Treasurers with long memories may look nostalgically back to 2006 when commentators were asking, “Is FX volatility dead?” They may even wish for the steady but high levels of volatility experienced during the financial crisis. That’s because in a trending environment edging decisions are relatively straightforward. In today’s market however, periods of low volatility are interspersed with periods of very high volatility, making foreign exchange forecasting and hedging extremely difficult. Few treasurers will use the tools available to the investment community to hedge against the volatility of volatility, notably total return swaps on volatility indices such as those launched in February by Credit Suisse. So what can they do in this environment?
The answer is to go back to basics. The first step is an in-depth appraisal of risk sensitivities. What foreign-exchange risk exposures does the company have? How do different values of these exposures affect the company’s key performance indicators? And what level of tolerance does the company have for each of these risks? Often this is not an analysis that has been rigorously performed with values ascribed to each answer. It needs to be done.
Companies with relatively high risk tolerances should adopt what the banks call a “risk-on risk off” hedging strategy. That is, instead of locking themselves into medium- or long-term hedges based on forecasts with similar horizons, they should try to match their hedges to market conditions, hedging more in periods of higher volatility and less in periods of flat volatility. This strategy is only suitable for those with a higher level of risk tolerance because by definition, some of these shorter-term trades will expose the company to the possibility of losses, to be counterbalanced later in the strategy by other trades. Clearly this requires a level of sophistication in both systems and personnel that is likely to be found in larger rather than smaller corporations.
Corporates with lower risk tolerances or who lack the resources to adopt an active hedging strategy should seek the most flexible solutions within their longer-term hedging strategy. This is at odds with treasurers’ normal aversion to any kind of structured products and to options with upfront premiums. Treasurers contacted by Treasury Today are, if anything, even more strongly attached to the very simplest products than they were before. These products are unlikely to give them the flexibility they need to react to this new environment of volatile volatility.
That said, until there is greater regulatory and accounting clarity on where derivatives are to be traded and how they are to be treated, treasurers are constrained in the solutions they can implement.
Of course this turbulence in the foreign exchange markets is a reflection of wider trends. Political upheavals in emerging markets, the continued sovereign debt crisis in Europe, commodity price volatility and the spillover into foreign exchange and the problems in Japan all come together to create what one head of global foreign exchange: calls “the most challenging environment for both corporate hedging and for alpha generation on the institutional side that I have ever seen.” So if treasurers are feeling the pressure, they’re not alone.