Firms are marketing innovative currency and rate swaps to emerging market sovereign debt issuers, in which the swap knocks out if the sovereign defaults. Countries such as Mexico, South Africa and Russia are reported to be entering into these so-called knockout swaps, with notionals of anywhere between USD100,000 and USD1 billion, to hedge interest rate and currency risk on bond issues.
Market players attributed the rise in emerging market vanishing swaps to an increase in liquidity of the underlying bonds and subsequent decrease in the cost of the deal. "It's cheaper for banks to do the vanishing swaps across the whole term of the transaction and do it in the size they want to," said one trader.
Officials also said firms are happy to trade the currency and interest rate exposure of emerging markets in this structure because of the high default risk on the countries' underlying bonds. "Counterparties don't have to unwind the asset class trade so they see it as a saving," noted one player. Firms also add a credit adjustment charge and run a higher running coupon for the transaction.
But these swaps have knock-on effects in the credit derivative market, say dealers. The combination of rates and fx with default risk means dealers are bundling into the sovereign credit-default swap market to hedge the deals and in such volumes traders have noted jumps in CDS prices. "When done in large enough sizes the effect will seep through to the secondary market," one trader noted. Another trader said firms will typically hedge USD100 million of a USD0.5 billion swap and this is large enough to move the CDS price. He declined to say by how much.
Firms reported to be pitching the deals include ABN AMRO, Goldman Sachs and Morgan Stanley. Trading and sales officials at ABN and Goldman declined comment. Carlos Melville, spokesman for Morgan Stanley in London, did not return calls by press time.
