Japan has been the first major economy to blink in the game of currency valuation. Due to new Prime Minister Shinzo Abe’s aggressive monetary policy, such as a higher 2% target for Japanese inflation, the yen (JPY) has experienced a 20% fall since November. The depreciation has also been a primary driver of the longest weekly run of gains for the Nikkei index since 1959, according to Reuters.
The action is clearly a calculated attempt to wrench Japan out of its 20-year plus stagnation pattern. The idea is that as the JPY weakens, Japanese exporters will become more competitive at the expense of other Asian exporters. A weak currency also increases the cost of imports, thus making domestic producers more competitive in the national economy, again driving growth. (However, the negative side is that it drives up the costs of imports, for example oil, and runs the risk of encouraging inflation.)
This has fuelled fear of a new round of ‘currency wars’, as other countries respond in kind and simultaneously weaken their own currencies in order to stay competitive. The other G7 nations – the US, UK, Canada, Italy, Germany and France – were quick to condemn, using economic policy to target exchange rates; however, the G20 meeting in Moscow, following close after the G7 statement, only called for a “commitment to refrain from competitive devaluations” and stated that “monetary policy would be directed only at price stability and growth”.
Japan responded by leaving the door open for outright purchases of foreign bonds to weaken the JPY further, a move that could put it on a collision course with the US and Europe.
FX volatility: possible rise in 2013?
In 2012 FX volatility – both on an implied and actual level – had fallen back from the elevated levels created in the aftermath of the financial crisis in 2007/8, which had affected even ‘safe’ currencies such as the US dollar (USD), the euro (EUR) and sterling (GBP). For example, one-year implied volatility for the EUR versus the USD slipped below 9% on 20th November, the lowest since February 2008. On the same day, JPMorgan Chase & Co.’s G7 Volatility Index declined to the lowest since 2007.
A low volatility environment persisted in spite of the fact that many macroeconomic risks, such as the Eurozone crisis, the US debt crisis and the central bank’s unconventional monetary interventions, remained to a large extent unresolved. This puzzled many industry analysts over the course of the year.
However, it was the knock-on effect of these unconventional activities – whether direct, such as the active suppression of volatility in the case of the Swiss franc (CHF), or indirect, such as keeping the interest rates low – which helped to dampen volatility, effectively sinking the carry trade. Carry trade is the practice of obtaining funds in a country with low borrowing costs and investing in those nations with higher interest rates. According to Kevin Lester, Director of Risk Management and Treasury Services at Validus Risk Management: “killing off the carry trade effectively kills off a lot of market activity and, in turn, volatility.”
In addition, Lester believes that a retreat in corporate hedging programmes contributed to a low volatility environment. This pull-back happened for a variety of reasons. “One reason is that the global macro uncertainty made corporate’s cash flow forecasting much less certain and therefore made them more unwilling to hedge,” he explains. “In addition, the cost of hedging is going up with new Basel III regime coming in. As we all know, as the cost goes up, the incentive to do it goes down. These factors, among others, came together last year to bring volatility right back down to – and in some cases below – the long-term average.”
Although much of the FX fluctuation seen early in 2013 has been a by-product of JPY developments, it can also be seen as a result of a resurgence in the carry trade, which had its best start to the year since 2007. “If we see – and that is a big if – a return of carry trade activity by the speculative side of the market, then that will be a catalyst for volatility,” Lester says.
Another reason why the FX market is experiencing increased volatility is because of uncertainties surrounding the end game of unconventional central bank actions. “We knew this was coming from the day that quantitative easing (QE) was initiated, but it can take a long time to play out,” says Lester. He highlights Financier and Philanthropist George Soros’ statement at Davos indicating that interest rates will spike this year on the back of inflation. “Even though most people wouldn’t necessarily agree that it will happen this year, it is a sign that people are starting to factor in what the effects of unwinding QE will be and how we can put the genie back in the bottle, so to speak. That will be a source of volatility in the FX market without a doubt.”
A Financial Risk Manager at a large cruise liner company, who asked not to be named, agrees with Lester’s general assessment of the state-of-play. “I think that volatility will increase this year due to the likelihood of government action – no one knows what to expect, so government announcements and central bank actions cause a great deal of activity in the FX market,” she says.
When measuring and predicting FX risk, the more advanced treasury group usually employs value-at-risk (VaR) and/or cash-flow-at-risk (CFaR); some even use Monte Carlo simulation to quantify their risk. For non-financial corporates, CFaR is the more appropriate tool, according to Rey Sermonia, ex-Treasurer turned Treasury Advisor, for it gives a probability distribution or range of values of a company’s operating cash flow over a specific time horizon, based on information available today. VaR, on the other hand, focuses on asset values and is usually used for shorter time horizons, such as a day or a week.
The Financial Risk Manager’s approach to assessing FX risk is to look at exposures to each currency and historical and implied volatility to see what the company’s range of outcomes could be from FX revenues/expenses and commitments. She also tries to assess whether the company’s exposure to currencies has any natural offsets (for example fuel) before implementing any hedging. But she admits that there are some disadvantages to using these inputs. “There is no guarantee that historical relationships will continue to hold, nor is there any guarantee that FX will be within its implied range, so we could be relying on information that will bear no resemblance to what actually happens,” she explains.
This is an important point to make, particularly at a time when many are expecting volatility to return to the market. According to Validus’ Lester, treasurers need to be careful about relying too heavily on probabilistic analysis tools because a bias can be “baked” into the analysis and they need to be cognisant of this. “When using these tools treasurers will plug in a volatility number, which would be a relatively low number according to 2012’s market conditions. As a result, treasurers will see their risk reducing and also the value of hedging coming down – but in reality that is a dangerous mistake. It highlights a big flaw in this type of risk analysis tool, which is plugging in a constant for volatility – which is anything but constant.”
Sermonia believes that one could also use the Monte Carlo method. “If I were doing it today, I would use Monte Carlo simulation,” he says. “Monte Carlo is a computerised mathematical technique using algorithms which gives you a range of possible outcomes and the probabilities that they will occur for any choice of action, for example what happens if you hedge versus what happens if you don’t.”
Fundamentals: making the hedging call
Most treasurers’ gut reaction is that hedging is a good thing, but nothing can be a good thing all of the time. For example, Honda Motor Co. Ltd was one Japanese company caught out by the recent JPY depreciation. According to Reuters, Honda’s CFO Fumihiko Ike reported that the company hedged currency trades three month out (a common practice among Japanese exporters) which meant its fourth quarter sales were booked at JPY levels near a record high.
But how does a treasurer know when – or if – to hedge? Sermonia believes that treasurers shouldn’t be hedging if they can’t identify where the value is coming from. Jonathan Binke, Global Head of FX Products at SuperDerivatives, adds that a company also needs to be clear as to its risk appetite and target levels. “You also need to have an informed opinion about your expectations for the future path of each market you are exposed to. In light of the answers to these questions, you can start to consider the relevant pros and cons of each strategy, and then focus on those strategies that best meet both your targets and expectations for the future.”
The Financial Risk Manager agrees that determining risk tolerance, balanced against liquidity constraints, will help to determine which products to use, as well as how much exposure to hedge.
“Treasury needs to understand the company’s risk tolerance, tolerance for earnings volatility, and whether paying option premiums would be considered, and then determine whether hedging should be done to take some risk off the table.”
Lester identifies three fundamental questions that will help in determining whether hedging is in the company’s best interest:
- How does FX hedging relate to the internal business? For example, if the business has a lot of pricing capacity and capability, it might not need to hedge.
- What is the objective of hedging? Is the company trying to stabilise cash flows, prevent a violation of a lending covenant or improve ability to forecast future cash flows?
- How is the FX hedging programme integrated with the underlying business?
“Many companies miss the third point,” says Lester. “It is useful to step back and ask where exposures come from – and if they are managed differently, what is the knock on effect to business? It is all about integrating risk management with the underlying commercial objectives of the business.”
Returning to his earlier point, Lester emphasises that low volatility is a dangerous indicator as to whether to hedge or not. “When volatility, and therefore the cost of hedging, is coming down, then it makes sense to hedge more – but intuitively we take the opposite stance based on the expectation that low volatility will continue into the future. But history tells us that a period of calm is followed by a period of volatility. Currently volatility is low and hedging is quite affordable, so all things equal you should be hedging more.”
Robert Wade, Head of Corporate Electronic FX Sales at Deutsche Bank, agrees. “Our view would be that treasurers should use this opportunity, when it is more cost efficient to hedge, to better position their company for the extreme events.”
The Financial Risk Manager adds: “there is no guarantee that FX rates will mean-revert, so not hedging in anticipation of a particular rate returning to more of a historical norm is just increasing exposure. Having said that, I don’t think that companies should rush to hedge when rates get away from them. A measured approach to hedging, with the opportunity to increase hedging if rates become more attractive, is prudent.”
The gold ticket
A recent report from the World Gold Council promotes the use of gold as a valuable option in hedging currency risk in emerging markets.
According to the World Gold Council’s report, entitled ‘Gold and currencies: hedging foreign exchange risk’, gold is a much overlooked yet valuable option for hedging FX risk in emerging market currencies. Although gold is not a substitute for an FX hedging programme, it can supplement the strategy in a positive way.
The report argues that there are certain things that work in gold’s favour as part of a hedging strategy:
- Gold has a negative correlation to developed market currencies, in particular the US dollar, but also applies to other currencies such as sterling and euro, especially during periods of systemic risk.
- It is positively correlated to emerging markets growth cycle, as a significant demand comes from emerging markets. For example, India and China have made up about 50% of the world’s demand over the past few years.
- Gold has a lower cost of borrowing than emerging market currencies. To put up a position in India rupee, Brazilian real or Russian rouble would mean borrowing at the country’s (sometimes offshore) interest rate, which is what makes hedges expensive. If a company included a gold overlay, it could borrow cash directly at its local cost of borrowing, which is currently extremely low.
- It offers tail risk protection. Therefore, if there is a systemic risk within the financial system that creates a flight to quality, then gold is going to benefit. In this way it can be used to hedge away a tail event within an FX exposure.
“One thing that stands out – and will always be present – is that gold offers tail-risk protection to investors with or without foreign currency exposure,” says Juan Carlos Artigas, Global Head of Investment Research at the World Gold Council. “But the other three factors also need to be present for gold to be useful as an emerging market currency hedging strategy.”
Key findings of the report include:
- Over eight periods of crisis conditions examined in the report, including gold in currency hedging strategies in an emerging market portfolio offered cumulative outperformance of 2.4% above an un-hedged portfolio and over 1% above a currency-hedged portfolio.
- Adding a gold overlay to emerging market assets reduced portfolio peak-to-trough declines over the past decade, on average, to 9.2% from a 12.5% decline in currency-hedged portfolios and a 13.1% decline in unhedged portfolios.
- The average costs of hedging a basket of emerging market currencies is currently over 4% compared to less than 50 basis points on borrowing costs for a gold overlay.
“Over the past few years, gold has become more widely accepted as a source of collateral and a high quality liquid asset,” says Artigas. “Therefore, more corporates are coming to understand the value of gold as one tool in their arsenal to hedge currency risk.” He believes that it is first a matter of “awareness, knowledge and implementation” before it becomes widespread practice among corporates.
