Onshore–Offshore KRW Basis and Hedge Selection
A London-based emerging-markets fund holds a KRW 40bn receivable from a Korean exporter, due in 45 days. The fund has no onshore Seoul account and cannot post KRW collateral. It sees USD/KRW onshore spot at 1,342.50/1,343.00, a one-month onshore deliverable forward at 1,345.80/1,346.40, and a one-month non-deliverable forward at 1,348.20/1,348.90. The fund reports in USD and has a USD 25m credit line; collateral may be cash or US Treasuries. Korean regulators have recently tightened local banks' forward-position limits, and the won has traded between 1,330 and 1,355 for six weeks. The risk committee asks whether the roughly 2.4 won gap between the NDF and the onshore forward is a riskless arbitrage, and whether the NDF will settle against the same rate the exporter will use. The fund must decide within two days, before its hedge authority expires.
1. Explain what drives the gap between the onshore forward and the NDF, and why an offshore fund cannot treat it as a riskless arbitrage.
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The gap is an onshore–offshore basis, not a free lunch. The onshore deliverable forward is priced in Seoul off KRW/USD interest rates and local bank balance-sheet capacity, and it requires KRW deliverability and onshore documentation. The NDF is cash-settled in USD against an official Seoul fixing, so it embeds (i) the market's expected fixing path, (ii) the cost of hedging offshore without KRW funding, (iii) compensation for regulatory and convertibility risk, and (iv) the balance-sheet cost of the NDF provider. When regulators tighten banks' forward-position limits, onshore forward supply shrinks and the onshore/offshore gap can widen.
Arbitrage requires the ability to transact both legs and deliver KRW; the fund cannot. Even an onshore bank that can arbitrage faces position limits, capital charges, collateral costs, and fixing risk. The NDF fixes to the official Seoul rate, which may differ from the rate the exporter will use for conversion, so there is basis risk between the hedge and the exposure. The gap can therefore persist and widen, and it is compensation for segmentation and risk rather than a riskless profit.
2. Recommend how the fund should hedge the KRW 40bn receivable and identify the residual risks it must report to the risk committee.
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Use a 45-day USD/KRW NDF for the KRW 40bn exposure, sized to the receivable and matched to the fixing date, because the fund has no onshore access and cannot deliver KRW. Execute with two approved counterparties to reduce quote risk, and confirm the fixing source and fallback in the ISDA schedule. Do not use a deliverable onshore forward unless the fund can establish an onshore account and settle KRW, because that creates settlement risk the fund cannot manage.
Residual risks to report: fixing basis (the official fixing versus the exporter's conversion rate); rollover risk if the receivable is delayed; liquidity and wide NDF spreads in stress; counterparty credit and collateral calls under the CSA; and KRW convertibility risk. The fund should also stress the hedge cost at 30–50 pips wider and confirm that the USD 25m credit line covers initial margin plus a stressed variation-margin call. A common error is to chase the 2.4 won onshore/NDF gap without the ability to settle the onshore leg.