Thursday, August 11, 2005

Hedging It

John W. Snow appeared on CNBC and finanlly admitted that Chinese authorities have engaged in the derivatives market to exploit hedging techniques. I wrote about this in my July newsletter for R.W. Wentworth.

Here's a section from that newletter:

The more that people have attempted to explain Greenspan’s conundrum, the more confused everyone seems to be. Well, let’s break the situation down. We know that entities have been purchasing long-term Treasuries, pushing down the yields on these securities. Many believe the Chinese have contributed to this phenomenon.

Here is a possible explanation to why entities have bought Treasuries. Before the Asian crisis came to fruition, Asian institutions have been engaged in the “carry-trade.” Many hedging institutions use carry-trade strategies to profit handsomely from discrepancies in interest rates between economies. To briefly explain this hedging method, one would borrows (short) from the economy with the relatively lower interest rate and lends (long) to that with the higher interest rate.

Under some crucial assumptions, this strategy virtually allows one to make what I like to call free money. However, conventional wisdom tells us that there is no such thing as free lunch. For instance, a cross-border carry-trade method works only under a fixed exchange rate system with interest rate differentials, because exchange risk must be eliminated. Under a floating rate system, participants are vulnerable to foreign exchange risk. If China is abusing the carry-trade strategy, then that may explain their true reluctance to float the Yuan. China has been able to borrow on international capital markets at a lower rate than the World Bank charges.[1] According to Nouriel Roubini, Associate Professor of Economics and International Business at Stern School of Business (NYU), credit in China is reported to be unusually low, both in nominal and real terms.[2]

Certain requirements may provide some light to China’s situation. Some participants use derivatives like swap contracts to set their positions and profit from carry-trade. Typically, the only capital involved in swap agreements is the posting of collateral, which is usually in the form of G-5 currencies or government securities (excluding Japanese government securities).[3] Perhaps China has been using swap agreements and has bought U.S. Treasuries for collateral.

As mentioned, this is only a possible explanation because this cannot be confirmed by public data. Entities that use derivatives keep their positions off-balance sheet, allowing users to elude accounting rules or government regulations.

[1] http://www.dawn.com/2005/07/03/ebr12.htm
[2] http://pages.stern.nyu.edu/~nroubini/ChinaTripReport-Roubini-Setser.pdf
[3] http://www.financialpolicy.org/dscrole.htm

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