A New Dimension to FX Dealing
by François Masquelier, Head of Corporate Finance and Treasury, RTL Group, and Honorary Chairman EACT
Banks are seriously contemplating credit-adjusting the prices they quote on FX derivative transactions. The credit parameter to be included in price quotes would have a significant impact on the cost of hedging, unless corporates use collaterals. It may turn out to be one of the consequences of the current financial crisis.
Is the price right?
In the future, treasurers will have to consider the potential extra margin to be included in forward FX transactions to reflect the credit risk faced by bank counterparties. As is the case in the famous game show created by Fremantle, the question to be asked is whether the price is right. Is the FX pricing fair, given the current market situation? For more than two years, some cautious financial institutions have already been quoting higher and longer maturity FX deals, to reflect the greater risk taken. However, one of the unexpected or unsuspected consequences of the current financial crisis is or could be a significant increase of FX pricing on longer periods. Dealers are beginning to think more seriously about credit-adjusting the prices quoted on FX derivatives in general (‘derivatives’ sensu lato, as defined in IAS 39).
The pressure on banks may force them to adjust pricing up on longer period FX transactions to include this credit risk element. It means that, leaving aside swap points and interest differentials, the longer a forward deal, the more expensive it will be (higher margins). This evolution we have noticed over the last few years seems to be crystallising now. The current inflation is rather surprising for many corporations although it was inevitable, especially after such a deep credit and faith crisis we are currently facing. The non-delivery risk is now a risk to consider carefully when dealing in FX. We all know in Europe that a bank default is no longer a merely theoretical issue. Banks will now try to incorporate the credit risk element in their quotes or look for alternative protection against it.
Cash collateral solution
The method of reducing the extra cost adjustment applied to FX transactions is to sign a cash settlement agreement to collateralise bilaterally amounts corresponding to changes in mark-to-market valuation of the portfolio of FX transactions made with the bank. The idea, as for margin calls, is to secure the potential (unrealised) loss on the revaluation of the portfolio of FX deals. If the portfolio has a negative change in fair value (lower value compared to the inception value), the customer would have to secure this amount with a cash collateral deposit. In the case of a positive change in fair value, the deposit in cash would be made by the bank. Both deposits are or can be remunerated at the EONIA rate, for example. It means that in case of default of the corporate counterparty, the bank would be compensated for the FX deal its customer will not deliver at maturity and it would be able to unwind the contract without any losses (given the cash collateralisation agreed). Conversely, the corporate would be compensated in case of default of the financial institution.