Hedging of New Zealand's foreign currency denominated overseas debt - article

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Key Statistics - article, July 1999, p.7
 

Summarises the results of a survey on the hedging (financial risk) of New Zealand's foreign currency denominated overseas debt. The survey results also provide estimation of the market value of financial derivatives.
 

Hedging of New Zealand’s foreign currency denominated overseas debt¹

A special survey was recently undertaken on the hedging (or financial risk management) of New Zealand’s foreign currency denominated overseas debt. The survey was run as a supplement to the overseas debt surveys 1998 and 1999, and involved the major New Zealand enterprises which contributed the bulk of New Zealand’s foreign currency overseas debt. The survey results supplement the Overseas Debt statistics by providing information on the extent of hedging and estimating the market value of financial derivative contracts.
 

Section 1 of this article summarises those results; section 2 describes how they were obtained; section 3 discusses the limitations of the market value estimates; and then, in the technical notes in section 4, there is discussion of hedging in the context of the results presented.
 

Readers should note that the results are intended as indicative estimates only.
 

1. Summary of results - (refer to Tables 2 and 3)
 

The 31 March 1998 results show that of the $32.4 billion foreign currency denominated overseas debt that was covered by the survey:
 

• 54 percent was hedged by financial derivative contracts
• 41 percent was naturally hedged against foreign currency balance sheet assets or expected foreign currency revenues (a ‘natural hedge’ is defined as asset and liability exposures being matched but without entering formal derivative contracts), and
• 5 percent was not hedged.

The 31 March 1999 results show a similar picture, with some further breakdown of the natural hedge position. Of the $38 billion foreign currency overseas debt covered by the survey:
 

• 64 percent was hedged using financial derivative contracts
• 33 percent was naturally hedged against foreign currency balance sheet assets and expected future foreign currency revenues, and
• 3 percent was not hedged.
  

The survey also collected indicative data on the market value of derivative contracts with nonresident counter-parties, in relation to foreign currency overseas debt. This showed that at 31 March 1998 financial derivative contracts against non-resident counter-parties were in a net asset position of $755 million, and at 31 March 1999, a net asset position of $766 million.
 

Statistics New Zealand stresses that these results are indicative only. This aspect is further discussed in section 3.
 

2. Scope - (refer to Table 1)
 

The scope of the survey was limited to: 1) seeking the extent of hedging arrangements in relation to foreign currency overseas debt, and 2) estimating the net asset/liability position in relation to those hedging arrangements. This hedging survey is therefore a partial measure. It does, however, contribute to the comprehensive treatment of financial derivatives as part of a project for producing a quarterly financial account to International Monetary Fund standards.
 

The survey sought information from New Zealand enterprises which contributed the most to foreign currency overseas debt liabilities. It included the New Zealand Treasury which represents the official sector. The chosen enterprises account for about 85 percent of New Zealand’s foreign currency overseas debt liabilities. Note that the analysis excludes the ‘unallocated estimate’ (ie the value of debt used to account for enterprises not surveyed as part of the Overseas Debt sample survey).
 

New Zealand’s foreign currency overseas debt at 31 March 1998 and as originally published in June 1998 was $43.2 billion. The foreign currency overseas debt encompassed in the results accounted for $32.4 billion, 75 percent of the $43.2 billion total. The corresponding figure for the $49 billion of foreign currency overseas debt as at 31 March 1999 was $38 billion, 78 percent (ref Table 1).
 

Several of the enterprises approached for hedging information had difficulty meeting the data requirements due to the way in which their foreign currency risk is managed - a handful were unable to supply data. In general, these reporting problems arose because exposures are pooled for risk management purposes, making it difficult to isolate hedging information for New Zealand residents’ debt liabilities.
 

The survey asked respondents to:
 

• State, by currency, their total foreign currency overseas debt as at 31 March. This was to be the same figure as reported to the overseas debt survey.
• State the percentage of these overseas liabilities that were:
  
  
  1. Hedged using financial derivatives. Included in the definition ‘fully hedged’ is the practice of rolling over or renegotiating derivative contracts of shorter term than the underlying liability.
  2. Naturally hedged against assets or other receipts. These encompassed both financial assets and expected export receipts. The natural hedge position of banks represents their on-balance-sheet foreign currency assets. The 1999 questionnaire was reworded for banks to take specific account of this.
  3. Not hedged. This was an uncommon situation. Several respondents reporting unhedged positions also indicated ongoing monitoring of those positions and the undertaking of formal risk management arrangements at preset limits.
     

The survey also asked respondents to report the market value of their derivative contracts on overseas liabilities as both net asset and net liability positions at 31 March. At March 1998, this showed net asset positions in relation to non-resident counter-parties to be $755 million and, at March 1999, $766 million.
 

The currency information presented in Table 4 shows that virtually all of the United States dollar denominated overseas debt at March 1998, and 1999, was hedged in some way. The other major borrowing currencies - the Japanese yen and the Australian dollar - are hedged to a slightly lesser degree. Debt denominated in other currencies was hedged to a level of 76 percent at March 1998, and 77 percent at March 1999.
 

3. Net market value - (refer to Table 3)
 

The net market value (net asset position) of $755 million at 31 March 1998, and $766 million at 31 March 1999, are indicative estimates, and should be interpreted in the following context:
 

• The results only relate to the foreign currency overseas debt reported as being hedged by derivative contracts.
• Whatever the term of the underlying liability, associated derivative contracts are often of a shorter term and are rolled over or renegotiated through the life of the underlying liability. The effect is that at each rollover/renegotiation of the derivative contract, the issuer will record profits and losses made on the derivative contract in their accounts. Because the survey takes a snapshot of the market value of contracts in place at 31 March, the results take no account of profits or losses recorded from the earlier succession of contracts.
• Banks in general found it difficult to extract the required market value information. Direct matching of an overseas liability to a particular hedge was not possible, and alternative ways of providing information were established. Therefore, the market value results for banks should be interpreted with care.
• Distinguishing the residency of counterparties was also a problem for respondents. Some corporates were reasonably able to do this. While some non-bank corporates deal direct with non-resident counter-parties, indications are that the usual practice for other non-bank corporates is to deal with a resident bank. Banks indicated that their practice was to engage with non-resident counter-parties at levels close to 100 percent.
  

4. Technical notes

Hedging
 
Hedging is the action of managing one’s financial risk so as to protect against, or at least reduce, risk. A wide range of financial risks are hedged, including movements in interest rates, movements in asset and commodity prices, and movements in exchange rates.
 

The aim of the survey was to collect information on the extent of hedging activity in relation to New Zealand’s foreign currency overseas debt, and to estimate the market value of the derivative contracts in place.
 

The specific risks targeted were exchange rate movements affecting the New Zealand dollar value of overseas debt in foreign currency. Information was sought on the type of hedge used to manage these risks. The types of hedge employed were:
 

• Financial derivatives
  This involves using derivative instruments such as forward contracts, futures, options and swaps. A financial derivative is a contract in its own right entered into with a counter-party, and separate from the borrowing contract. The financial derivative derives its value by reference to the value of an underlying instrument, eg a defined amount of foreign currency.
  
• Natural hedge
  This includes situations where a foreign currency borrower holds foreign currency assets as a ‘natural’ part of its business operations. For example, a bank’s United States dollar (USD) financial assets (eg securities) may be used to hedge the currency risk associated with a USD loan. A future income stream may also be used as a hedge for a foreign liability. For example, an exporter with a USD liability may use an expected USD income stream from future exports to hedge the currency risk associated with the USD liability.
  

The net asset, net liability position
 
This is the difference between the value of the derivative contract, and the current value of the underlying instrument.
 

To illustrate this, the following highly simplified example encompasses the raising of a foreign currency liability, and its associated derivative contract.
 

A New Zealand enterprise raises a loan from overseas lenders to fund New Zealand operations. While the loan is denominated in USD, the borrower’s requirement is for New Zealand dollars (NZD) to fund New Zealand operations. The loan is for US$100.

In order to satisfy the requirement for NZD, the New Zealand borrower and a counter-party swap currencies at an agreed rate, with an agreement to swap them back again at the agreed rate on the payment date of the original USD loan. Therefore, the New Zealand borrower locks in repayment obligations with certainty, because the original debt obligation and the derivative contract close on the same date, and the NZD liability is fixed by the terms of the derivative contract.
 

At the inception of the derivative contract, the New Zealand borrower delivers to the derivative counter-party the US$100 in exchange for NZ$172.4. The NZD:USD exchange rate established is 0.58. At the agreed future date, when the original loan and the derivative contract mature, the derivative counter-party delivers to the New Zealand borrower US$100 in exchange for NZ$172.4 from the New Zealand borrower. The New Zealand borrower then settles the original debt of US$100 with the non-resident lender.
 

Market value of the derivative contract
 
The swap agreement is a contract in its own right, but the value of the contract is derived from the underlying instrument. The value of the contract is determined by comparing the value of the contract with market values pertaining at some other date. The difference between the two values determines whether the contract is in an asset (in the money) or liability (out of the money) position. (More sophisticated methods of valuation are used by market transactors, but in the interests of simplicity these are ignored here.)

In the example above, the contracted NZD amount of the swap - that is, the NZD amount received, and which needs to be paid back - is NZ$172.4. The exchange rate used in determining this value was 0.58. If this contract had an inception date of 1 April 1998, and a conclusion date of 31 March 1999, and if the USD:NZD exchange rate at 31 March 1999 was 0.53, then at 31 March 1999 the contract has a net asset value (for the New Zealand borrower) of NZ$16.3, ie the difference between the NZ$172.4 swap obligation and the NZ$188.7, (USD100/0.53) which would have had to be paid back if the rate had not been pre-agreed at 0.58. Note that the figure reported in the Overseas Debt statistics as at 31 March 1999 would be NZ$188.7, ie the US$100 loan converted to NZD at the exchange rate prevailing at 31 March 1999.
 

Conversely, if the prevailing exchange rate at 31 March 1999 was 0.63, then the New Zealand borrower would be in a liability position of NZ$13.7, ie the difference between his or her obligation to the derivative counter-party of NZ$172.4, and the NZ$158.7 which would have been required to purchase US$100 at the exchange rate prevailing on 31 March 1999. In this case, the figure reported in the Overseas Debt statistics would be NZ$158.7.
 

If you wish to discuss this article, contact Peter Roche, Lila Jackson or Salendra Kumar Tel: 0-4-495 4600 Email: peter_roche@stats.govt.nz

Footnote

¹ This project was worked on by Peter Roche, Lila Jackson, and Salendra Kumar, Balance of Payments Division, Statistics New Zealand.

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Overseas debt