Facilitating Foreign Exchange Risk Management for Bond Investments in ASEAN+3

Bond investors typically have a long position in local currency bond markets. To manage their foreign exchange risk, they may want to hedge that exposure for a period of time. They also want to be sure they can easily convert the local currency to dollars upon the sale of a bond.

Hedging instruments

The hedging instrument most commonly used by bond investors is the foreign exchange forward rather than the cross-currency swap. Foreign exchange forward markets are generally more liquid and flexible, can be easily rolled over, and suit investors’ need to hedge the value of a portfolio rather than a series of bond cash flows. Swaps are used by investors to take a position rather than to hedge, and by issuers to hedge their debt servicing obligations. Foreign exchange options are used sparingly.

Recommendations

While investors can generally manage their foreign exchange risk offshore today, this report attempts to identify the major issues they face in hedging foreign exchange risk onshore, and makes a number of recommendations toward making onshore markets more accessible and more integrated with offshore markets. The proposed measures also aim to widen the overseas investor base given that the best route to market stability is to have the widest and most diversified investor base. These include:

• Consider measures that would make it easier for foreign investors to transact in the foreign exchange and foreign exchange hedging markets, as well as the real demand principle regulations associated with capital controls;
• Improve liquidity of onshore foreign exchange derivatives markets to facilitate their integration with offshore foreign exchange markets; and
• Improve cross-border access to local currency government bond markets and hence their liquidity, which reinforces the development of onshore foreign exchange markets.

About this publication

While the scope of this study is the Association of Southeast Asian Nations (ASEAN) and the People’s Republic of China, Japan, and the Republic of Korea, collectively known as ASEAN+3, it focuses on five economies in particular: the Republic of Korea, Indonesia, Malaysia, the Philippines, and Thailand, which are collectively referred to as the KIMPT economies. The other ASEAN+3 economies either have very liquid foreign exchange markets (Hong Kong, China; Japan; and Singapore) or have markets that are still embryonic (Brunei Darussalam, Cambodia, the Lao People’s Democratic Republic, Myanmar, and Viet Nam). The People’s Republic of China warrants a special study of its own and is beyond the scope of this study.

ADB has been working closely with the ASEAN+3 to foster the development of local currency bond markets and facilitate regional bond market integration under the Asian Bond Markets Initiative (ABMI). This was launched in 2002 to strengthen the resilience of the region’s financial system by developing local currency bond markets as an alternative source to foreign currency denominated short-term bank loans for long-term investment.

This study was undertaken under ABMI and funded by the Government of Japan.