Taming the Emerging Market Curve
October 31, 2014

Kalahari Limited develops analytical and price discovery software using FINCAD® Analytics and is a member of the FINCAD® Alliance Program (FAP). To download the latest trial version of FINCAD Analytics or more information about FAP, contact a FINCAD Representative.

In this article, Kalahari walks us through some of the challenges traders are facing in the emerging currency markets and examines some tried and tested pricing models.

Trading in Emerging Markets

Trading Emerging Market (EM) currencies is by nature challenging. As these currencies are indeed emerging, traders have to learn new markets, with new characteristics, often in instruments like NDFs (non-deliverable forwards) designed specifically to deal with those characteristics.

During the past decade some of these currencies, like the Mexican Peso, have become convertible and are widely traded in their time zone. Other currencies that were convertible, like the Malaysian Ringitt, are now blocked currencies and offshore trading has all but ceased.

The primary challenges that traders face includes lack of liquidity, lack of timely economic news, erratic data for most EM currencies and the potential for currency inconvertibility. There is also event risk which is the risk of specific country shocks and/or regional shocks impacting a traders positions directly, or via the domino effect.

At a recent foreign exchange conference in New York the headline speaker, the manager of a large money fund, concluded that: "excessive concentration in EM currencies is dangerous" and that rather than rely on economic data, his company's approach is to pay more attention to daily market prices because: "daily market prices have the advantage of being current and reflect the actions of market participants."

At Kalahari we agree with these comments; however, daily market prices themselves are not always timely or accurate and developing methodologies to tackle EM currencies, including pricing yield curves in those currencies, is a science unto itself.

Seeing demand for Mexican Peso TIIE in what was then a nascent market, the company responded by developing a calculator that uses data from the forward FX swap market, TIIEs, US Dollar IRS curves, and Mexican basis points. With three out of four of these components, the fourth can now be calculated effectively.

As simple as this process seems, and as anyone who has traded Emerging Markets will have discovered, nothing is ever simple in EM. As is often the case, the devil is in the detail.

Pricing Emerging Market Currencies Accurately

To illustrate this point consider that Mexican Peso domestic instruments are priced using a 28-day month. Therefore, TIIE swaps are calculated using thirteen months in a 364 day "year" for the fixed and floating legs. Moreover, the USD rate against which cross-currency swaps are settled depends on 1-Month LIBOR, which then has to be converted to a 28-day value.

Additionally, the calculations must also be adjusted for value date variations. Cetes and TIIEs trade on a plus one-day basis (T+1) in Mexico City, whereas spot Mexican Peso in the US trades on a (T+2) basis in New York, and, if the curve is being driven against a LIBOR-based dollar curve, the final calculation must also take into account London holidays. Finally, an adjustment for basis has to be included at the correct stage of the calculation, particularly if trading medium term interest rate or FX swaps.

Trying to model such unique characteristics using a spreadsheet is quite a challenge. One of the advantages of kACE™ (Kalahari Advanced Calculation Environment) is that it allows in-house design and implementation of calculation models through its modeling environment. This unique environment gives the user complete freedom to change the mathematical structures using its codeless framework. Models can be designed and saved as a calculation, and then uploaded into the system, allowing the trader to begin trading instantly.

Kalahari began tackling the challenges of pricing Emerging Market currencies a few years ago and tried to include as many of the same analytical capabilities that are offered in the major currencies as possible.

Using Kalahari's standard Money Market and Foreign Exchange model, (MM & FX) in kACE, traders are able to look at any of the included currencies in a variety of ways; translating forward points into equivalent yield curves, "forward/forward" FX swaps into FRAs, and adjust for differences in basis to more accurately reflect where the prices should be. The application also allows the user to construct curves "on-the-fly" from a variety of products, (e.g. deposits, LIBOR, IRS, OIS), depending upon availability and preference, and at splice points determined by the user. kACE also provides the facility to calculate curves using linear, exponential or cubic-spline methodology, allowing customizable forward curves to reflect a trader's individual mark-to-market methodology, and/or funding sources when arbitraging.

Kalahari recently developed a South African Rand (ZAR) pricing model that calculates IRSs, FX forward curves and basis, as well as a model for calculating Korean Won FRAs from NDFs. Both these currencies are now offered as part of Kalahari's Emerging Market suite within their MM & FX model.

Also included in the MM & FX model are Czech Koruna, Hungarian Forint and Polish Zloty, each with its own unique quirks, and the company plans to add Turkish Lira in the near future. In addition, Hong Kong Dollar, Singapore Dollar and, Thai Baht are included in the company's Asian deliverable suite and collectively provide the core EM currencies traded on a physical or deliverable basis.

In current development is a Brazilian Real (BRL) model, which, like the Mexican Peso, presents another challenge. BRL forwards are traded on a non-deliverable (NDF) outright basis. Pricing, however, is closely linked to the domestic market, with a particular emphasis on various local (BM&F) futures contracts. Like Mexican, the interest rate base is completely different, working from an actual/252 day year. The futures contracts and local debt markets used to develop the curve have alternately T+1 or T+2 settlement dates, and consequently the futures contracts trade for different value dates. When such characteristics as a T+2 settlement for spot (priced offshore), and a LIBOR input are added, similar challenges to those involved in creating a dynamic Mexican curve have to be resolved.

Following completion of the Brazilian Real project, Kalahari plans to develop and incorporate the primary traded NDF's into its MM & FX model, and will begin researching the rest of Latin America, (Argentina, Chile, Colombia and Peru) in order that kACE's leading-edge technologies can be applied to analyzing how NDFs are priced.

Trading Emerging Markets will continue to be a challenge. But Kalahari's philosophy is that if it is priced correctly, more than half the battle's won.

Kalahari is dedicated to providing a leading-edge Emerging Market suite; one that will incorporate deliverable and non-deliverable products covering Asia, Emerging Europe, and Latin America, and so meet the pricing requirements of a wide range of financial institutions as well as assist Emerging Market traders in their efforts to "tame the EM beast".


Your use of the information in this article is at your own risk. The information in this article is provided on an "as is" basis and without any representation, obligation, or warranty from FINCAD of any kind, whether express or implied. We hope that such information will assist you, but it should not be used or relied upon as a substitute for your own independent research.

For more information or a customized demonstration of the software, contact a FINCAD Representative.