probability of financial distress.
- Hedging thus facilitates achieving an optimal capital structure.

### How currency derivatives can destabilize exchange rates during distress
- Market makers as foreign currency payers in forward contracts can hedge by creating a reverse position synthetically in the money market:
  - Borrow the present value of the notional amount of the contract in domestic currency.
  - Exchange it for foreign currency in the spot market today and deposit it in a money market account.
  - When the contract matures, the foreign currency deposit principal and interest offset the foreign currency payment; the domestic currency received is used to pay the domestic currency loan.
- During a financial panic, hedging activity by market makers may lead to upward pressure on interest rates and downward pressure on the domestic currency beyond what fundamentals justify.
- Historical example: Brazil in mid-2002 — uncertainty about the presidential elections boosted demand for currency hedging in the forward market; substantial selling pressure in the spot market drove the Brazilian real and domestic interest rates to all time highs.

### Option-selling and delta hedging amplification
- End-users who want to hedge buy foreign currency call options (equivalently, domestic currency put options).
- Market makers selling foreign currency call options to end-users can hedge their short position using delta hedging.
- Delta hedging requires buying an amount of foreign currency proportional to the notional amount of the option contract; the amount is determined by the “delta” of the contract, a measure of the sensitivity of the option price to changes of the exchange rate.
- When the exchange rate depreciates (the foreign currency becomes more expensive relative to the domestic currency), the delta increases, forcing the market maker to buy increasingly larger amounts of foreign currency, which puts additional downward pressure on the domestic currency.
- See Briys et al (1998) for a comprehensive explanation of how to manage option positions.

*Source: _wp0537 - Box 2. What Factors Determine the Demand for Foreign Exchange Hedging*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp0537.pdf_