Through this in-house developed solution, Google can selectively optimise the trade-off between premium cost and risk reduction based on its own particular risk appetite and market conditions across varying exposures and time horizons.

The challenge:

Back in 2008, Google established a foreign exchange (FX) cash flow hedging programme to mitigate FX volatility on the income statement. The programme consisted primarily of a portfolio of options to hedge the company’s euro, British pound and Canadian dollar exposures.

However, by 2014 Google’s revenues had grown by approximately four times since the FX programme initially launched. Meanwhile, the hedging costs associated with its options portfolio were rising and the weakness of the US dollar at that time meant that more and more of the options in its portfolio were expiring ‘out-of-the-money’. To address this concern and to better align its FX goals with its current business goals, treasury determined it necessary to reassess its exposure profile, risk tolerance and hedging strategy.

The solution:

Google began working on a new FX cash flow risk management strategy with a defined framework to provide more flexibility for dynamic hedging under varying market conditions. By employing the framework strategy Google expanded the scope of the cash flow hedging programmes to significantly reduce risk from Australian dollar and Japanese yen exposures while doing so in an economically efficient manner.

“Google takes a quantitative approach to hedging its FX exposures across its different currencies and exposure time horizons,” says Peter Chau, Treasury Manager at Google. “By evaluating realised and implied option volatility and spot conditions against historical ranges and current market conditions, Google can apply market intelligence to vary the amount and extent to which cash flow exposures are hedged by adjusting hedge ratios and option strike ‘money-ness’. This can be viewed as analogous to an insurance policy in which a lesser or greater amount of ‘insurance’ can be purchased, but the extent of protection or ‘deductible’ can vary based on risk profile and appetite.”

By allowing for this flexibility within set policy boundaries, Google can capitalise on favourable market conditions to increase hedge ratios and opportunistically lock in more attractive hedging rates to increase the potential for hedge gains. If market conditions are less favourable, Google can reduce hedge ratios or increase option ‘deductible’ by purchasing more ‘out-of-the money’ strikes. This can help reduce the costs of hedging and preserve optionality to optimise smoothing of FX impact on earnings by hedging exposures in future periods under more favourable market conditions.

Best practice and innovation:

Few, if any, corporates have successfully developed an FX cash flow hedging framework approach to systematically manage risk across varying exposures and time horizons utilising a portfolio of options. Now, as a result of this project, Google can selectively optimise the trade-off between premium cost and risk reduction based on its own particular risk appetite and market conditions across varying exposures and time horizons.

Ultimately, it means the company is able to mitigate the longer-term impact of FX fluctuations on operating profit, take a more opportunistic approach to hedge execution (with set parameters) be more effective in the management of overall exposures varying time horizons with respect to both cost and risk. “This strategy provides a unique risk-reduction solution that is tailored to Google’s long-term business outlook while opportunistically leveraging favourable market conditions,” says Chau.

Following implementation of the new FX strategy, Google has been hedging more exposures at favourable spot rates with volatility at multi-year lows before the swift and dramatic USD strengthened in the second half of 2014. Thanks to this, Google recognised $171m of hedging revenue in 2014.

“Benefits of the new strategy began to materialise by the end of 2014, with the cash flow hedge portfolio increasing in value to over $800m with approximately 35% related to the new framework strategy,” Chau adds.