Insight & Analysis

Currency hedging in the eye of the storm

Published: Apr 2020

The COVID-19 pandemic is affecting almost all areas of business, and companies are having to look at ways to manage and mitigate the risks that are coming with it. We take a look at the issue of currency hedging, what role it’s playing in protecting cash, and what role it will have in the future.

Green bushes circular labyrinth, hedge maze. Top view.

It’s unlikely that most treasurers will be strangers to the concept of currency hedging, but a fair few might be unfamiliar with currency hedging during a global crisis.

For Jonathan Pryor, Head of Corporate Foreign Exchange at Investec, the challenge for treasurers comes from the need to look at currency hedging through a dual lens. “One element of it is naturally keeping an eye on market rates and volatility – not just in FX markets but in financial markets in general – and the other, more important element is actually keeping an eye on their business,” he says.

The risks

Pryor believes there are three main elements to currency hedging risk at the moment. The first, he says, is “literally just trying to make heads or tails of what is going on”. He explains that it isn’t necessarily an ideal situation for a corporate to try to make significant decisions around hedging future risks when the global economy “has pretty much flipped upside down”. As a result, he believes treasurers have got to be sensible and measured in trying to interpret any of the volatility that’s being seen in the market and the reasons behind it.

The second element, says Pryor, is the volatility itself. “If you look at sterling/dollar volatility, we’ve seen the rates fall down to levels not seen since 1985.” Therefore treasurers need to be far more cautious in trying to navigate the challenges. “The risks to getting that wrong naturally increase,” he says.

The third and final element is the importance of picking the correct partner to work with. “Treasurers need to make sure that they’ve got facilities with FX providers that are substantial enough, that the credit limits are sufficient, and any margining can be met by the business,” says Pryor. “In extreme times like we’ve seen, this is where you need to really make sure that the quality, the nature, and the number of the facilities you have with banks is sufficient to ride out that volatility.”

Change will come

The world is in “the eye of the storm” at the moment, and therefore it’s too early to see any changes in policy to accommodate current risks, as companies are more focused on firefighting. But Pryor does expect to see policy changes materialise once the major risk has passed.

“We did see this a lot after the global financial crisis. It puts a spotlight on why corporates hedge, and I think that over the coming months, or next year or so, corporates will take that opportunity to build more stringent policies.” Indeed, hedging protects an organisation’s cash, and so the policies need to be appropriate and robust enough to do that in times of extreme volatility.

The usual safe havens

As usual, there are certain currencies that are deemed ‘safer’ than others. The Japanese yen and Swiss franc have upheld their ‘safe haven’ status, but interestingly, says Pryor, the dollar didn’t do so immediately. “That was probably because the Fed cut rates as a pre-emptive move, and at that point the dollar was sold off. That move was corrected very quickly though, and for the past few weeks you’ve seen the safe haven of the dollar be more apparent than ever.”

Likewise, the opposite is also evident of people moving away from riskier currencies – specifically emerging markets. Whilst this isn’t a good thing for those currencies, it is typical of a global crisis, and thus the recovery should theoretically follow the same path as seen in the past as well. “I don’t think it’s linear, but the trend is certainly on track,” says Pryor.

Can the storm be ridden out?

Pryor calls the current situation a classic “stick or twist” problem. It’s very likely that in six to 18 months’ time, things are going to normalise, and so there is a very clear expectation that currency flows will follow suit. Treasurers are therefore faced with a dilemma: “do they trust that rates will normalise and they’ll have better forecasts, or in extreme times do they take the approach of risk mitigation and continue to adhere to their policy?”

For Pryor, there is no right or wrong answer. He theorises that were the environment slightly less volatile, it’s likely that organisations would be “paying premium for vanilla options”. But, he says, with the level of volatility being so high, options are inordinately expensive and as they take cash directly out of the business, may not be the best solution.

In the meantime…

The economic effects of the virus are showing little sign of slowing down, and so treasurers are naturally focused on mitigating the risks and limiting the financial impact on the wider company. However, once things start settling and returning to normal, businesses will likely be slightly quieter than usual. Pryor suggests this could be the time for treasurers to “spring clean” policies and processes. “We are seeing that for any business that is fortunate enough to still be pretty secure at the moment, their focus is very much turning to opportunity and improvements in their business so that they are ready and equipped when things turn,” he concludes.

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