INTERNATIONAL CAPITAL: The Role of Derivatives in Crisis-Driven Capital Outflows 3

Posted by Connie R. Aponte on August 7, 2014 in INTERNATIONAL CAPITAL |

The bank in the example must find a counter party bank to engage in the swap. By entering into a one-month baht foreign exchange swap, the counter party bank effectively lends baht spot to be repaid in one-month. When the baht are sold on the spot market, they are bought by the Bank of Thailand—and the other regional central banks that support it—in the campaign to defend the exchange rate. In lending spot baht through the swap, the counter party bank acquires the baht needed for spot delivery either by discounting paper through the standing facilities of the Bank of Thailand or through outright sale or sale with repurchase through the Bank of Thailand’s market operations.

Derivatives and the Dynamics of Capital Flow Reversals

Even in countries where currency forward contracts did not play a role in a sudden reversal in capital flows, other derivative products may be present in sufficient quantities to affect the dynamics of a crisis. The Mexican peso crisis of 1994 is such a case. Speculators did not use the forward market suddenly to short sell the peso. Rather, outstanding products of the sort outlined earlier drove the near-in movements of capital going into and coming out of the devaluation of the peso.

The derivative positions that drove the crisis were established by a weak banking system hungry for current income. The Mexican groups that had purchased the banks on privatization in 1991-1992 had financed the aggregate $12 billion price through substantial amounts of borrowing. Interest due had to be paid through current bank income, and this led the banks into taking increased credit risk through on-balance sheet expansions and increased market risk through off-balance sheet growth.

Tesobono Swaps

Industry sources in Mexico report that there was a stock of about US$16 billion of tesobono swaps at the time of the devaluation.18 Of the US$29 billion of tesobonos outstanding on December 19, 1994, about US$16.1 billion were held by foreign addresses. Thus, sufficient tesobono swaps existed to repackage the entire foreign holding of tesobono risk: foreigners held tesobonos primarily to hedge tesobono swaps and Mexican banks held the tesobono risk. long term payday loans

When the crisis arrived, tesobono market values in dollars suddenly fell. From December, 1994 to January, 1995, tesobono yields jumped from 8 percent to 24 percent, and several of the interim offerings had failed. The fall in market value reduced the value of the collateral and triggered margin calls to deliver dollars or close out the positions.

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