Emerging Markets and Hedge Execution: A USD/MXN case study

CalendarMarch 15, 2024

Emerging Markets and Hedge Execution:

A USD/MXN case study

Earlier we described structural changes in the global economy that are reshaping the considerations for US businesses involved in shifting supply chains from factories in China to factories in Mexico. While this shift can complicate the lives of finance executives who now must consider the implications of direct FX risk exposure on their P&L and setting up new banking relationships in Mexico, there can also be material benefits from operating in Latin American currencies that are often underrated.

In this piece we will outline some situations where financial professionals can potentially benefit from using FX derivatives. Prudent use of these products can help businesses secure and enhance financial performance relative to budget, while also help reduce risks that may arise as supply chains shift closer to home.

Higher Interest Rates, Higher Volatility & Higher Opportunities

In our earlier piece, we discussed macro factors driving the shift in manufacturing production to Mexico from China, and associated challenges for FP&A and treasury planning. Specifically, due to the full convertibility of the Mexican peso, direct FX exposures on financial statements, and the higher relative volatility of the Mexican peso (MXN) versus the Chinese yuan (CNY), these factors tend to shape prudent planning and execution of FX transactions.

Source: Bloomberg

Chart: Corpay Cross-Border

Beyond full convertibility and the likelihood of Mexico-based vendors to request payment in local currency, there are other important considerations to be weighed when operating in Mexico.

For example, the full convertibility of MXN currency, relative ease in cash management, pooling and repatriation comes with some potential downsides. Namely, the Mexican peso, like most Latin American currencies, is quite a bit more volatile than the Chinese yuan. The latter is subject to capital controls and significant intervention by the People’s Bank of China with the objective of managing its stability. Those same interventions don’t take place with the peso. Instead, Banxico (Mexico’s Central Bank) maintains interest rates that are markedly higher than those of the United States, the EU & Canada: higher rates which can present opportunities for firms carrying expenses or liabilities in the peso.

Unlocking value via hedging

Source: Bloomberg live Interbank market pricing for the date indicated above

The typical US, European, or Canadian multinational with operations in Mexico carries MXN expenses and liabilities on their financial statements. This is true of maquiladoras (‘free trade’ factories) and other businesses that utilize cheaper labour in Mexico to improve their profit-margins and competitive position.

Looking at the table of exchange rates above, we can see hedging Mexican peso FX risk can help on two fronts:

  1. Helps increase price certainty on the portion of expenses/liabilities hedged. This is important because the Mexican peso is historically one of the more volatile major currencies. Additionally, recent experience indicates that the Mexican peso can get materially stronger in a very short time. So your variances aren’t going to always end up going in a positive direction.

  2. There are potential pricing advantages to hedging FX against a budget rate. We can see in the chart above the impact of hedging $1MUSD worth of MXN six months out, versus taking one’s chances in the spot market.

The potential price advantage from hedging MXN-denominated expenses is often underrated in terms of the significant value this can add. Additionally, because the Mexican peso is relatively volatile for a ‘major’ currency, option-based hedges can price much better than what you would see for a less volatile major currency or in Chinese yuan non-deliverable hedges.

These sorts of phenomena can add value for treasury and FP&A teams that are able to identify and hedge appropriately. This is fairly low-hanging fruit, though in further pieces we will explore how dynamic hedgers can utilize tenors, structures, strike rates/deltas and volatility to help target specific outcomes and price advantages that can arise on the execution of FX hedges.

Opinions expressed in this article are those of the author. Please consider contacting an independent advisor of your choosing – an advisor completely independent of Corpay – to help you ensure that solutions discussed here are right for your business’ needs.

The hedging products described in this document can be useful but are also associated with significant added complexity; obtaining a thorough understanding of each such product's trade-offs/pros-and-cons (fully describing these is beyond the scope of this article) is important before choosing to use any of these products.

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Sean Coakley, CFA

Sean Coakley, CFA

Director, Strategic Sales, & Market Strategist

Sean works with mid-market corporates, focusing on FX risk management and international working capital optimization. He blends experience in finance and capital markets with a robust understanding of business performance and capital markets knowledge.