FX Risk Management in LATAM: Conversation with Matheus Zani from Deaglo

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FX Risk Management in LATAM: Conversation with Matheus Zani from Deaglo

FX Risk Management in LATAM: Conversation with Mateus Zani from Deaglo

Navigating the dynamic world of finance, FX risk management in LATAM (Latin America) stands out as a topic of heightened relevance. Current trends in the industry underscore the necessity of understanding currency challenges and the strategies deployed to combat them.

Have you ever wondered about the intricacies of restricted currencies? Or how businesses navigate the turbulent waters of currency restrictions in the region? Today, we’re going to uncover these questions and more.

Joining us in this exploration is Matheus Zani, a pivotal figure at Deaglo. As the head of FX risk management, Matheus is honored to be Deaglo’s inaugural employee, starting in 2020. His extensive consultancy background and successful collaborations across Latin America make him a trusted voice in the industry.

In this article, we’ll touch upon:

  • The essence of restricted currencies and their influence on financial operations.
  • The roadblocks businesses and investors encounter due to Latin America’s currency constraints.
  • The evolution of the FX risk terrain in the region over the years.
  • A deep dive into MDFs and their growing significance in Latin America.

By the end, you’ll gain invaluable insights beyond mere data, offering a panoramic view of FX risk management. So, join us as we explore these critical facets, offering insights that could shape your approach to FX risk management.

Understanding Restricted Currencies and Their Impact

Governments control restricted currencies to manage capital flows, preserve foreign exchange reserves, and influence monetary policy. These controls can significantly impact the currency’s value. Governments typically implement these measures to prevent extreme depreciation against stronger currencies like the dollar or to mitigate inflation’s adverse effects.

Why Governments Restrict Currencies

Countries like Argentina and Venezuela restrict currencies like the Argentine peso and Venezuelan bolivar in Latin America. These restrictions help combat hyperinflation and exchange rate volatility. For instance, Argentina’s inflation exceeds 120%, prompting strict controls on currency exchange to stabilize the economy. Similarly, Venezuela faces intense exchange rate fluctuations, prompting the government to intervene.

The Challenges of Restricted Currencies

Restricted currencies pose challenges for businesses and investors. In Argentina, the government’s stringent controls on currency exchange hinder companies from accessing liquidity. This limitation affects both exporters and importers, complicating transactions and conversions between the Argentine peso and the US dollar. These restrictions lead to limited trade and weekly limitations, adversely affecting the economy.

Latin America’s Currency Landscape

While Argentina and Venezuela face currency restrictions, other Latin American countries like Brazil, Mexico, Chile, and Colombia have more open currencies. Their central banks foster a pro-business environment, avoiding obstacles that could harm their economies. The Argentine peso and Venezuelan bolivar remain the most restricted, while other regional currencies enjoy greater liquidity and fewer controls.

Impact of Restricted Currencies on Foreign Investment and Business Operations

Investors face significant challenges in markets with restricted currencies. Due diligence is crucial; they must understand a country’s regulatory framework and political risks. Currency volatility is a major concern, with the potential for significant depreciation. For instance, an investment in Brazil could suffer losses if the Brazilian Real depreciates against the dollar. Additionally, investors may find it difficult to repatriate capital. Countries like Nigeria have seen investors unable to collect dividends or sell company values due to currency restrictions.

Impact of Restricted Currencies on Foreign Investment and Business Operations
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Corporate Strategies in Restricted Currency Zones

Companies operating within restricted currency zones must be creative and sophisticated in financial planning. With potential government-imposed limits on foreign currency purchases, businesses must find ways to meet their liabilities and avoid defaults. Strategies include:

  • Establishing offshore entities with dollar reserves
  • Accessing offshore liquidity
  • Building relationships with diverse financial counterparts
  • Ensuring accurate cash flow forecasting to manage currency and central bank action volatility

Argentinian companies, for example, face additional hurdles. They often need to set up offshore structures to expand and access other markets. Moreover, their Argentinian origin can negatively affect their credit quality due to perceived elevated central bank and political risks.

Trends in Restricted Currencies Across Latin America

The situation with restricted currencies varies significantly by country:

  • Mexico maintains a relatively stable currency environment, though political events can influence the peso.
  • Chile’s currency is tied to commodity prices, particularly copper, affecting its stability.
  • Peru has seen volatility in its currency, the Sol, mainly due to political instability.
  • Brazil, once a restricted currency, now enjoys a more free-floating currency but remains influenced by political and economic factors.
  • Ecuador adopted the dollar to stabilize its economy, with discussions in Argentina about potentially doing the same to combat inflation.

Each country presents unique challenges and policies regarding its currency, emphasizing the need for businesses and investors to monitor political and economic developments closely.

Challenges of Credit Lines in Corporate Treasury

Treasurers face unique hurdles when exploring credit lines within corporate treasury, particularly in Latin America. Each country’s currency restrictions and varying credit capacities significantly impact multinational companies seeking global banking partners.

Banks in certain regions may not provide ample credit, not due to a company’s credit rating but because of stringent currency limitations. This creates a complex environment for corporations managing credit lines, as they must navigate different interest rates and banking capacities in each country.

Impact of High Inflation on Treasury Activities

Inflation, particularly in Latin American countries, has been soaring. Central banks are increasing interest rates to combat this, increasing companies’ borrowing costs. Organizations face difficulties in restructuring debts at lower costs amidst such high rates.

Previously, companies might have sought foreign debt in USD as a solution, but this has also become costlier due to similar rate hikes by the Federal Reserve and European Central Bank.

Inflation and Its Complexities in Corporate Management

Inflation’s volatility presents complex challenges across all company departments, from pricing teams to CFOs managing cash flow. It complicates profit maximization and cost reduction strategies.

Rising interest rates resulting from high inflation also lead to increased borrowing costs. Under these economic pressures, Companies must balance their cash flow, liabilities, and assets.

Navigating Foreign Exchange Landscape in Latin America

Latin America presents a diverse array of currency regulations and economic challenges. Countries like Brazil have complex economic environments with unique currencies, while Argentina struggles with recurrent currency crises and stringent capital controls.

Chile, in contrast, offers a more open and stable foreign exchange market. This diversity underscores the impossibility of generalizing Latin America’s financial landscape; each country has its distinct situation requiring tailored strategies.

Understanding FX Risk Management in LATAM

Foreign Exchange (FX) risk is a critical concept to grasp, especially in Latin America. FX risk represents potential losses and gains a company may encounter due to currency fluctuations. It’s not solely a negative aspect; FX risk can lead to increased profitability if managed well. However, unmanaged, it can significantly lower revenue.

Understanding FX Risk Management in LATAM
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Why Is FX Risk Management Crucial in Latin America?

Latin America presents a unique scenario regarding FX risk management, primarily due to its high currency volatility. For instance, Brazil’s annual currency volatility recently reached around 16%. To put this in perspective, a $100 million cash flow could potentially face a $26 million loss due to this volatility. Compared to developed markets, Latin American currencies like the Brazilian Real, Colombian Peso, and Chilean Peso exhibit much higher volatility. This heightened volatility translates to greater FX risk.

Consequently, businesses exposed to these currencies must implement robust FX risk management strategies. The goal is to mitigate currency volatility and stabilize cash flows. Stable revenues and liabilities are crucial for businesses; they reduce the impact of currency fluctuations and facilitate more predictable financial planning.

Alternatives to FX Risk Management in LATAM

In the face of such complexity, some corporations might consider transacting primarily in US dollars. This approach is a form of natural hedging. If both the supply chain and buyers operate in dollars, currency risk is virtually eliminated. This practice is advantageous as it negates the need for a comprehensive hedging program. However, it’s not always feasible. Customers may prefer or require transactions in their local currency for various reasons, including competitiveness.

A prime example is SaaS companies aiming to internationalize. To sell their software globally, they often need to charge customers in the local currency, not their base currency. This practice introduces currency risk, necessitating effective management strategies.

In summary, FX risk in Latin America is a double-edged sword, offering both challenges and opportunities. Effective management is crucial for businesses operating in this region due to its high currency volatility. While transacting in US dollars can be a practical solution, it’s not universally applicable, making solid FX risk management strategies indispensable.

How Should Global Treasury Managers Approach FX Risk Management in LATAM?

Regarding foreign exchange (FX) risk management, a one-size-fits-all approach doesn’t work, especially in Latin America (LATAM). Currency control and regulations vary greatly between countries, necessitating tailored strategies.

Understanding Market Conditions

Each LATAM country has unique market conditions that influence FX risk management. Different financial instruments like non-deliverable forwards (NDFs), options, and cross-currency swaps are available, but their accessibility and cost-effectiveness differ by country.

Country-Specific Strategies

In Brazil, for instance, booking NDFs for 24 months is possible and cost-effective. However, this isn’t an option in Peru due to limited liquidity. Similarly, options and swaps have varying levels of accessibility and affordability across the region. These nuances demand a specialized approach for each country.

Customized Hedging Strategies

Effective hedging requires an in-depth understanding of each market’s volatility, interest rate differentials, and liquidity. What works in Brazil might not be feasible in Colombia or Peru. Therefore, a customized, country-specific strategy is essential for managing FX risk effectively.

Real-World Examples: Successes and Pitfalls

In Brazil, high-interest rate differentials make NDFs expensive for firms dealing with the Brazilian Real. Instead, options structures, which consider interest rate differentials, currency pair volatility, and contract maturity, can offer more cost-effective hedging. Options also provide flexibility, allowing for downside risk capping and potential upside participation.

Conversely, the high inflation and volatility in some LATAM countries can lead to significant losses when hedging, as market changes might outpace the benefits of a hedge. This highlights the importance of a nuanced understanding of each market.

Tailored Solutions

Ultimately, FX risk management in LATAM is not about generalizing regional strategies. It’s about recognizing and adapting to each country’s unique financial landscape. Treasury managers must craft customized solutions, considering market conditions and their company’s risk profile, to navigate the complexities of LATAM’s FX market effectively.

Evolution of Hedging Technology in Finance

Hedging, a crucial financial strategy, has significantly evolved over the past decade, largely due to technological advancements. Let’s dive deeper into how this transformation unfolded and what it means for businesses today.

Evolution of Hedging Technology in Finance
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Technological Shift in Agribusiness

A prime example of innovation in hedging is seen in the agribusiness sector. Instead of adhering to traditional FX consulting, many firms now heavily incorporate technology when addressing currency risk. The adoption of machine learning and artificial intelligence (AI) has brought a revolutionary approach, focusing on a holistic understanding of FX risk management. This is especially pertinent for emerging market currencies, which often exhibit challenges like volatility and interest rate differentials.

The Broader Technological Landscape

The past decade has witnessed significant technological shifts in the FX risk management space, with batch computing and the emergence of fintechs playing pivotal roles. Today, the use of AI is set to revolutionize the domain further. Companies and FX specialists are increasingly using AI to enhance analyses and simulations. The main benefit? Expedited hedging analyses backed by greater accuracy.

The days of relying solely on manual Excel spreadsheets and limited data for hedging decisions are fading. Modern technology, particularly machine learning and AI, is ushering in an era where strategies are more accurate, reducing “noise” in analyses. The goal is straightforward: to design FX risk management strategies that are both robust and adaptable to a country’s specific financial conditions.

Understanding Non-Deliverable Forwards (NDFs)

Non-deliverable forwards, commonly known as NDFs, are derivative contracts mainly used for hedging currencies in markets where the currency is not freely convertible. They are agreements between two parties, like a company and a financial institution, to exchange the difference between the predetermined forward exchange rate and the actual spot rate at maturity. A key feature of NDFs is that they do not involve the physical delivery of the underlying currency, making them ideal for managing exposure to restricted currencies.

Key Characteristics and Advantages of NDFs

  • NDFs are cost-effective compared to options strategies or forward contracts.
  • They are readily available “off-the-shelf” products in many financial institutions, especially in Latin America.
  • NDF contracts offer greater flexibility in terms of tenure, extending up to six months or even a year, unlike forwards that are usually limited to shorter durations.
  • Only the difference in rates is settled, reducing the risk for financial institutions.

NDFs in Developed vs. Emerging Markets

NDFs are more prevalent in emerging markets, such as those in Latin America, Africa, and parts of Asia. This is due to the higher risk perceived by counterparts in these regions, making NDFs a safer option. In contrast, developed markets like Europe, the UK, the US, and Canada prefer forward contracts. The reasons behind this preference require further investigation, but it may relate to the risk profiles and profitability of these instruments for financial institutions.

NDFs in Latin America: A Case-by-Case Basis

In Latin America, countries like Mexico, Colombia, Chile, and Brazil utilize NDFs as part of their hedging strategies. However, whether NDFs are the most suitable option depends on the specific market conditions, the risk tolerance of the business, and the hedging costs involved. Businesses must understand these factors to choose the best instrument for their currency risk management strategy. The decision hinges on their budget, risk tolerance, and the extent of protection they seek for their currency exposure.

Choosing the Right Hedging Instruments for Short-Term and Long-Term Needs

When it comes to hedging, the choice of instruments largely depends on the timeframe and the specific requirements of a business. For short-term hedging, typically under 60 days, forwards are the preferred instrument. This is primarily due to their ease of setup, as they often don’t require extensive paperwork or authorization processes like their counterpart, the Non-Deliverable Forwards (NDFs). With forwards, a simple call to the bank is enough to secure a deal, making them a convenient and time-efficient option.

Choosing the Right Hedging Instruments for Short-Term and Long-Term Needs
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Variety of Hedging Instruments in LATAM

In Latin America, businesses employ a range of hedging instruments to manage their financial risks. Apart from NDFs and forwards, options, cross-currency swaps, and vanilla swaps are also commonly used. Each of these instruments offers different levels of flexibility and can be tailored to match the risk profile of a company. The choice depends on what a company aims to protect, be it revenue, long-term debt, or interest payments.

Tailoring Hedging to Specific Business Scenarios

Selecting the appropriate hedging instrument can be crucial, especially in uncertain or complex transactions like mergers and acquisitions. In scenarios where there is a currency risk but the deal’s completion is uncertain, using NDFs might not be ideal. They assume the deal will go through, and if it doesn’t, the company could face significant losses. Instead, options or deal contingency hedging could offer the right balance of risk protection without the obligation, safeguarding the company even if the deal falls through.

Each derivative comes with its own costs, and it’s essential to weigh these against the benefits they offer. By understanding the nuances of each instrument, businesses can effectively shield themselves from financial risks while ensuring they don’t commit to unnecessary costs or obligations.

Hedging Costs in LATAM vs. Other Regions

In Latin America (LATAM), hedging costs are often higher than in other regions. This is primarily due to the significant interest rate differences between LATAM countries and major economies like the United States or the European Union. For instance, if a LATAM country has higher domestic interest rates to fight inflation, as seen in Brazil post-COVID, the cost to hedge its currency against the US dollar increases. The hedging cost in Brazil was 8.4% in 2021, 6.7% in 2022, and around 3.9% currently.

Factors Influencing Hedging Costs

Several factors can influence these costs:

  • Central Bank Policies: Central banks altering interest rates can affect hedging costs. For example, Brazil’s Central Bank reduced its SELIC rates, lowering hedging costs as the interest rate differential with the US decreased.
  • Interest Rate Differentials: When one country has higher interest rates than another, hedging costs rise. In LATAM, countries with higher rates than the US or EU will face steeper costs.

A New Perspective: Hedging Pact

It’s worth considering the term “hedging pact” instead of “hedging cost.” This perspective acknowledges that the impact depends on the direction of the trade. If you’re buying dollars and selling local currency, it’s a cost. However, if you’re an exporter earning in dollars and buying local currency, this differential can be beneficial, offering a positive carry and increasing revenue.

Strategies to Minimize Hedging Impact

Businesses can adopt several strategies to manage these costs effectively:

  1. Duration Management: Instead of hedging for the full duration at once, consider shorter periods that may offer lower costs.
  2. Hedge Ratio Adjustment: Decide what portion of your portfolio or cash flow to hedge. A full hedge eliminates currency risk but comes with higher costs, whereas partial hedging balances risk and cost.
  3. Options Strategies: Utilizing options can be beneficial, especially if market conditions change. Factors like reduced volatility or the short-term nature of an option can offer cheaper hedging alternatives.

Understanding the specific market conditions, risk profiles, and hedging tools is crucial to navigate these costs. There’s no one-size-fits-all solution; each case requires a tailored approach to manage hedging costs effectively.

How is Deaglo Tailoring FX Risk Management for LATAM?

Deaglo is revolutionizing FX risk management in LATAM with a holistic approach, offering customized solutions that meet the region’s unique challenges. Here’s how Deaglo stands out:

How is Deaglo Tailoring FX Risk Management for LATAM?
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Tailored Solutions for LATAM Challenges

You’ll appreciate how Deaglo offers customized solutions that directly address LATAM’s unique challenges. By merging advanced technologies like machine learning, AI, and Bayesian regressions with statistical methods, they’re at the forefront of innovation.

Combining Technology and Local Expertise

Imagine having the power of advanced tech combined with local knowledge. Deaglo is doing just that by forming a robust team in Brazil. This move brings them closer to their clients, ensuring timely and effective responses.

Empowering Businesses

Think about navigating the ever-changing FX landscape with confidence. Deaglo aims to arm businesses with essential tools and knowledge. Through their FX risk management platform, businesses can:

  • Access vital market data, trends, and analysis.
  • Utilize multi-card simulations for modeling potential outcomes. This includes considering factors like volatility, skewness, amount, and maturity to gauge potential risks.
  • Craft tailored FX hedging strategies. Plus, businesses can evaluate the performance of each strategy, understanding hedging costs and their effects.

Evaluating Hedging Instruments

For a company, knowing the liquidity implications of financial instruments is critical. Deaglo’s tools let companies assess various hedging instruments, from NDFs to cross-currency swaps. They evaluate these tools from a liquidity standpoint, particularly their collateral implications.

Tools for Investment Industries

If you’re in the investment industry, Deaglo’s tools are tailored for you. They’ve developed a tool that compares different cash flows, especially regarding cash flow for hedging. This allows the evaluation of currency hedging’s impact on a fund’s performance.

In a nutshell, Deaglo offers an array of statistical tools that provide insightful data, enabling clients to make informed decisions. By addressing specific LATAM challenges and combining technological advancements with local expertise, they are revolutionizing FX risk management in the region.

For individuals seeking further details about operations in LaTAM or the services offered by Deaglo, a clear path is provided. You are encouraged to visit Deaglo.com, for a comprehensive look at their solutions tailored for emerging markets, particularly LaTAM. The website also offers a way to connect with foreign exchange specialists. For direct inquiries, you can send email to info@Deaglo.com.

Concluding Thoughts:

We’ve journeyed through Latin America’s intricate currency landscape and its influence on businesses and investors. You’ve learned about the motivations behind government-imposed currency restrictions and the associated challenges. Every country in this region offers a unique currency scenario, underscoring the need to stay updated on political and economic shifts.

Investors in these restricted markets face considerable obstacles. Companies operating here have to think outside the box to navigate these challenges. With Latin America’s high currency volatility, robust foreign exchange risk management is not just usefulβ€”it’s essential. You’ve seen the pros and cons of transactions in US dollars as an alternative.

One can’t overlook the role of evolving technology in managing currency risks. Firms like Deaglo stand as prime examples, merging tech with local expertise. We also considered the choice of hedging tools for varying durations, weighing the costs and stressing the value of custom-tailored strategies. The distinct factors affecting hedging costs in the region and ways to mitigate their effects also took center stage.

In essence, to succeed in Latin America’s FX scene, you need a thorough grasp of its intricacies and a bespoke risk management strategy. Staying informed, harnessing technology, and pursuing tailor-made solutions will guide you in this vibrant financial terrain.

Frequently Asked Questions (FAQ)

What is a restricted currency?

A restricted currency is one that a government tightly controls. This control aims to manage money flow, protect foreign reserves, and steer monetary policy.

Why would a government restrict its currency?

Governments impose restrictions to fight extreme inflation, stabilize exchange rates, and lessen inflation’s negative impacts.

Which Latin American countries have currency restrictions?

Argentina and Venezuela are examples of countries that restrict currencies, such as the Argentine peso and Venezuelan bolivar.

How do these restrictions impact businesses and investors?

Such restrictions create hurdles. They can limit access to funds and make transactions difficult for those buying and selling internationally.

Are there Latin American countries with more open currencies?

Yes, countries like Brazil, Mexico, Chile, and Colombia have fewer currency controls.

What challenges do investors in these markets face?

Investors must deal with complicated rules, political risks, and unpredictable currency values. Moving money out of these countries can also be tough.

What can companies do to work around currency restrictions?

Companies can form offshore branches, seek international funding, forge ties with financial partners, and plan their cash flow carefully.

How does high inflation affect company finances?

Severe inflation means higher borrowing costs. This makes it harder for companies to reorganize debts at lower rates.

What are NDFs, and what role do they play in Latin America?

Non-deliverable forwards (NDFs) are contracts used to protect against currency risk in markets where direct trading of the currency is restricted. They are both affordable and common in Latin America.

How can businesses reduce hedging costs in Latin America?

Businesses can manage these costs by adjusting the duration and ratio of hedges and by using options strategically.

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