Treasury Today Country Profiles in association with Citi

To hedge or not to hedge?

Hedge tunnel with path

Determining the trigger point at which your treasury committee decides to hedge can be a difficult task. No matter how diligently treasurers apply hedging best practice, they may still have to navigate around increasing regulation, corporate debt worries and the Eurozone crisis.

A question at the forefront of many treasurers’ minds at present is whether or not to hedge their risk exposures. The art of hedging has become increasingly complex and managing a variety of risk exposures – such as foreign exchange (FX), interest rate, commodity and counterparty – can be a daunting task for any treasurer.

Hedging has therefore taken on a new importance in these difficult economic conditions. According to the International Swaps and Derivatives Association (ISDA), over 94% of the world’s largest corporates use derivatives to hedge their risk exposures, making use of instruments ranging from plain vanilla forwards to elaborate customised swaps.

In such a volatile market, treasurers would like to think they have carte blanche to hedge left, right and centre. Unfortunately, Boards of Directors and shareholders are less inclined to agree. It is the treasurer’s role to protect the business from unfavourable market fluctuations, doing so with minimum expense. As such, treasurers must be prudent with their cash. It follows that not every exposure can be hedged. So, is there a prudent strategy by which treasurers can decide whether to hedge?

The old formula of ‘identification, measurement and management’ still wins out when it comes to executing effective hedging strategies. But the difficulties presented by the current economic environment must also now be factored in, leading to the rise of three formative trends crucial to hedging, which we will now explore in more details.

Risky business

  1. Although interest rate risk has subsided somewhat – it is highly likely that rates will continue to remain rock bottom in the near future – FX and, in particular, commodity risks have increased substantially. The former’s rise is understandable: the Eurozone crisis is currently challenging the very foundations of a globally traded currency; while demand for emerging market currencies, such as the Brazilian real and Chinese renminbi, is surging despite administrative red-tape barriers. Effective FX hedging is now an activity that requires more time, research and effort.

    The ascendancy of commodity risk can be attributed to the simple fact that, with the exception of certain companies and niche industries, treasurers did not treat it with sufficient seriousness before 2008. Once bitten, twice shy however. Where many businesses were caught out by the volatility in oil prices four years ago, a PricewaterhouseCoopers’ corporate treasury survey in 2010 (the most recent) highlighted that 33% of corporates now pursue an ‘active or aggressive approach’ to commodity risk – a sizeable increase over pre-Lehman years’ activity.

  2. Additionally, a wall of corporate debt that needs to be refinanced in 2013-15 is having a major impact on hedging strategies – as well as potential costs associated with their execution. Many businesses binged on easy borrowing conditions pre-2008. Now the party is over, they are left with an unappetising bill.

    “A big trend we are seeing is refinancing, as companies seek to diversify and manage the cost of funding through recourse to capital markets and private placements,” says Paul Higdon, Chief Technology Officer at IT2 Solutions. “When undertaken in multiple worldwide markets, this naturally gives rise to FX and interest rate exposure – all of which has to be managed, typically using interest rate swaps and currency swaps to manage translation risk.”

    “A big trend we are seeing is refinancing, as companies seek to diversify and manage the cost of funding through recourse to capital markets and private placements.”

    Paul Higdon

    Furthermore, as the liquidity crunch tightens, corporate debt is increasingly under the spotlight. In the first half of 2012 leading credit ratings agencies, such as Standard & Poor’s and Moody’s, issued corporate downgrades almost on a weekly basis. Given that hedging costs are ranked in tandem with a corporate’s bank debt – after all, both are calculated by financial institutions’ internal risk weighting models – they could spike sharply were the treasurer’s company to be downgraded. If a business holds investment grade debt, then the treasurer can avail of significantly better rates.

    “It is all confidential among the banks,” says one treasurer, who preferred to remain anonymous for this article. “We get better rates on their internal risk-weighting models than we would have if we lost our investment-grade rating. Banks basically have a read-across with regard to corporate debt and hedging costs.”

  3. Another factor only adding to corporate worries is that a wave of financial regulation, both regional and global, is hitting the trading markets, sparking fears that hedging costs for corporates will further increase. If it is not the European Market Infrastructure Regulation (EMIR) keeping treasurers awake at night, then it is the Dodd-Frank Act, Basel III or MiFID II.

    “Do I think regulation is going to hit companies with higher costs?” asks Rick Martin, Group Director of Treasury and Investor Relations at Virgin Media. “In my opinion, the answer is yes. But I doubt treasurers will bear the full weight of the increased cost associated with regulatory impacts on hedging. Some of it will be competed away, absorbed by the banks – though it would be difficult to know the proportion.”

    There are always two sides to the equation when it comes to regulation. Take the Dodd-Frank Act in the United States for instance. It is widely accepted that with over-the-counter (OTC) derivatives being subjected to compulsory clearing and margining, treasuries seeking customised hedging solutions will face increased costs (although there are exemptions from margining for non-systematically important corporates engaged in risk management.) Nevertheless, it can also be argued that the potential availability of more standardised, market-traded instruments is a positive outcome. After all, the OTC derivatives market was largely unregulated before the financial crisis. The Dodd-Frank Act could therefore allow for a greater degree of transparency for OTC end-users.

    But it may well have unexpected side effects. Several critics argue that the Act’s rule writers spent insufficient time working out the intricacies of the OTC derivatives market. As a result, certain rule provisions were extrapolated across a variety of different OTC derivative instruments.

    “There are a number of corporates out there with their heads in the sand. They have an idea that Dodd-Frank is just about banks trading and speculating over derivatives. But some of the larger corporates are more aware that the legislation does impact business. Derivative regulation is going to change the landscape of how products are sold, traded, cleared, settled and collateralised,” says Jiro Okochi, Chief Executive Officer and Co-founder of Reval.

    “The ostensible aim of Dodd-Frank is to create efficiency and transparency that will benefit end-users through lower prices. But there is a big difference between, say, the equities market and the OTC derivatives market. The volumes just won’t be there for a majority of products [to make this legislation pay off]. The big question is what products have enough liquidity where prices go down because everyone is trading them.” continues Okochi. “Take the interest rate swaps market, for example. Markets are anticipating that perhaps 2,000 contracts will trade a day. Compared to equities, that is a paltry amount. There is not enough volume to drive prices lower. With the landscape changing, some products will see sudden death, such as customised swaps and some commodities.”

    It is likely that American corporates will face a limited menu in future when it comes to customised swaps. Specialised transactions in less liquid markets will be more difficult to clear as a result of Dodd-Frank, leading banks to curtail their services to simpler variants such as plain vanilla derivatives.

Best practice makes perfect

Blending all these factors together, it is understandable that treasurers are wary. In an unpredictable market, simple hedges have become increasingly popular. Few treasurers wish to play with fire by using complex instruments that may backfire if the market, or regulations, move unfavourably. This may well explain why over 90% of corporates use plain vanilla forwards or swap transactions to hedge their underlying risks, says Krishnan Iyengar, Vice President, Global Solutions at Reval. Indeed, an ISDA June report stated that OTC derivatives had declined by 10.3% in the past 12 months. The figure excludes the volume of FX contracts, however, reinforcing the impression that treasurers are keeping it simple.

Interestingly, some instruments, such as participating forwards, are enjoying a new lease of life according to Iyengar. Participating forwards in effect offer some of the protection of a normal forward while allowing the treasurer to ‘participate’ in any favourable market movement. In other words, it is a halfway house between a forward and an option strategy. No premium is required. The downside is that the treasurer also has to ‘participate’ in any unfavourable movements – exposing the business to risk. Hedging preferences aside, what practices should a treasurer partake of in such an uncertain climate?

As mentioned above, there remains a tried and tested method of moving towards hedging best practice. It can be boiled down to three actions: identify, measure and manage.

  • Identification

    Identification depends upon the creation of a robust treasury policy that acknowledges and locks down systematic means by which relevant markets risks are collected and subjected to management,” says IT2’s Higdon. A corporate’s financial characteristics and structure will have an enormous influence on how treasurers identify threats to the cash flow in addition to the type of risks and asset classes assessed.

    Take two multinational companies, for instance: the first makes commercial investments overseas; the second seeks to secure large tranches of funding in one or two currencies, say the dollar and euro. Both corporates have materially different priorities when it comes to risk identification. Locating exposures therefore demands a careful look at the company’s business practices.

  • Measurement

    Measurement is perhaps the area of risk management that has seen the most development in recent years, both in terms of technology and professional best practices. Any global corporate with a centralised treasury team will have to tackle a variety of hedging activities almost on a daily basis – dealing requests, exposure reports and forecasts from their business units and subsidiaries, to name a few. How can a corporate capture all these material FX exposures?

    As Higdon notes: “Measurement of Value at Risk, scenario testing and the effectiveness of historical simulation, variance-covariance and Monte Carlo methodologies in turn depend for their effectiveness on the fundamental measurement methodology. For this reason, the design and implementation of consistent, robust and timely reporting workflows can result in significant gains in accuracy, both in initial quantification of exposures and in the analysis of contingent risks. Certainty of outcome is king.”

  • Management

    With risk exposures identified and measured, it is a matter of controlling them by implementation and active management of a hedging programme. Such a programme can place serious demands on treasury teams that are, frankly, often understaffed. The so-called ‘on-boarding’ of new positions with counterparties and trades, when monitored on the basis of Excel spreadsheet analyses, can be prone to errors, for instance. As a result, a rigorous approach to management, careful of its design, approval and control, is required from the very start.

    So much for implementation – what about the ongoing management implications of a hedging programme? Continual market fluctuations mean that treasury teams need to understand the marked-to-market value of positions and question whether existing hedges are still effective. Moreover, are the accounting procedures transparent enough for the company’s auditors? According to the 2010 PricewaterhouseCoopers survey, ‘the swings and uncertainties seen in various markets during the financial crisis have encouraged a gradually increasing number of participants to curtail the volatility in their financial statements through the use of hedge accounting.’ But whether a corporate partakes in hedge accounting or not often depends on the size, and consequently the sophistication, of the company itself and its treasury team – as the table below demonstrates.

    Nevertheless, supranational efforts to align accounting procedures with risk management strategies are well under way – albeit making slow progress. The compliance date of IFRS 9 – an international financial reporting standard that is set to replace the IAS 39 – has been postponed by two years to 1st January 2015. IFRS 9 allows for the potential to designate hedges on the basis of their alignment with risk management objectives, with the resulting policy more operationally appropriate and less accounting-driven.

Hedge accounting applied by size of participant in PricewaterhouseCoopers survey, 2010

Revenue size of company Applying hedge accounting
More than €10 billion 91%
€1 billion – €10 billion 69%
Less than €1 billion 53%

Source: PricewaterhouseCoopers

Taking a step back, the end result of a hedging programme should resemble “preconfigured, consistent reporting workflows, fully integrated accounting and market data, and real-time management and accounting dashboards,” says Higdon. “All these clearly represent best practice.” High levels of automation, therefore, should be the primary objective for treasurers.

“Bank positions have been subject to automated management by bots for some years, bringing the ability to apply policy consistently, and without the risks and costs associated with intensive human intervention,” continues Higdon. “Already in corporate treasury, automated workbenches are able to provide real-time intelligence on the performance of hedging policy with regard to risk and accounting objectives and to provide optimum suggested deals, making best use of expert human input. Whilst the expert treasury manager is clearly here to stay, it is not inconceivable that we could see more extensive use of bots to implement corporate hedging policy in the not too distant future.”

Corporates need to ensure they have the following:

  • A clear risk management objective.

  • A structured hedging strategy.

  • Flexibility of strategic hedging decisions.

  • Assured knowledge and an open mind to all derivatives – from plain vanilla forwards to tailored swaps.

  • Efficient pricing of hedging instruments.

  • Careful monitoring of the cash flow.

Determining the trigger point

Yet behind all these considerations lies one important decision-making structure: the treasury committee. It is a fact that many corporates, if not the overwhelming majority, have a structured system in place, organising meetings and formulating the priorities and parameters of a hedging strategy. The teams are small – often just four people – and usually include the group treasurer, chief financial officer, managing director and head of product management. “Hedging best practice all comes down to setting your policy and conforming to it,” says Reval’s Iyengar. “Now, policies can of course change and be updated. But treasurers and finance departments should strive to stay within the determined strategy. The treasury should certainly have a mechanism for changing those policies in a well thought out process.” It is at the stage of hedging strategy formulation, Iyengar argues, that the trigger point for making that hedge should be decided.

In such uncertain times, not all corporates can avail of this advice. The Italian tourism company Alpitour is a case in point. Bought by two private equity funds and a number of private investors earlier this year, the company is currently undergoing an overhaul of management. These changes have in effect zeroed its treasury committee, according to Enrico Rao, Group Treasurer. The last meeting took place in December 2011 – and concerns become all the more pressing as Alpitour will soon enter its busy winter season. Normally hedging strategies would have been reviewed five times per annum.

“The rest of the treasury committee have not survived the buy-out,” says Rao. “Only I remain at present. This is not a good period to be zeroed because there has been a lot of movement on the FX market. At present we don’t have a clear strategy as normally this would have been discussed in the committee.” Rao expects a treasury committee to reform by the end of July at the latest.

The example of Alpitour demonstrates that, no matter how diligently treasurers apply best practice, they must still operate and hedge in the real world – and counter all the challenges that go with that. Whether it is a new wave of regulation, increasing scrutiny of corporate debt or the Eurozone crisis, the trigger point decision to hedge should be a firm yet flexible one. Conforming to hedging strategy is important, but an element of dynamism should be incorporated to offer the treasury committee the freedom to react effectively to events.