Risk and return

While we are on the subject of asset returns, we must introduce two other measures into the BRL analysis. Both have short histories, but both also provide tantalizing clues about emerging market currencies.

The first is a measure of the insured returns on Brazilian government debt. We can calculate this on a three-year horizon by calculating the raw spread between Brazilian treasury notes and U.S. treasury notes and subtracting the cost of a three-year credit default swap (CDS). A CDS acts like a put option on a bond; a CDS buyer surrenders basis points of yield to a CDS writer in exchange for a promise to deliver the underlying bond at par in the event of a default or other stipulated credit event, such as a material downgrade. The riskier the bond, the greater the insurance cost.

It shows that since mid-2005 there has been a distinct relationship between the BRL and the insured yield spread. As Brazilian bond yields fall and the insured yield spread falls apace, the BRL is seen as a less risky asset and rises in value.

Once again, the simplistic approach of greater yield leading to a stronger currency fails, but not completely. By August 2006, the BRL decoupled from the insured yield spread as improvements in credit quality alone were insufficient to strengthen the currency. We should expect the opposite to occur if and when the BRL weakens: Both the nominal yield on Brazilian debt and CDS costs on that debt should rise.

The second measure is volatility on BRL options. Just as CDS costs rise when government debt becomes riskier, option volatility should rise when demand for insuring a currency downturn rises. This appears to be the case, and the asymmetry noted for CDS costs applies here in a similar manner. Lower volatility alone cannot drive the currency higher, but a weaker currency can drive volatility higher.