Better hedging tools for Chinese corporates – FX Options and swaps to be traded onshore

China's FX markets have been growing since the world's second largest economy has been exposed to FX risk with a

China’s FX markets have been growing  since the world’s second largest economy has been exposed to FX risk with a massive rise in global exports in the last 20 years. The renminbi has been controlled by the central bank and had very little fluctuation. The Peoples Bank of China made minor changes in 2005 when it allowed the Chinese Yuan to float against the US dollar within a certain range.

China’s currency regulator has sanctioned the trading of cross currency swaps and fx options by corporates. This is a grand move for corporates who are exposed to currency risk and had limited products to hedge their exposure.

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A cross-currency swap is an interest rate swap in which the counterparties of the transaction exchange their cash flows in different currencies. Upon initiation of a cross-currency swap, the counterparties make an initial exchange of notional principals in the two currencies.

During the life of the swap, each party pays interest to the other. And at the maturity of the swap, the parties make a final exchange of the initial principle amounts, reversing the initial exchange at the same spot rate. US dollar/renminbi, yen/renminbi, euro/renminbi and sterling/renminbi CCS have traded onshore in China to-date.

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Previously, corporates wanting to hedge currency risks could only do so through offshore non-deliverable forwards (NDF) markets. These short-term, cash-settled currency forwards take place between them where the profit or loss is adjusted between the two counterparties based on the difference between the contracted NDF rate and the spot forex rate on an agreed notional amount, on the agreed settlement date. NDFs are typically traded in US dollars.

This has been a massive boost for overall liquidity in China’s as the notional value of contracts traded with corporate counterparts reached $10 million–20 million per contract and daily transaction turnover exceeded $50 million, compared with an average $20 million per week in interbank market at the start of 2011.

The RMB is still non convertible and has limited use outside of China, although trade in Hong Kong has increased from $181 billion in 2010 to $237.6 billion in 2011.

China’s State Administration of Foreign Exchange (SAFE) is the national regulator and policy maker on FX products, SAFE is keen to develop products including derivatives to ensure China’s monetary policy is in line with economic expectations.

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