INTERNATIONAL CAPITAL: Data on the Extent of Derivative Markets 6

Posted by Connie R. Aponte on July 26, 2014 in INTERNATIONAL CAPITAL |

Again, balance of payments accounts will report a gross inflow of $1 billion worth of equity purchases for portfolio investment or perhaps foreign direct investment and an outflow of $200 million in bank deposits. The Mexican bank—and therefore the national balance sheet— holds the equity risk, while the foreign address is only a short term dollar lender.

Structured Notes

Structured notes exist in many forms, but the example studied here will determine the payoff on what might be described as a “Bullish Obligation on the Peso,” as presented in Table 4. For example, a Mexican bank or its foreign subsidiary might buy a note with a 29 day maturity from a New York investment house for $10 million. The coupon on the note and the principal on the note are payable in dollars. Suppose that the coupon offered in the note is 195 percent annually multiplied by the ratio of the current spot value of the peso to the peso-dollar exchange rate at maturity. Interest rates on peso paper such as cetes—peso denominated treasury bills are 85 percent per annum and 5 percent on dollar paper.

The principal repayment also depends negatively on the peso value of the dollar at maturity—suppose it will be-[l+3x(7.0-Pm) f?m] x $10 million, where 7.0 is the initial peso value of the dollar and Pm is the value at maturity. In an extreme case, if the peso has depreciated by 50 percent at maturity, from say 7.07 to 14.0 pesos per dollar, the principal repayment will be -$5 million. The overall payoff is then -$3.25 million. Conversely, if the peso appreciates significantly, the payoff can be a multiple of the initial investment. Table 4 shows that this is the payoff structure of a position that is currently short about $19.92 million at a market dollar interest rate of 5 percent per year and long 209.95 million pesos at a market peso interest rate of 85% percent per year. Effectively, the initial $10 million investment has been leveraged three-fold and invested in peso paper.

Overall, through the payoff formula, the New York investment house would have a position equivalent to being short 209.95 million worth of peso paper and long $19.92 million worth of dollar loans. In addition, it has the initial $10 million from the sale of the note. To hedge, it may wish to buy the peso by investing in one-month cetes while simultaneously selling the dollars in the position. It would then appear in the on-balance sheet accounts as a foreign buyer of a peso-denominated asset rather than as a dollar-denominated lender, which is its true position.

If the seller of the note hedges the position, the balance of payments accounts will report a net inflow of about $20 million. This will result from a gross inflow of about $30 million in the form of portfolio purchases of short-term, peso denominated government paper and outflow -of $10 million in the form of a Mexican bank’s purchase of a short maturity, dollar denominated note.

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