2022 Perspectives for the Public Sector

28 SDR hedging solutions and caveats The types of instruments available to hedge SDR exposures are similar to those available for any currency pair, ranging from forwards and swaps to various option structures such as collars, call/ puts and spread options. There are nevertheless certain considerations — specific to SDR — that are important to consider when hedging risk. 1. The Non-Delivery (“Synthetic”) Nature of SDR Whether used in a loan, grant, hedging contract or as a reserve, SDR is not deliverable (e.g. in the form of its five constituent currencies). When the proceeds of an SDR-denominated support or a derivative arrive at the borrower/grantee’s bank account, it is in one of its constituent currencies, usually USD. However, it is important to recognize that the borrower/grantee’s economic risk is to SDR, rather than to the settlement currency. 2. Fluctuation in SDR Composition Every five years the SDR basket is reviewed to reflect the relative importance of its constituent currencies in world trade and economy. This process is complex and focuses on a multitude of criteria, making it difficult to predict any alterations. The good news is that actual modifications seldom occur — the SDR basket has been modified only twice in the last 40 years. There is notwithstanding the risk that there may be a mark-to-market impact resulting from having to reduce the weight of a constituent currency during the term of the hedge. 3. Implications of the SDR Low Carry Cost (Interest Rate) As the SDR constituent currencies are low-yielding, the SDR “carry cost” is low — currently hovering around 0.80% in 5-year term — compared to a typical emerging markets currency. As a result, hedging an upcoming SDR grant (or an SDR reserve conversion), effectively buying local currency and selling SDR should not be a difficult dilemma — as the client is receiving through the hedge the higher yield of the local currency and paying the lower yield of the SDR. Risk Management Strategies for Special Drawing Rights (SDRs) Solutions for hedging an SDR loan vs illiquid and/or high-carry local currency Partial Approach: Coupon-Only Hedge of SDR Loan to Local Currency Proxy Approach: Conversion of SDR loan to a More Liquid, Correlated Currency Diversification Approach: Conversion of SDR Loan to another Hard Currency 1 Basket/Efficient Frontier Approach: Conversion of SDR loan to a Correlated, Liquid and Lower-Yielding Currency Basket 4 MEX$ 3 MEX$ 2 The Cascade Approach for hedging an SDR loan