We’ve talked about what affects mark-to-market: 1. Interest rate changes, 2. Exchange rate movements, 3. Time decay. And yes, we assume you hold these forwards until maturity.

So, what’s the step-by-step model?

First, we ignore interest rate changes and time decay because we’re holding till maturity. At maturity, the value depends on the current spot rate vs. the agreed forward rate. Interest rates and time decay don’t matter then!

Second, we separate the cost of hedging from exchange rate movements affecting the forward’s value (mark-to-market). The borrower pays the forward cost, so they need to reserve cash for it. Instead of keeping cash in reserve, why not finance that cost and increase the collateral borrowing base? I find amortizing the hedging cost to be the fairest way.

Let's go back to our scenario:

• 200m MXN capital call
• Spot @ 20
• Forward @ 21
• Term: 6 months

A borrowing base of 200m MXN gets $10M USD. We assume the spot trade of 200m MXN has the same spot rate as the forward. We won’t cover execution risks in this post.

Remember to follow the excel here: https://shorturl.at/KYmzr

There are 3 parts to embed the mark to markets of forward contracts into the Borrowing Base:

1. BB in Pesos:
• Start with your usual calculation in pesos with advance rates.

2. Hedging Cost:
• Amortize the hedging cost. The borrower increases the collateral base by the needed amount. You can leave the cost till the end (risky) or charge it upfront (costly for the borrower). But this depends on the scenario at hand.

3. Fake Mark-to-Market:
• Approximate mark-to-market based on exchange rate movements. If the spot rate is 22, take the difference between 22 and 20. This means a loss in liability but a gain in the forward.

Math:

{BB in Pesos} - {Accrued Hedging Cost in Pesos} + {Fake Mark-to-Market in Pesos}.

Divide this by the spot rate of the day to net out exchange rate movements on both liabilities and assets.

That’s why this series is called “ALM.” If you’re confused, just think: Balance both sides and include everything

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Btw.. all of this should change in the near future!
And ofc our Vaas Core automatically calculates this en un Suanfonson 🌬️🌪️🌩️⚡

Qué es un Suanfunson? https://shorturl.at/ZeNfl
Disfrútenlo <3

This decision impacts how you treat your forwards.

Reasons for Using:

USD

• You always know the borrowing base value in dollars.
• Easier to manage, especially with Colombian pesos, Mexican pesos, and all other kinds

MXN:

• Simpler to maintain the amount of pesos the borrower received, making it easier to compare apples to apples.

Reasons for Not:

USD:

• If you calculate the borrowing base in dollars at the spot rate of the day, you must include the forwards mark-to-market to balance any gain or loss.

MXN:

• The lender either heavily relies on the borrower hedging correctly or takes the hedging position, which can reduce returns depending on your capital structure.

Why is it not straightforward to have a USD borrowing base with embedded forwards?

Imagine struggling to access a bank’s API for your cash balance. Now imagine asking your hedging provider for daily mark-to-market updates. If any bank can provide this, let’s talk. But since we don’t have that luxury, let’s continue.

Given the limited market for daily mark-to-markets, how have I approached this? Thanks to Juan Sebastian Carvajal, CFA and Paolo Carreno Toro, CFA, we developed a model a couple of years ago.

200m MXN capital call
spot @ 20
forward @21
term: 6 months

How do you embed the mark to market of this forward? Let's first discuss what would affect it..

1. Interest Rate Changes:

• Fluctuations in the interest rates of the involved currencies. For example, if the US cuts interest rates and Mexico doesn’t, the value of the contract increases. Imagine buying World Cup final tickets at a fixed price today. If Argentina is likely to make the final, ticket value skyrockets due to demand. Similarly, if US rates decrease while Mexican rates remain, your USD/MXN forward contract value increases.

2. Exchange Rate Movements:

• If the spot rate of USD/MXN moves from 20 to 22, there is a gain in the forward, and the hedging provider would pay you if you traded that day.

3. Time Decay:

• Greek letters like gamma and delta can be confusing. Simply put, imagine it’s minute 89 of the World Cup, and the score is 1-0. The team leading is likely to win with little time left. Similarly, as the contract nears expiration, there’s less time for significant market changes, so the contract’s value is less likely to change drastically.

How to Embed Forwards Without Daily Mark-to-Market? I'll cover it in the next and final post, but:

This model assumes trading forwards to cover FX exposure, not for speculation. This means that you will trade it on a day that you know you will either repay your loan (regardless if the reason is amortization or prepayment) or roll the forward.

Also, if you got this far. I asked gpt “if you were to disagree with 2 things, where would you highly disagree”:

Response:

Read the Google Doc

In our last post, we explored converting the MXN collateral borrowing base into dollars. Remember, ALM means moving assets and liabilities in the same cadence. If you only adjust for the spot rate, what happens with the hedge?

Let’s first learn the basics of the cost of forward contracts. While it seems complicated, once you understand Interest Rate Parity (IRP), you’re all set.

Imagine investing at the US Fed funds rate of 5% interest or Mexico’s TIIE at 10%. It sounds great to invest in a Mexican bond, except for the fact that exchange rates can change. IRP ensures no risk-free profits by setting forward rates to reflect interest differences.

What is a forward rate?It is a price you agree to today for exchanging money in the future between two different currencies.

In simple terms:
A forward rate is like agreeing today on the price you’ll pay for a Vaas subscription next year, even if the features and value of the service change over time. (And no, we don’t sell forwards subs on Vaas 😂)

Example:

• U.S. interest rate: 5%
• Mexico interest rate: 10%
• Spot rate: 1 USD = 20 MXN
• Forward rate: 1 USD = 21 MXN

Without IRP:

• Convert 1,000 USD to 20,000 MXN.
• Invest at 10%, get 22,000 MXN in a year.
• If the exchange rate stayed the same (1 USD = 20 MXN), you would convert 22,000 MXN back to 1,100 USD, making a profit of 100 USD without any risk.

With IRP:

• Convert 1,000 USD to 20,000 MXN.
• Invest at 10%, get 22,000 MXN.
• But with the forward rate (1 USD = 21 MXN), you can only convert your 22,000 MXN back to about 1,048 USD. No free lunch here!

IRP adjusts the forward rate, ensuring you get the same returns, no matter where you invest.

How does IRP affect forward costs?
It balances the scales. The forward rate accounts for interest rate differences, neutralizing extra gains. Understanding IRP helps you grasp why forward rates are set this way and how they impact FX hedging costs.

What does this mean?

If the interest rates are currently:

• United States: 5.25%
• Mexico: 11.25%
• Colombia: 13.25%
• Argentina: 68.81%
• Brazil: 13.75%

Interest Rate Differentials (IRD):

• US vs. Mexico: Approximately 5.75% :: (11.25% - 5.50%)
• US vs. Colombia: Approximately 7.75% :: (13.25% - 5.50%)
• US vs. Argentina: Approximately 63.31% :: (68.81% - 5.50%)
• US vs. Brazil: Approximately 8.25% :: (13.75% - 5.50%)

While the IRD is not the only factor that accounts for the cost of the hedge, generally speaking, 80-90% of the cost comes from the IRD. The rest comes from market volatility, credit risk, liquidity premium, and transaction costs—factors that people don’t always consider today due to the lack of options in the market to receive lines of credit to operate forwards.

Hopefully, this explains why the cost of the hedge is different between countries.

Let's first discuss the three most common methods I've seen for calculating borrowing bases, and the issues with each.

Scenario: Imagine you have a 200 million MXN collateral borrowing base. How do you measure the borrowing base on a daily basis given two different capital calls that have different spot rates and forward rates?

Method: Static FX Rate

One not-so-common approach, but I've seen it used, is to use a static FX rate, like the average rate over the last 5 years.

•⁠ ⁠Pros: It is the easiest method. You divide the collateral borrowing base by the same FX rate, similar to a simple mathematical calculation for a street purchase. You don't really care if you are 20-30% off.

•⁠ ⁠Cons: If you are a borrower and the peso appreciated, like it did in the last 2 years, you should be getting more dollars per peso of collateral borrowing base. Recently, I saw one borrower leaving $2 million USD on the table because of this method

Method 2: Weighted Average of Spot Rates

A more common method is using the weighted average of the spot rate of all capital calls.

•⁠ ⁠Pros: This approach tries to be more reflective of the actual rates at which capital was called, assuming the FX rates remain constant over time and the cost of the forward is zero (ofc, is never true).

•⁠ ⁠Weighted Average Calculation: (Sum of all MXN at respective spot rates) / Total USD Invested

•⁠ ⁠Cons: While it might initially seem more accurate, it doesn't accurately reflect the amount of collateral needed to pay the dollars forward. While the lender will be receiving $10 million USD, the borrower will be paying more than 200 million MXN due to the cost of the hedge.

Method: Weighted Average of Forward Prices Lastly, some use the weighted average of all forward prices.

•⁠ ⁠Pros: This method incorporates the forward rates. It is the most conservative approach assuming you will he holding it to maturity and will be paying all the forward points.

Forward Price Calculation: (Sum of all MXN at respective forward rates) / Total USD invested

•⁠ ⁠Cons: It does not reflect the true value of the collateral given that you're assuming you have already paid all the forward points embedded within the derivative from day one. As a result, you (the borrower) may need to start putting more collateral from the beginning because you will be needing more pesos (as implied by the forward rate). Without additional collateral, you could easily end up in a borrowing base deficiency.

Adjusted for Fluctuations: A Dynamic Approach Instead of relying on static FX rates, what if we calculate the borrowing base using the spot rate of the day? What would be missing from this approach?

In the next post, we will discuss:

What is a forward, the costs associated with them, and different methods on how to include them in the borrowing bases?

I vividly remember a call with someone I deeply respect and admire. She advised me to rest, as if studying those extra three hours wouldn’t make a difference. But for me, it was my favorite chapter—understanding how interest rates impact a bank’s balance sheet was fascinating.

Although I never saw myself working at a bank (perhaps because I thought they wouldn’t hire me), the principles of ALM were crucial for understanding the fintech landscape I was diving into.

Today, I want to shift our focus to why ALM is vital in the context of FX and its impact on borrowing bases, a topic that many debt funds are increasingly recognizing due to recent FX fluctuations. Proper ALM in off-balance sheet structures ensures that assets and liabilities are balanced, mitigating risks associated with currency movements.

Consider this scenario: A fund invests $10 million and receives MXN 200 million in assets as collateral. How should one hedge this? Should you base your strategy on interest rate differentials? Or perhaps, should you consider the potential volatility in FX rates and their impact on returns?

This is where the foundation of ALM becomes invaluable.

Over the next few days, I’ll be posting a five-part series on LinkedIn, diving into the nuances of ALM within the context of FX and BBs. We’ll explore practical strategies and the underlying theories that can help navigate this complex yet essential aspect of financial management.

Stay tuned and hopefully you find it useful and not boring <3