In 2008, Google established a foreign exchange (FX) cash flow hedging programme to mitigate FX volatility on the income statement. The cash flow hedge programme primarily comprises a portfolio of options to hedge euro, sterling, and canadian dollar exposures. When the financial crisis hit in late 2008, FX volatility soared and the cost of options increased significantly. In 2009, faced with the increasing costs of hedging with an options portfolio and a weaker dollar resulting in more options expiring out-of-the-money, it became clear that Google needed a new approach to measure the performance of its hedging programme.

Google determined that it should establish a benchmark to measure the performance of its options portfolio. However, a standard benchmark or corporate approach did not exist. As a result, Google set an objective to develop a methodology to benchmark the performance of its cash flow options portfolio.

Axel Martinez, Assistant Treasurer, explains, “Google created a quantitative framework which represents an algorithmic approach to currency hedging through purchased options. This specific approach offers an automated, objective, and highly scalable methodology to both constructing an optimal option hedging portfolio – the ‘benchmark’ portfolio – as well as measuring the incremental value of any discretionary hedging decisions that deviate from the benchmark.”

Google is able to compute, for a given strike and maturity at a specified confidence level, the risk-neutral expected value of:

• The ‘insurance’, or the value of a purchased option.

• The ‘deductible’ or the difference between the spot and the strike.

Armed with the expected values of the insurance and the deductible, and adding in the market price of options – the insurance cost – Google’s particular approach then enables the selection of an optimal strike(s) from all possible strikes for a given expiry. This optimises the interaction between insurance, deductible and insurance cost.

Recognising that Google, like most market participants, is risk averse, the benchmark framework also incorporates the ability to fine-tune the optimal strike selection based on Google’s unique risk and/or uncertainty aversion.

“No other corporate has successfully developed a way to systematically construct an optimal option hedging portfolio and measure the relative quality of any discretionary hedging decisions.”

Martinez comments, “Specifically, the optimisation process has been calibrated to Google’s historically exhibited preference on the trade-off between risk reduction vs option premium.”

Google now has the ability to evaluate any discretionary strike selection by its FX team on an ex-post basis. In particular, on any expiry date, the performance of a discretionary strike selection can be compared to that of the benchmark by comparing their respective realised values of the insurance, deductible, and insurance cost.

The collection of this data over time will enable Google’s FX team to refine its ex-ante decision-making process as well as allow Google’s management team to evaluate the quality of the FX team’s decisions ex post facto.

The development of the benchmark option portfolio allows Google to systematically create an objective, optimal hedging programme and quantitatively measure the effectiveness of the FX team’s discretionary hedging decisions. Prior to the benchmark approach, Google’s management had no consistent, quantitative measure for evaluating the quality of the FX team’s strike selection in the context of expected risk reduction vs overall premium cost.

“No other corporate has successfully developed a way to systematically construct an optimal option hedging portfolio and measure the relative quality of any discretionary hedging decisions,” says Martinez.