The start of the financial crisis marked an abrupt reversal in currency markets and the current volatility levels look to be here to stay. Treasurers are looking to re-evaluate their hedging strategies and in some cases are starting to revisit the types of structured product which fell out of fashion during the crisis. Meanwhile, the ways in which the largest multinationals hedge FX risk is increasingly diverging from the hedging strategies of smaller MNCs.
Treasury Today’s 2010 European Benchmarking Study in association with J.P. Morgan found that almost 40% of treasurers were most focused on FX risk – more than any other type of risk. This is unsurprising, given the increased volatility in the market since the financial crisis.
In the years leading up to 2007, FX volatility was both low and stable. “It remained stable throughout 2007, before some extreme fluctuations towards the end of 2008,” comments Seamus Desouza, Executive Director, J.P. Morgan Treasury Services Foreign Exchange. “While volatility has been much lower at times since the end of 2008, it hasn’t been stable. It’s relatively low for a period, then higher for a period before returning lower. The current intermittent levels of volatility appear to be the new norm. Much of this was to do with sovereign risk.”
This trend shows no signs of subsiding. Last year, Mansoor Mohi-uddin, Head of Global Currency Strategy at UBS, was quoted as saying that “the divergence between the strength in emerging markets and the unusual levels of uncertainty in the world’s major economies” will cause “super volatility” in 2011 – and in the coming years.
“Volatility has always been there,” argues Robert Wade, Managing Director, Capital Markets and Treasury Solutions, Deutsche Bank. “It may be greater now, but it hasn’t dramatically changed behaviour. The question to focus on is why volatility is higher – the underlying causes of this, such as potential defaults in the Eurozone, are more of a concern for corporate treasurers.”
Nevertheless, Stefano Diamantini, Co-Head of FX structuring for EMEA and North America at Morgan Stanley believes that increased volatility itself has had a significant impact on corporate hedging behaviour. “We see people that were not previously interested in FX as a hedging getting interested now because of currency movement in the market. I think that now people are much more concerned about currency risk in general.”
FX risk is a concern for any company with international operations and as corporations become more global, so their FX concerns multiply. In recent years this has meant treasurers are increasingly looking to manage emerging market currencies, which present their own challenges.
“In the past year, there has developed increasingly clear differentiation between how some emerging markets are behaving,” commented a banker who wished to remain anonymous. “Rates are going up in lots of countries, but in Turkey, for example, rates are being kept low. This is leading to a sort of non-correlation that the markets are not used to.”
Today many corporations recognise the necessity to separate their risk management practices between emerging market and G10 currencies. Based on this trend, CitiFX’s Corporate Solutions Group has recently launched two different risk models which allow companies to benchmark their current practices against a number of alternative risk management strategies.
In addition, Erik Johnson, Director, CitiFX Corporate Solutions Group, warns against categorising emerging markets into one single bucket of risk. “The Brazilian real, Russian rouble and Chinese renminbi all possess different risk profiles which, as a result, often leads to various hedging solutions.”
A risk management study carried out by Citi in 2010 found that 61% of respondents had revisited their risk management policy as a result of the financial crisis. One of the most common adjustments was to ‘hedge smaller amounts of exposures’.
“For many corporate treasurers an immediate response to the financial crisis of 2008 and 2009 was to simply reduce their hedging ratios and tenors,” comments Johnson. “On the surface this was quite understandable given an uncertain business climate. However, in retrospect, what many senior managers have now realised is that this approach actually added risk rather than reducing it. Today, many corporate treasurers are now turning to options to counter these and other forecasting concerns.”
“We protect smaller risks than we did three years ago,” comments Alfred Buder, European Treasurer, Flextronics. “It’s a question of learning that what is regarded as a small risk can hurt when volatility is unexpectedly high. On a month by month basis, there are often huge, unexpected volatilities for whatever reasons – political, economical. But while we are hedging larger volumes than in the past, the processes have got more efficient, so it’s no longer such a big effort – just a mouse click.”
In terms of risk management instruments, the Citi survey found that 17% of companies had changed their strategy to use more options than forwards. While forwards are the instruments most commonly used to hedge FX exposures, more than half of the respondents to the study used options, with zero-cost option combinations the most popular type of contract.
According to Johnson, paying option premiums remains a key barrier to many corporates looking to use this type of instrument. “Premiums can be a concern but when fronted with issues such as forecasting error, business volatility and even meeting earnings expectations, many senior managers have recognised that options need to be a part of their risk management tool kit. If applied and measured correctly, options can actually enhance a company’s bottom line.”
Nevertheless, many treasurers remain reluctant to stray beyond vanilla hedging instruments. “We use spot and forward trades and avoid anything with an option element,” commented a treasurer who wished to remain anonymous.
“We don’t like to pay an option premium and we need to ensure we achieve 100% effectiveness for hedge accounting.”
“If applied and measured correctly, options can actually enhance a company’s bottom line.”
Another anonymous treasury source observes that there are two business cases for using options. “The first is when cash flow is not certain. For example if there was a dispute underway and you knew you might have to pay CAN $10m in six months’ time, and the rates were good now, it might be a good idea to buy an option for the possible liability.
“The second scenario is when you expect a currency to move in a favourable direction and you see the potential do so and want to limit the risk – this would be a good reason for buying an option.”
While most treasuries focus on plain vanilla FX instruments, structured products are showing signs of making a small comeback. Such products were a casualty of the financial crisis: in the wake of the collapse of Lehman Brothers, some banks were forced to settle with clients who claimed the banks had been offering certain structured products without fully explaining the downside or providing the right sort of scenario analysis.
One particularly striking example related to hundreds of Korean companies which went to the courts in 2009 to sue banks which had sold them derivatives contracts known as Kiko (knock in, knock out). The products allowed the companies to sell dollars at a fixed rate, but only while the won stayed within a defined range. If the won moved out of the range, the companies were forced to sell dollars at an unfavourable rate. When the won unexpectedly fell 30% against the dollar in 2008, these companies found they were facing uncapped losses, which amounted to around $2.8 billion. In the majority of lawsuits, the courts found in favour of the banks. However, there were some exceptions: Hana Bank was ordered to pay Sampo Trading 340m won for failing to explain the product adequately.
Today, some banks are beginning to promote structured products again, albeit with watertight documentation this time. As our anonymous banker commented, “People always underestimate how quickly the market forgets once people see an opportunity to make money.” Banks are reporting increased levels of interest in more complex products such as window forwards. Unlike a vanilla forward, a window forward does not have to be settled on a specific date – instead, it must be settled within a specified ‘window’, eg a period of three months. This type of product may be useful when the exact date of a cash flow is uncertain.
“The market [for structured products] stopped completely between 2009 and 2010,” says Diamantini. “But from late 2010 we have seen people getting more and more interested in structured solutions.
“The reason is simple: the vanilla solution, like a basic forward, is not really the ideal solution for every situation. It’s an all or nothing solution where the customer can be protected completely but doesn’t have any participation at all, should the markets move in the direction of the underlying exposure.
“While volumes for structured solutions decreased as a result of the financial crisis, people are now starting to reassess their priorities and are becoming more willing to pay some kind of premium in the face of volatile markets and high uncertainty. Even though their first reaction was to say, ‘it is expensive, I’m not doing it,’ now people are slowly starting to change their minds as they start to see the advantages of adding some flexibility on their risk management strategy.”
Nevertheless, many treasurers prefer to use simpler instruments. “Using plain vanilla instruments makes it easier to compare what different banks are offering,” commented one of the anonymous treasury sources.
“Complex option structures usually have too speculative elements for companies. In any case, I haven’t seen any new products on the market for a while – very often you see a new label on a product that might have been invented in the 1990s.”
On the strategic side, another trend is for corporates to move from traditional six to 12-month rolling forwards to a layered approach in response to the increased volatility in today’s market.
“We’re condoning layered hedging strategies,” comments Johnson. “For example, you might hedge 100% for six months; 75% for 12 months and 50% for 18 months. Extending the hedging horizon coupled with layered hedging reduces the volatility of the year-on-year achieved rate.”
Divide grows between largest MNCs and next tier companies
The hedging practices of the largest multinational companies are experiencing an ever greater split versus those of the next tier down in terms of size and complexity. Some top-tier multinationals are reducing their translation risk hedging in order to provide investors with exposure to global currencies and are taking a view on long-term currency market positions.
In contrast, second-tier multinationals are beginning to hedge more as volatility continues in the FX market, and with hedge accounting expected to become easier under IFRS and US GAAP.
At one end of the spectrum, the largest of MNCs with a truly global footprint are beginning to reduce the amount of translation hedging that they do to reduce volatility of consolidated US dollar P&L. This driver for change relates into their view on where the US dollar will move in the coming months and years, according to Jeffrey Wallace, Managing Partner at Greenwich Treasury Advisers.
“Some MNCs are starting to think that with the US dollar in decline as the main foreign reserve currency, does it make sense to hedge into the US dollar?” he says. “They are starting to recognise that with the US dollar as a weak currency then it is no longer logical to do whatever hedging you can to minimise volatility of the consolidated dollar P&L.”
He adds: “A lot of people are wedded to managing their quarterly earnings and will always be doing that. But if you really have a long-term view of dollar weakness – or if you think you have an investor-base that view it that way, then hedging into dollars is not necessarily what they want.” He says a big theme in corporate hedging strategy is how they are reacting to the idea of long-term dollar weakness.
What equity investors want from an investment is thus increasingly affecting the way that companies hedge their exposures. “Shareholders want more foreign currency exposure and are increasing their investment in foreign companies. Those same investors also want to invest in MNCs that have foreign currency exposure, but they do not want them to hedge into dollars, they want that foreign currency exposure.”
This translation risk is the exchange rate risk involved in translating the value of assets, liabilities and equity classes held in foreign currencies into the functional currency on the balance sheet. Hedging that risk can help reduce the impact of currency movements on earnings. In the recent survey by Citi, 22% of respondents said that they actively managed currency translation and consolidation risk associated with their foreign subsidiaries’ net assets.
According to Wallace’s position, hedging translation risk can be compared to an investor in a gold company who is looking for exposure to fluctuating gold prices. If the company hedged all of its commodity risk for the next ten years, investors would not be getting that exposure. But people that are buying stock in gold want that risk.
By the same token, for a company with around $5 billion or $15 billion in revenues where 40%-50% of those revenues are garnered in overseas markets, investors are aware of, and in fact want, that foreign exposure, says Wallace. He says companies are increasingly thinking of that when they plan their hedging strategies. “That means keeping that exposure in the P&L.”
Medical products company Becton Dickenson, for example, recently announced that it has stopped foreign currency translation hedging.
Becton Dickenson has long had a fairly sophisticated hedging strategy, as it has exposure to a number of foreign currencies, including the euro the Japanese yen, Canadian and Australian dollars, and British pound. After moving from options to forward contracts a few years ago when options became too expensive, the company experienced quite some volatility in its results – going from a $100m hedging gain in 2009 to a $31m loss due to hedging last year. Rather than continue having to explain away such earnings impact, Becton Dickenson is cutting the translation risk hedging programme altogether.
While the company still uses hedging to mitigate transaction-related FX risk, it is no longer hedging risk associated with converting worldwide results into the US dollar, its functional currency.
However, there are clear risks to not hedging against translation risk, most particularly the impact on shareholder equity, should that bet be wrong on the direction a particular functional currency will take. Investors may want exposure to foreign currencies, but if losses due to translation risk start piling up year-on-year – assuming that functional currency starts to gain momentum against foreign currencies – their desire for that exposure may wane.
Smaller MNCs get more sophisticated
At the other end of the spectrum in terms of size, there is no doubt that the increased volatility in foreign exchange markets – particularly the way the euro has fluctuated over the past two years – has led a number of second-tier MNCs to move to hedging that may not have done so previously. For smaller MNCs the complexity of hedge accounting may have been a disincentive to hedge, although this is much more the case in the US than in other countries.
In fact, US companies are very much driven by the impact of hedges on accounting and are much less open to the idea than their global counterparts of hedging without applying hedge accounting treatment because of the potential earnings impact. European companies are less so, according to the Citi survey.
Of the survey respondents, only 17% of US companies said they would enter into hedges without applying hedge accounting, whereas 30% of their peers in Europe said that they would. In addition, although 37% of respondents said that hedges must undergo hedge accounting treatment, 20% said they would hedge for economic reasons regardless of hedge accounting and 43% said they would accept some earnings impact from derivatives used for hedging.
However, with hedge accounting in the US set to get easier, as FAS 133 hedge accounting rules are expected to be simplified this year, it is likely that more second-tier and smaller US companies will think more seriously about reassessing their hedging strategies.
Meantime, companies worldwide are still in a state of flux over what the final outcome will be on their costs for buying OTC derivatives, of new regulations covering the derivatives marketplaces and efforts to move OTC derivatives to clearing through exchanges.
In the US, for example, under Dodd-Frank, the US Congress enacted end-user provisions exempting some companies – users of derivatives for hedging commercial risks – from the need to set aside more margin for derivatives.
However, they left it up to regulators how to enact that and who would be exempt, which is a concern for corporations. How that will play out has yet to be determined.
In Europe, the proposed European Market Infrastructure Regulation (EMIR) was released in September 2010. Like Dodd-Frank, EMIR seeks to ensure that OTC derivatives are traded on regulated exchanges. The impact of these changes on corporates remains to be seen.
“Right now corporates are not too concerned,” says Diamantini. “It’s not clear whether or not corporates will have to go through clearing houses. So for now it’s business as usual but we are monitoring quite closely any change in the regulation which could affect us.
Upcoming changes to hedge accounting regulations are also likely to have an impact on corporate hedging behaviour. While many feel it is too early to say what this impact will be, it is likely that the changes will facilitate more complex hedging practices.
“Another reason why things are moving towards more complex solutions is the change in accounting legislation,” says Diamantini. “Even though this will happen probably in 2013, it seems from the first draft that this accounting legislation will give more flexibility in the way structure will get hedge accounting, so that people start to have an open mind about different products now.”
Reasons for hedging
Although there are a number of basic reasons why companies hedge FX exposures, the specific goals of a particular company will change based on the risks they face, their growth strategy, and quite simply their goals in terms of risk mitigation.
Many companies prefer to keep their hedging programmes flexible and not adopt a formal, documented hedging strategy, but without a straightforward policy in place it can not only be difficult to maintain structure and discipline in hedging, but also reduce transparency in hedging practices, and make it harder to have continuity in hedging practices as staff change or evaluate the efficacy of a particular hedging program.
According to the Citi survey, most companies hedge first and foremost in order to reduce risk to transactional cash flows over a discrete time period. While 65% of respondents use hedging primarily for that purpose, just 34% hedged principally to reduce risk to earnings and 20% of respondents mainly wanted to minimise period-on-period volatility in earnings. Most companies have a number of different objectives in mind, including some or all of the above.
Foreign exchange hedging programmes generally cover three different types of exposures – net monetary assets and liabilities, including foreign-currency-denominated payables and receivables, foreign currency debt and inter-company loans; forecasted exposures in cash flows; and net investment exposures.
Given that the vast majority of companies are re-evaluating their risk management strategies post crisis – and in fact most companies undergo some sort of regular RM policy review – it behoves the corporate treasurer to keep in mind some basic tenets for achieving risk management goals and creating an effective hedging programme that meets those goals.