Appropriate hedging for SDR-denominated CD's

Abstract

JEFF MADURA Florida State University Special Drawing Rights (SDR's) were initially created to serve as a reserve asset for central banks. The nature of their multi-currency composition encourages their application to bond denomination in order to reduce exchange rate risk. Since 1974, eight internationally placed bonds have been denominated in SDR's valued at about SDR 263 million in aggregate. Also SDR-denominated certificates of deposit (CD's) have been issued in the U.S., Great Britain, and Japan. The recent revised formula defines the SDR in terms of five currencies (compared to 16 currencies before the revision) which promises to encourage further use of the simplified composite as a unit of account. As its role expands, traders within the international capital markets should be aware of its weighting structure. The SDR is defined by summing the products of the component currency exchange rates and their respective allotted "units." These "units" were determined by the International Monetary Fund to achieve the initially desired weights for each currency in comprising the SDR value. Although the "units" are held constant over time, the exchange rates of the currencies comprising the SDR fluctuate, forcing the weights to change. The weight computation will be described shortly. Table 1 compares the initial weights of the simplified SDR on its commencement (January 2, 1981) to the weights six months later (June 2, 1981). Notice that the dollar's weight has increased at the expense of the other currencies, a result of the dollar's strength in the first half of 1981. tant implications for hedging. Consider a onemonth CD issued by U.S. bank to a firm in Japan on June 2, 1981, which has a par value equivalent to $1,000,000. The issuing bank could have hedged by purchasing the SDR currencies forward in the correct proportions. If it recognized the actual weights at the time of issuance, it would have enacted a risk-free hedge. However, if it presumed that the weights initially installed into the SDR at its commencement were still intact, it would have attained an overhedged position for all the currencies other than the dollar. The hedged excess amounts to the equivalent of $40,600. At this time, several points are noteworthy. As time progresses, the weights may diverge further from their initial level causing greater hedging mistakes. The size of the hedging error in the example provided is not affected by the maturity of the CD. Yet, the costs of using the forward market as well as the markets limitations should be realized. Transaction costs in the forward market were not considered since the analysis would derive the same implications. The scenario described is intended not to deter use of the SDR as a unit of account, but to suggest the correct hedging approach for SDR-denominated CD's. This requires the precise weight computations for the currencies at the time a CD was issued. The weight for a component currency at any given moment can be found by first multiplying its exchange rate by its allotted "units." This product represents a percentage of the SDR value which serves as the actual weight measure. Recognition of the weight changes has imporTABLE 1