CNH: Hedging Currency Risk amid Heightened UncertaintiesCME: USD/Offshore RMB ( CME:CNH1! )
Even though the Chinese Yuan is not a component in the US Dollar Index, Dollar-Yuan exchange rate generally tracks the dollar index. If dollar gains in value, most foreign currencies depreciate against it, yuan included. When dollar is weakened, the opposite holds true. Foreign currencies appreciate relative to dollar.
However, this year the two trends diverged prominently. Dollar index was quoted 103.2 on Monday, down 0.8% year-to-date. Meanwhile, dollar/yuan rate moved up 5.2% to 7.26. A higher price quote means that yuan depreciated against the dollar.
In conventional thinking, yuan should have risen when dollar declined. The reversal of the trend could signal a major technical breakout down the road.
In the past ten years, the Yuan has been trading in the range of 6.0 and 7.3. looking back in early 2000s, the official exchange rate used to be set at a narrow band around 8.28.
Exchange Rate Key Driver: Interest Rate Parity
Let’s revisit a basic concept in economics. The interest rate parity (IRP) states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
In plain English: An investor has the options of investing in either dollar or yuan. With higher interest rates, dollar asset will produce a higher return. To make yuan more attractive, the investor would need to get more yuan per dollar. Therefore, yuan will depreciate. This is the logic behind the IRP. It is called the Law of One Price.
Since the Federal Reserve began hiking interest rates in March 2022, the Fed Funds rate has risen 525 basis points in the following 17 months. At the same time, the People’s Bank of China cut interest rates by 15 basis points, from 3.70% to 3.55%.
• The US-China interest rate spread has widened by 540 basis points.
• If the investor held dollar denominated asset, his return would be 7.65% higher than someone holding the same asset denominated in yuan (=5.40% x (17/12) years).
• Meanwhile, the exchange rate went from 6.39 to 7.26, a 12.0% Yuan depreciation.
In this example, the IRP explains 64% of the total variation of Dollar/Yuan exchange rate. It is remarkable that fundamental economic theory works so well in the real world.
Relative Stock Market Performance
Another key factor driving capital flows in and out of China is the performance of its stock market relative to that of the global market.
China’s stock market had a good start this year. The hope of economic recovery pushed the Shanghai Stock Exchange (SSE) index up by 9%. However, economic data deteriorated markedly in the second quarter, which helped erase most of the gain.
• As of Monday, the SSE produced a meager 1.8% return YTD.
• For a comparison, the S&P was up 15.8% while the Nasdaq gained 37.8% YTD.
Relative Strength in the Economy
While interest rate spread and stock market performance drive the exchange rate trend in the short- to medium-term, the long-term value of one country’s currency is determined by the strength of its economy.
The US economy has so far managed to avoid a hard landing:
• Solid job market (unemployment rate below 4%);
• Strong GDP growth (the economy expanded from Q1 to Q2);
• Inflation getting under control (headline CPI around 3%);
• A banking crisis is contained (only a handful of bank failures);
• The debt ceiling crisis is resolved (new bill suspected the debt ceiling until 2025).
This year, China’s economic engine appeared to have lost steam.
• GDP growth slowed dramatically after a brief spike in Q1;
• Export declined by double digits;
• A gigantic housing market crisis is brewing to the boiling point;
• Debt crisis with provincial and local governments, many are technically bankrupt;
• High unemployment rates (youth unemployment exceeding 20%);
• Deflation discourages business activities and put further pressure on the economy.
Could the second largest economy in the world weather all the headwinds? This heightened risk profile warrants the need to proactively deploy risk management strategies.
Hedging for Currency Exposure Amid Rising Risk Outlooks
US-China relations remains the top geopolitical risk amid heightened uncertainties. In recent years, the relations have hit the lowest point since President Richard Nixon visited China in 1972.
While China now accounts for a smaller share of the US international trade, in 2022, both U.S. exports to China and imports from China continued to grow, according to the Bank of International Settlement data.
• U.S. exports totaled $153.8bn, an increase of 1.6% ($2.4bn) from 2021;
• U.S. imports from China totaled $536.8bn, an increase of 6.3% ($31.8bn);
• And the trade deficit with China was $382.9bn, an increase of 8.3% of ($29.4bn).
U.S. importers, exporters, and US companies operating in China all face significant risks when the exchange rate is so volatile. Some of the cost may be in one currency, while the revenue is in another. Hedging net currency exposure is key to locking in profit.
Where is the Dollar/Yuan Exchange Rate Heading?
In the previous sections, I highlighted the key drivers in the US/China currency exchange rate: relative interest rates; relative stock market performance; relative economic strength; and the state of the US-China relations.
If things are moving unfavorably for China, I could see the yuan breaking out of the recent range and going above 7.50. There are a lot of moving parts affecting the outcome.
CME Offshore RMB (CNH) is a futures contract on the Dollar/Yuan exchange rate. It has a notional value of $100,000 and is quoted as the number of Yuan per $1.
In a hypothetical case, let’s imagine that a commercial firm expects to receive 10 million yuan in six months. Should the exchange rate go from 7.26 to 7.60, the expected receipt in dollar terms would decline from $1.38M to $1.31M, down $70K or -4.7%.
The firm could hedge this exposure by buying 14 CNH contracts. The aggregate notional value is $1.4 million, matching over 10 million yuan at current market price. When yuan depreciates, futures price would go up as each dollar is getting more yuan. Therefore, when the firm loses money in business operation due to yuan depreciation, currency futures hedging would compensate for the losses.
Holding 1 CNH contract requires $21100 in minimum margin. If the exchange rate moves by 1 tick, or $0.0001, the futures account would gain or lose 10 Yuan.
A smaller firm could consider Micro RMB futures (MNH). It is 1/10 of the standard size CNH contract with a $10K notional. Margin requirement is 1/10 of the original, at $2110.
Happy Trading!
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs www.tradingview.com
