Over-hedging – entering into more hedging contracts than necessary to cover FX exposure – leaves companies exposed to a range of issues including increased trading costs and significant mark-to-market charges or adjustments to the hedged rate or rates.
These misalignment and hedge amount errors are typically a result of inaccurate forecasting and/or poor communication. Sales teams may offer optimistic forecasts or operations teams might miscalculate inventory and production cycles, but there are other causes that are just part of doing business such as delays to shipments, deals being cancelled or renewed at a lower value, or clients going out of business.
Jamie Yardley is Finance Manager at UK packaging solutions specialist Clingfoil, which is part of the Samuel Grant Group.
“Our FX hedging requirements are focused on our overseas raw material imports,” he explains. “The lead time from production to delivery is often several months and global volatility in logistics, lead times, infrastructure and economies in recent years has seen us tighten our risk policy to ensure we are hedged against any material events.”
Clingfoil evaluates target margins at the time of order with the procurement team and fixes its rate using forward contracts to satisfy the full balance of the obligation on each specific consignment. Window forwards are used for large scale material purchases that fall inside a pricing agreement or specific consignment requirements.
The company constantly reviews its hedging strategy to ensure it is not over-hedging. “We work hard to ensure we are always on a refreshed view of our projections,” says Yardley. “The constant flow of communication between procurement, the finance team and sales management keeps all stakeholders focused on inventory flows.”
A large portion of the business’s revenue stream is not locked into contract due to the nature of the product supplied and the competitiveness of the industry.
“Where we do manage to get tenders in place, forward contracts service the target margin requirements and keep us within sight of the desired profit ranges,” says Yardley. “Utilising the tools with a risk-averse approach has mitigated over-hedging opportunities.”
A worrying trend – especially with medium-sized companies – is the proliferation of complex derivatives which include path-dependent outcomes and/or leverage (where the contract specifies a protected amount that is less than the potentially obligated amount) observes Harry Mills, Director of specialist currency manager Oku Markets.
“These often multi-leg or ‘structured’ options products are tempting because they tend to offer attractive terms from the outset, such as in-the-money hedge rates, but the potential risks can be devastating,” he says.
According to Mills, over-hedging due to forecasting issues is quite common and the solution might be as straightforward as using a FX swap to realign the hedge profile. “Over-hedging due to purchasing inappropriate derivative products is increasing, chiefly thanks to the significant P&L opportunities for banks and brokers who sell these products,” he adds.
Companies that operate with uncontracted future sales or sell to clients at a higher risk of default are more prone to over-hedging issues. For example, it is highly unlikely a medical supplies company selling into the NHS will suffer from over-hedging of its imports, whereas a metals stockholder selling into the construction and automotive sectors is far more at risk due to the nature of its customers and the volatile nature of its supply chain.
“Treasurers should have sufficient information available to them from internal stakeholders to select an appropriate hedging ratio and I would suggest that most should aim for a marked and quantifiable reduction in risk rather than an elimination of it,” says Mills. “It is best to err on the side of caution when it comes to hedge ratios – solve for the ratio that provides the required reduction of risk rather than trying to select a ratio without first considering its outcome.”
