Risks from emerging markets Russian corporate event. Moscow, 19 June 2014 Stanley Myint Head of Risk Management Advisory

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1 Risks from emerging markets Russian corporate event Moscow, 9 June 4 Stanley Myint Head of Risk Management Advisory

2 Contents. Early Warning Signals. Most efficient hedging instrument

3 Early Warning Signal algorithm Three criteria need to be satisfied Start looking for devaluation when the probability distribution of the CDS is highly non-normal At any point Signal is on only if the local markets (Equity, FX and CDS) are weakening within the next three months In addition, Econometric signal has to be bigger or equal to a given Threshold, equal to.75 No Signal No CDS has non normal returns? Yes No Signal No Local markets weakening? Econometric indicators Indicator Weight Risk Indicator Yes Equity Prices (Y/Y growth) 5% Low Real Effective Exchange Rate (Y/Y growth) 8% Low Current Account Balance (% of GDP) % Low M/ Reserves (Y/Y growth) % High No Signal No Econometric signal threshold? Short term Capital inflows (% of GDP) 8% High Exports (Y/Y growth) 7% Low Industrial Production (Y/Y growth) 7% Low Signal Yes

- 4 May - 4.Econometric signal ON May - Aug - Nov - Feb - 4 May - 4 Number of Indicators triggered Index Percentile Signal.

4 USDRUB June 4.CDS signal OFF.RSI signal OFF CDS Change of Regime CDS Signal Threshold -Equity RSI CDS RSI FX RSI Threshold 8 8 Crisis May - Aug - Nov - Feb - 4 May - 4.Econometric signal ON May - Aug - Nov - Feb - 4 May - 4 Number of Indicators triggered Index Percentile Signal. RTS Standard Index % REER 6%.5 ECO Current Account (% GDP) 8% M/Reserves 79%. ST Capital inflows (% GDP) 7% Exports % Industrial Production 8% Weighted average.7 (May 4.7) Threshold.5. Feb - 4 May - 4 -May 9-May 6-May -May -May Econometric signal is ON 4

5 How does the method perform for USDRUB (since release) USDRUB FX rate and Number of Signals triggered 7 Signal (rh) USDRUB (lh) May- Aug- Nov- Feb- May- Aug- Nov- Feb- May- Aug- Nov- Feb-4 May-4 USDRUB /8- / /5- /6 /-/6 /7- /9 / -/5 4 Depreciation % 5% 4% % 8% Ann.depreciation 9% 45% 6% 6% 9% USDRUB All period Depreciation 7% Ann.depreciation 8% USDRUB RED signal Depreciation 4% Ann.depreciation 4% 5

6 July We provide the monthly update of the Early Warning Signals for 8 Emerging Market currencies We notice only downgrades. Four currencies are in the red area: BRL, RUB, ARS and RON Indicators and Transitions No. of signals triggered USDBRL USDZAR USDMXN USDRUB EURTRY EURPLN USDIDR USDMYR USDTHB USDARS EURCZK EURHUF USDKRW EURRON USDCLP USDCOP USDPHP USDILS RSI RSI RSI ECO RSI RSI CDS ECO,RSI ECO, RSI CDS,RSI CDS,RSI ECO,CDS ECO,RSI ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 6

7 August We provide the monthly update of the Early Warning Signals for 8 Emerging Market currencies We notice mainly downgrades. Six currencies have been in the red area this month: BRL, ZAR, RUB, CZK, HUF and RON Indicators and Transitions No. of signals triggered USDBRL USDZAR USDMXN USDRUB EURTRY EURPLN USDIDR USDMYR USDTHB USDARS EURCZK EURHUF USDKRW EURRON USDCLP USDCOP USDPHP USDILS ECO RSI RSI CDS RSI CDS CDS,RSI CDS,RSI ECO,CDS ECO,RSI ECO,RSI CDS,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 7

8 September We provide the monthly update of the Early Warning Signals for 9 Emerging Market currencies. This month we include the INR for the first time Starting from this month, we made some adjustments to our methodology for CDS signals. We noticed that the CDS distribution is rarely normal anymore, so we now compare the distribution over the past days vs. the preceding 9 days. If the Kolmogorov test is above the threshold and the CDS returns are increasing, the signal is ON At the beginning of August, we had 6 currencies in the red area, but this month only HUF remains red. However, the overall risk remains high, as most of the currencies are in the orange area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR CDS RSI ECO ECO CDS RSI ECO,CDS ECO,CDS ECO,RSI ECO,RSI ECO,RSI CDS,RSI CDS,RSI ECO,RSI ECO,CDS CDS,RSI ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations. Since India sovereign CDS is not liquidly traded, we use the CDS of State Bank of India as proxy. See the main presentation for more details about our new methodology 8

9 October We provide the monthly update of the Early Warning Signals for 9 Emerging Market currencies We notice a general improvement. There is no currency in the red area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR ECO RSI RSI ECO ECO RSI ECO,CDS ECO,RSI ECO,RSI ECO,RSI CDS,RSI ECO,CDS ECO,RSI CDS,RSI ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations. See updated main presentation to have more explanations about our new methodology 9

10 November We provide the monthly update of the Early Warning Signals for Emerging Market currencies.this month we include USDUAH for the first time We notice only improvements. There is now only USDUAH in the orange area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH ECO ECO ECO ECO ECO ECO ECO ECO ECO ECO CDS ECO ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations

11 December We provide the monthly update of the Early Warning Signals for Emerging Market currencies Most currencies are getting worse. BRL and RUB are in the red area, IDR, CLP and COP are in the orange area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH CDS ECO ECO RSI ECO ECO RSI ECO ECO ECO.RSI ECO,RSI ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations

12 January 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies We notice only downgrades since the last update. Three currencies are in the red area: BRL, RUB and THB Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH CDS CDS CDS CDS CDS RSI ECO CDS,RSI ECO,CDS ECO,RSI ECO.RSI ECO,RSI ECO,RSI ECO,RSI ECO,RSI ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations

13 February 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies The overall risk stays high. 5 currencies got downgraded and 4 got upgraded. Three of them are now in the red area: MXN, RUB and THB Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH CDS CDS ECO CDS RSI ECO ECO,RSI ECO,RSI ECO.RSI CDS,RSI ECO,CDS ECO,CDS CDS,RSI ECO,RSI ECO,RSI ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations

14 March 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies The overall risk remains high with ten currencies in the orange area and three in the red area: MXN, RUB and INR Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH CDS CDS ECO CDS CDS ECO,RSI ECO,RSI CDS,RSI ECO,CDS ECO,CDS ECO,RSI CDS,RSI ECO,RSI ECO,RSI ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 4

15 April 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies We notice a general improvement. Only RUB is in the red area and ARS, HUF and UAH are in the orange area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH ECO ECO ECO ECO ECO CDS CDS ECO ECO ECO,CDS ECO,RSI ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 5

16 May 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies The overall level of risk remains similar to last month, with a few downgrades and upgrades. After 5 months in the red (Dec to April), RUB risk has improved to yellow, leaving no currencies in the red area. Only INR and UAH are in the orange Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH ECO ECO ECO ECO CDS ECO CDS ECO ECO RSI ECO ECO ECO ECO,CDS ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 6

17 June 4 We provide the monthly update of the Early Warning Signals for Emerging Market currencies Since the last update there has been only one downgrade and one upgrade. Only BRL, INR and UAH are in the orange area Indicators and Transitions No. of signals triggered BRL ZAR MXN RUB TRY PLN IDR MYR THB ARS CZK HUF KRW RON CLP COP PHP ILS INR UAH ECO ECO ECO CDS ECO CDS ECO ECO ECO ECO ECO ECO,CDS ECO,CDS ECO,CDS. Please note that this information should be taken together with the explanations in the main EWS presentation, which presents the model and its limitations 7

Frontier Markets - mid June 4 EWS model has been developed to deal with Frontier Market Currencies. New features: Currency pegs Dependence of the economy on a commodity, i.e. oil EGP, NGN, GHS, AOA, KZT and gold GHS Impact of foreign currency reserves Explicit government targets, i.

18 Frontier Markets - mid June 4 EWS model has been developed to deal with Frontier Market Currencies. New features: Currency pegs Dependence of the economy on a commodity, i.e. oil EGP, NGN, GHS, AOA, KZT and gold GHS Impact of foreign currency reserves Explicit government targets, i.e. CPI and import cover Indicators and Transitions No. of signals triggered EGP NGN GHS AOA KES KZT CRC MUR BDT RES RES ECO ECO,RES ECO,RES ECO,RSI. Please note that this information should be taken together with the explanations in the main EWS Frontier Market currencies presentation, which presents the model and its limitations 8

19 Contents. Early Warning Signals. Most efficient hedging instrument 9

20 Optimal hedge for EM seller We compare 4 simple hedging strategies for a EM currency seller and show the strategy that performed the best historically in terms of hedge efficiency, including premium and bid-ask spreads, defined as: =. = Optimal m hedging product for EM seller, maximum period available Products 8% ZAR HIGH [CARRY x VOL.] m Forwards Historical Volatility 6% 4% % % ILS KRW CLP COP PLN MEDIUM [CARRY x VOL.] RUB MXN INR HUF IDR BRL TRY x m ATMF options (EM put) m OTMF options (5 delta EM put) m Risk Reversals (5 delta EM put) 8% 6% MYR THB CZK PHP LOW [CARRY x VOL.] RON 4% % % % % 4% 5% 6% 7% 8% 9% % Average m Annualised Carry (Interest Rate Differential) Optimal products generally follow a simple rule, with a few exceptions (PHP, INR, CLP, KRW, RON and COP): High product carry x vol. currencies OTMF options Medium product carry x vol. currencies ATMF options Low product carry x vol. currencies Risk Reversals. FX rate is expressed as EM vs. one unit of hard currency. We assume buying EUR vs. TRY,PLN,CZK,HUF and RON and buying USD for other currencies. We observe realised rates monthly. Start varies from Aug-99 for USDBRL to Jan-7 for EURRON, depending on the availability of historical data, end is April 4. See Appendix for details

21 Optimal hedge for EM buyer We compare 4 simple hedging strategies for a EM currency buyer and show the strategy that performed the best historically in terms of hedge efficiency, including premium and bid-ask spreads, defined as: = = Optimal m hedging product for EM seller, maximum period available % Products m Forwards 8% ZAR m ATMF options (EM call) Historical Volatility 6% 4% % % ILS KRW CLP PLN COP RUB MXN HUF IDR BRL TRY x m OTMF options (5 delta EM call) m Risk Reversals (5 delta EM call) 8% 6% CZK THB PHP RON 4% % % % % 4% 5% 6% 7% 8% 9% % Average m Annualised Carry (Interest Rate Differential) Risk Reversal is the best product for most currencies. FX rate is expressed as EM vs. one unit of hard currency. This definition is valid as long as realised carry is positive. We use another definition if realised carry is negative. See Appendix for details. We observe realised rates monthly. Start varies from Aug-99 for USDBRL to Jan-7 for EURRON, depending on the availability of historical data, end is April 4. See Appendix for details

22 Appendix: Early warning signals methodology Three indicators to anticipate a crisis in Emerging Markets The methodology employs three signals: Normality of CDS ( CDS ): Start looking for devaluation when the probability distribution of the CDS is highly non-normal. Relative Strength Indicator ( RSI ): Signal is on only if the local markets (Equity, FX and CDS) are rapidly weakening within the next three months Econometric signal ( ECO ): has to be bigger or equal to a given Threshold. Here we set this Threshold to be.75, but it can be changed depending on how much weight you want to put on the econometric data Focus on the Econometric signal: Based on the study of Kaminsky 4 on the Asian and Latin America crises in the 8s and 9s which aims to identify signs of economic distress with economic indicators Kaminsky compares each indicator to its historical distribution. For example, if the annual growth in the Real Effective Exchange Rate (in units of CCYUSD) is low compared to its historical distribution, the currency is depreciating strongly, and a signal is given We implement Kaminsky s method using a selection of indicators (see table). The criterion for choosing these indicators was their predictive power within a months window before the crises. Stronger signals get more weight. Each signal has values between and and, since the weights add to %, so does the weighted signal. If the weighted signal is above the threshold, the signal is on Econometric indicators Indicator Weight Risk Indicator Equity Prices (Y/Y growth) 5% Low Real Effective Exchange Rate (Y/Y growth) 8% Low Current Account Balance (% of GDP) % Low M/ Reserves (Y/Y growth) % High Short term Capital inflows (% of GDP) 8% High Exports (Y/Y growth) 7% Low Industrial Production (Y/Y growth) 7% Low. If CDS is unavailable, we use the Asset swap spread for long dated (>5yrs) bonds denominated in USD. This ignores the basis that is included in the Asset swap spread. We define this as Kolmogorov test of daily returns over days less than 5% (see main presentation). Defined as Relative Strength Indicator over days less than 45% for Equity Index and larger than 55% for FX spot and CDS. RSI = % * sum(positive returns)/[sum(positive returns) sum(negative returns)] 4. G. Kaminsky, Currency and Banking Crises: The Early Warnings of Distress, IMF working paper, Dec. 999

23 Appendix: USDRUB Example RUB seller We maximise the following ratio: = = Performance Best Second Third Worst Hedge Efficiency - USDRUB Average Exchange Rate Realised Carry (A) Historical Volatility Vol. Reduction (B) Hedge Efficiency (B) / (A) ) Spot % - - ) Forwards 9..6%.6% -.% -5. ) ATMF Options 8.88.%.% 6.4%.6 ATMF Options most efficient strategy ) OTMF Options 8.87.%.% 8.4%. 4) Risk Reversals 9..5%.% 8.% 4.8 OTMF Options cheapest strategy ATMF Options most risk reducing strategy For USDRUB, the hedge efficiency ratio is maximised for ATMF Options

24 Appendix: USDRUB Example RUB buyer Performance Best Second Third Worst Hedge Efficiency - USDRUB Average Exchange Rate Realised Carry (A) Historical Volatility Vol. Reduction (B) Hedge Efficiency (A) * (B) * ^4 ) Spot 9..% - ) Forwards 9.9.6%.% -.% -. ) ATMF Options 9.7.5%.% -.% -. ) OTMF Options 9.8.%.%.%. 4) Risk Reversals 9.9.%.% 8.6%. Risk Reversals most efficient strategy Forwards cheapest strategy Risk Reversals most risk reducing strategy For USDRUB, the hedge efficiency is maximised for Risk Reversals 4

25 Appendix Data availability We show below the availability of the data necessary for the back-testing (i.e. forward rates and implied volatilities). We start the back-testing when all data are available and finish it the st of April 4 Availability forwards Availability implied volatilities First date for back-testing USDBRL Aug-99 Jan-99 Aug-99 USDZAR Jun-97 Jul- Jul- USDMXN Apr- Jan- Apr- EURPLN Jan-99 Apr- Apr- EURTRY Jan-99 Dec-4 Dec-4 USDRUB Aug- Jun-4 Jun-4 USDIDR Feb-98 Mar-5 Mar-5 USDMYR Apr-5 Jan-6 Jan-6 USDTHB Mar-97 Jan- Jan- EURCZK Jan-99 Jan- Jan- EURHUF Mar-99 Jan- Jan- USDKRW Feb- Feb- Feb- EURRON Mar-6 Jan-7 Jan-7 USDCLP Jul-98 Jan- Jan- USDCOP Feb-99 Oct-6 Oct-6 USDPHP Apr-98 May-4 May-4 USDILS Nov- May-6 May-6 USDINR Apr-98 Jan-4 Jan-4 5

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EM FX Doing the rounds Nordea Research, 14 February 2014

EM FX Doing the rounds Nordea Research, 14 February 2014 M FX Doing the rounds Nordea Research, 14 February 2014 Deanie Marie Haugaard Jensen Global Research +45 3333 3260 @deaniemhj Deanie.haugaard@nordea.com Near-term relief amid a stream of positive news