Treasury Today Country Profiles in association with Citi

Smooth operators: hedging in a volatile world

Model figurines of businessmen looking skeptical at stock market chart

When it comes to currencies and commodities, the markets are unusually volatile. In attempting to smooth the ride, hedging can be a useful tool for treasurers. But what are the common mistakes and what constitutes best practice when using this risk management strategy?

In today’s volatile currency and commodities markets, treasurers crave certainty from both a cash flow and a P&L perspective (even if with full certainty the job would cease to exist). To hedge or not should never be a foregone conclusion, especially under the current circumstances, so now is a good time to review strategy and policy.

Doing so should ensure the approach taken is fit for purpose, not least in light of the hedge accounting changes implemented under IFRS 9 that became effective for annual periods beginning on or after 1st January 2018 at least for those corporates that have elected to adopt it.

But there is an even more pressing reason for treasurers to rethink hedging. Although the profession typically errs towards the vanilla end of the hedging spectrum, doing it badly still risks destroying more value than was originally at risk.

Alignment

“When we help companies review hedging strategies, it is not uncommon to find that decisions are not aligned with the company’s claimed hedging objectives,” notes Ian Farrar, Partner, Corporate Treasury Leader at PwC China & HK. “Equally, a closer look at these strategies may reveal that they are only optimal at certain points in the range of commodity or currency rates.”

An example of this would be where the use of certain instruments might be a sound strategy when oil prices are low, but not further up the curve. “We often find there is also an element of commodity basis risk,” continues Farrar. “Corporates often do not hedge their entire exposure – frequently on the grounds of availability of suitable instruments, a lack of clarity where they might uplift bunkers, or because the cost of a matching instrument is prohibitive.”

For hedging strategies in currency markets, the practice can generally be split into two main areas: FX exposures arising from trading, and exposures arising due to foreign currency debt. “Historically, many Asian companies have not hedged, or, for those that have hedged, under-hedged their FX exposure from trading activities,” notes Farrar.

In some cases, this was because these companies were actively taking a position on future currency movements. In others it was due to inadequate forecasting capabilities. Indeed, if a corporate cannot reliably estimate the extent of their currency exposure in any period, it is often prudent to scale back hedging activities.

Treasurers that have hedged tend to use simple instruments – swaps and forwards. But in the past few years more are now considering options-based products; in Asia this is particularly the case for those dealing with RMB, says Farrar.

A new view

When first engaging with hedging, the tendency is to judge the success of efforts based on whether or not a better rate was achieved, notes Farrar. Instead, he says, “treasurers need to measure their hedging strategy based on whether it achieved their objectives, regardless of whether a hedge ‘won’ or ‘lost’.” A ‘win’ in this respect therefore might mean the company managed to fix its cash flows successfully, giving it certainty.

“There is a lot that can be done to manage ongoing volatility,” comments Farrar. “It’s largely a question of making sure decisions made in the name of risk management are being made for the right reasons.”

Underlying effects

Joseph Braunhofer, Deputy Group Treasurer at Smith & Nephew, notes that often the transactional exposures hedged do not appropriately represent the full risk a company is exposed to. However, when seeking to establish the most effective hedging approach, he sees the basic structure of the organisation and the contracts it has entered into as having the defining role.

For Smith & Nephew, FX risk is for the most part concentrated in hubs, effectively centralising it and making it easier to manage. “If you are managing it on an individual basis across lots of decentralised entities you may be winning on one side but losing on another,” he warns.

Ideally, before implementing any FX hedging strategy, Braunhofer advises examining the fundamental economic risks within the company. “When you are analysing the economic risks underlying a business, sometimes it is not always immediately apparent what the FX risk is,” he notes.

“Contracting and procurement may have negotiated a contract in GBP, however this could be linked to an underlying USD market price. This could create an underlying FX risk within that contract that you don’t know about – or you may be transferring FX risk to one of your suppliers which you will ultimately pay for,” he explains.

To overcome this situation, he says it is vital to get into the detail in the first instance, “in order to fully understand what’s happening all the way through the chain”. For this to be possible, he adds that finance and other teams need to support treasury in getting the best available data.

From here it will be useful to assess and compare those risks versus industry peers, making a judgement on what certain FX movements will do to the company’s overall competitiveness in its market. Braunhofer accepts that it can be difficult to get competitor information of this nature and urges treasurers to be “a little bit more creative” here, exploiting other sources where possible.

Having created a view of the underlying risks, and benchmarked them, another useful step is to build in a view of the prevailing business environment. “In a business where margins are typically over 20%, Braunhofer believes that the treasurer might feel that doing less FX hedging may be entirely acceptable “because the worst possible outcome of all currencies moving against the business might only knock 1% off the overall margin”.

In any given year, this will still dent profitability. But for the high-margin player, it is unlikely to tip the business over the edge in terms of complying with any bank covenants, for example. However, for low margin businesses, the potential for losses and risks related to covenant compliance alone may dictate the decision to hedge or not.

Accurate forecasting

As a hedging programme is implemented, it is important to looking at the accuracy of cash forecasts and underlying flows for it to be effective. “Typically, companies are hedging 12 or 24 months out so it is vital to know they are not doing so on the basis of flawed data and then having to unravel that as the maturity date approaches,” comments Braunhofer.

The starting point of accuracy here is a matter of attending to the cash forecasting basics. “Most corporate treasurers recognise that this can be very difficult but if you are not doing some form of variance analysis on your cash forecasting, then it’s probably not going to get any better and you’ll never know how accurate you are.”

There are various systems and processes that can be used to improve cash forecasting, depending on whether it is for operational, tactical or strategic purposes (short, medium or long term). These include the receipts and disbursements method, distribution modelling, exponential smoothing and regression analysis.

Modelling

It is useful for treasurers to develop an approach to modelling risk in the context of hedging. In recent times, Braunhofer notes that the portfolio value at risk (VaR) approach has become the leading edge in hedging practice.

VaR calculations come in many forms (and complexities) and can be estimated by multiplying ‘market value’ by ‘price volatility’. Portfolio VaR essentially enables risk to be equated across products and for the aggregation of that risk on a portfolio basis.

A VaR model might, for example, measure the confidence (as a percentage) of the worst-case loss, under normal market conditions, across the base currency, over a given period due to adverse price moves. This calculation can be used to calculate VaR of individual positions and, subsequently, portfolio VaR.

Risk modelling can quickly become a complex proposition and adopting the more arcane techniques is not for everyone. “I would prefer to keep things as simple as possible,” states Braunhofer. Some market-data tools available to treasurers have modelling functionality built into them, allowing “anyone with a good handle on their exposures” to overlay concepts such as portfolio VaR with “relative ease”.

Flexibility and framework

With more extreme market movements than would otherwise have been anticipated, companies that are increasingly global in reach and connection, and the positive effects of having easier access to more accurate, relevant and timely data, companies are better able to understand the underlying elements.

Best effort now needs to be, and can be, better. As such, says Desiree Pires, Co-Head Corporate Sales, UK Financial Markets at Standard Chartered, “it is no longer prudent to have a one-size-fits all treasury hedging policy, and nor is it sensible to continue using a policy that was written a decade ago”.

The current trading environment and market volatilities are dictating the need for a more flexible hedging approach. Indeed, rigidity in today’s environment can create exposure to additional risk or cost.

With EUR and GBP forward points close to record highs, for EUR or GBP sellers it may be worth extending tenor of hedges to lock in the attractive forward points. For commodity purchasers, hedging for example base metal or energy in EUR rather than USD terms may mitigate the impact of higher commodity prices, says Pires.

“The record lows we have had in interest rates over the last few years encouraged many treasuries to fix their debt costs for longer term. Brexit GBP-related weakness may also bring opportunities for UK companies with foreign earnings or foreign companies with UK costs to lock these in for a longer period.” Being able to lock-in that cost gives the predictability that companies and stakeholders crave. This only comes from policy flexibility.

There may be certain accounting or finance considerations around the timing of a hedge, but Pires says treasurers should generally be striving to create market awareness across the organisation, up to board level, to try to reshape outmoded policy in the most appropriate manner.

Indeed, there must be an understanding of the nuances that exist, for example, between certain currency pairs, or at certain times in the market cycle, in order that the right degree of flexibility is sanctioned. And it needs to be sanctioned because shifting back and forth on tenor, for example, might, as Braunhofer notes, “look a little like speculation”.

Allowing treasury to do something different where necessary, possibly even look at FX options, as PwC China & HK’s Farrar suggests above some Asian businesses exposed to RMB are now doing, is clearly foresighted.

However, policy flexibility to the point of allowing ad hoc decisions is effectively no policy at all, cautions Pires. “When hedging, there will always be a need for a framework and guidelines,” she declares. “These typically warn against speculation but also provide certain tolerances within which treasury can operate.”

With more data available to build a better picture of the business and its risks, setting and fine-tuning limits, and understanding where the pain-points are, is now entirely possible.

Practical measures

In beginning to mitigate exposure risks, it should be apparent that treasurers should start by examining market conditions before taking the plunge. However, warns Pires, “spend too long studying the markets, or wait too long for it to reach a good level, and it might run away from you”. Setting time guidelines can avoid ‘paralysis by analysis’.

The cost of hedging should be a consideration too. It needs to be balanced by the benefits and the value of the underlying business; certain (usually emerging market) currencies, for example, may not be worth hedging because they are simply too expensive.

When adopting a hedging methodology, a ‘rolling layered approach’ is often advised as a practical means of reducing cash flow volatility. With a two or three-year horizon, for example, the treasurer would hedge a larger percentage of FX for the first six months (policy suggesting perhaps between 50% and 80%), reducing the percentage progressively to perhaps a tail hedge towards maturity.

The liquidity of the market will often dictate tenor; commodities tend not to be overly liquid beyond 18-months to two years, making a longer tenor unlikely. That said, an airline might take a different stance to a food manufacturer, so policy might dictate a very different approach.

But perhaps hedging can be approached in a different way altogether. As Farrar says, it may now be time for treasurers to look closer at options. Indeed, in certain cases, especially where there is uncertainty around the underlying, Pires says the ‘insurance’ of a simple option (as opposed to more complex derivatives, which are unlikely to gain acceptance amongst treasurers) “can outperform a rolling forward hedging programme”, giving lower volatility on the balance sheet.

It is worth noting too that where at an individual entity level, hedging may seem like the right thing to do, across a group, there may be natural – and therefore more cost effective – offsets that can be used instead, notes Jacqui Drew, Director, ION Treasury and Chairperson of ION’s Hedge Accounting Technical Taskforce.

Information is key here, she says. It is imperative that a company can identify all inflows and outflows across a company and across the asset classes including FX and commodities. The company can then identify any natural offsets in the first instance which would significantly reduce the volume of hedging and therefore the hedging costs.

Looking at exposures in siloes, where commodities and FX trades are treated entirely separately, is inefficient. “A more advanced treasury will be able to look at these exposures across the portfolio and gain an understanding of the correlation and potential offset of the different risks,” she notes. “We have worked with companies who have noted a 40-50% reduction in risk when considering the correlations across asset classes by using advanced risk functionality like Cash Flow at Risk. Cash Flow at Risk is relevant to corporates who are not looking to trade out of their hedging positions immediately and are looking to manage cash flows rather than balance sheet value.”

Technology, subject matter experts and banking partners will be a valuable source of input and of data in this respect, especially when seeking correlations and performing calculations and analysis. But where information can be shared internally, then it should be. Aside from the adoption of technologies that can facilitate sharing across the organisation – and here cloud solutions can prove beneficial – the different functions harbouring relevant data using independent market data can be helpful in treasurers adding value to the organisation.

It is here that treasurers can explain that helping to discover the different exposures being faced by the business will help level volatility and increase certainty through a better-executed hedging strategy. Ultimately though, it means driving growth and increasing profitability. Few could argue with that.

Hedging best practice: Jacqui Drew, Director, ION Treasury, offers her guidance

  • Build a formal hedging strategy and policy, with appropriate controls, and align your actions with it across the organisation and to the risk appetite of the organisation.

  • Allow your policy to have a degree of flexibility and ability to deal with unexpected changes in the economy.

  • View policy as a work in progress: review and revise as necessary and back test.

  • Stay abreast of the underlying business risks and regulatory changes.

  • Know what exposures you are trying to protect and be able to accurately identify them and keep them updated.

  • Hedge in good time: don’t wait for the market to turn.

  • Share information internally and look out for natural hedges across the organisation.

  • Hedging for treasurers is a means of risk mitigation not a source of revenue.

  • Invest in technology to support global and accurate capture of your exposures across your asset classes with risk management functionality to comply with your risk management policies.

  • Ask a trusted expert for advice on hedging strategies or risk management techniques.