INTERNATIONAL CAPITAL: The Role of Derivatives in Crisis-Driven Capital Outflows 5

Posted by Connie R. Aponte on August 11, 2014 in INTERNATIONAL CAPITAL |

For example, a US and a Mexican securities firm associated with a bank would jointly organize a company in the Caymans or in Bermuda which would agree to purchase ajustabonos at face value, with the funding provided from the sale of two series of securities, one senior and one junior, both denominated in dollars. Suppose that the deal involved a Mexican bank’s selling $120 million par value worth of ajustabonos to the company. The Mexican partner might put up $20 million and receive $20 million par value of the junior securities, which it would sell to the Mexican bank. Denominated in dollars, the junior notes could be counted as a foreign exchange asset in determining regulatory positions.

The US firm would invest $100 million and receive $100 million par value of the senior securities. The senior securities would be designed to pay a relatively secure dollar yield, which could be paid if the exchange rate did not depreciate excessively, and would be sold for LIBOR plus. The payoff on the junior securities was like that of a structured note–if the exchange rate did not depreciate, it would pay a high yield and make good the losses on the ajustabonos. If the exchange rate depreciated, the yield or principal of the junior note would decline according to a predetermined formula.

When the banking authorities became aware that the return on the junior notes was correlated with the peso, they required that 100% of the notes be covered with foreign exchange. Market sources estimate that S2 billion of the junior notes were outstanding in 1994. The banks began to cover their positions in September, 1994 and throughout the autumn, which contributed significantly to the drain on official reserves in the several months just prior to the devaluation.

The Banco de Mexico found out after the devaluation that the more general structured notes like that of the “Bullish Obligation” example existed in large amounts. Charged with enforcing the regulation on net foreign exchange positions of the banks, the Banco de Mexico immediately ordered the banks to cover their short dollar positions. This forced a scramble for several billion dollars of foreign exchange during the post-collapse floating period, leading to the highly volatile and illiquid foreign exchange market that dominated the first quarter of 1995.

Thus, taken in sequence, the ajustabono structures, swaps, and structured notes account for most of the currency market dynamics in the months surrounding the collapse of the peso. The Mexican peso crisis is an example of a systemic crisis whose dynamics were driven by a structure of outstanding derivatives. The timing and magnitude of the near-in reserve drain, the final attack on foreign exchange reserves, and the post-collapse market turbulence are explainable by the automatic credit and market risk-covering programs attached to the contracts by counter parties and regulators themselves. payday loan no credit check

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