Risk Management

Question Answered: Hedging strategies

Published: Jan 2016

This issue’s question

“What hedging strategies are being adopted across the region to address volatility in the commodity and currency markets?”

Devesh Divyia, Associate FX Strategist, FICC Research, Standard Chartered

Devesh Divyia

Associate FX Strategist, FICC Research
Standard Chartered

Robert Minikin, Head, Asia FX Strategy, FICC Research, Standard Chartered

Robert Minikin

Head, Asia FX Strategy, FICC Research
Standard Chartered

The USD has made significant gains against Asia ex-Japan (AXJ) currencies for three straight years. This weakness in AXJ currencies has been driven by a combination of Fed policy tightening expectations, weak external demand and a collapse in commodity prices. The currencies which have been the hardest hit, not surprisingly, are the largest net commodity exporters in the region – Indonesia and Malaysia.

We believe corporate treasurers in the region have now almost entirely embraced the expectation of continued USD strength both in the run-up to and beyond the first Fed rate hike in almost a decade. In line with that, corporates in Asia with USD payables have steadily increased their hedge ratios over the past year or so. As such, while we could still see incremental hedging-related USD demand post the Fed hike, we do not expect a ‘taper tantrums’ kind of market stress scenario, as corporates are much better hedged compared to 2013. In India, for instance, central bank data as well as our own proprietary FX flow data supports the view that corporates with FX liabilities have shown an increased propensity to hedge. The Reserve Bank of India reported that hedge ratios on external commercial borrowings and foreign currency convertible bonds had improved to 41% during April-June 2015, compared to only 15% during July-August 2014.

Hedging strategies for corporates with net USD receivables have not been uniform across AXJ markets. In India, given the very attractive carry, exporters have either increased the hedge ratios or extended the duration for which they hedge their receivables. However, in Malaysia, where domestic currency depreciation has been far more entrenched and the carry is not as attractive, exporters have generally remained on the sidelines awaiting better levels to sell USD-MYR.

In North Asia, China’s FX policy is in transition from an official focus on the CNY value against the US dollar to a focus on the CNY’s value against a trade-weighted basket of currencies. This creates scope for greater two-way variability in the USD-CNY spot rate and over time will likely prompt more active hedging of forward CNY-denominated receivables and overseas FX payables by corporates in the region. So far, MNCs in Asia have been particularly active in hedging their FX exposure. Mainland China exporters appear to have scaled back their USD forward sales following the August China fix reform and mainland importers may have boosted holdings of USD deposits onshore. However, there is still considerable growth for more active China importer hedging of FX risk – not least as the domestic options market finally springs into life.

Commodity prices at multi-year extremes have sparked an upturn in corporate hedging activity both by producers and consumers with a particular focus on metals (such as copper and aluminium). Consumers may have been active in longer forwards locking in depressed prices while option strategies potentially help protect producers from balance sheet stresses associated with any new downdraft in global commodity prices.

Ian Farrar, Corporate Treasury Leader, PwC China & HK

Ian Farrar

Corporate Treasury Leader
PwC China & HK

There has been considerable concern about currency volatility building over the last year. The weakening euro at the end of 2014 and early 2015, and the devaluation of RMB over three days in August 2015, were events that focused corporate minds on hedging possibilities that their companies perhaps had not previously considered in earnest. Last year also saw commodity prices plummet. Ensuing hedging strategies aimed at benefitting from such declines have tended to be industry – and often entity – specific. Chinese airlines, for instance, tend not to hedge fuel, giving rise to windfall gains compared to other airlines locked in at much higher rates. Unhedged airlines, however, are obviously susceptible to future increases in the price of oil if they remain unhedged.

Given the recent sea change for commodities and currencies, now might be a good time for corporates to revisit their hedging strategies. But such a review across Asia Inc is not necessarily evident from available information. When we help companies review hedging strategies, it is not uncommon to find that decisions are not aligned with the company’s claimed hedging objectives. Equally, a closer look at these strategies may reveal that they are only optimal at certain points in the range of commodity or currency rates. For example, the use of certain instruments might be a sound strategy when oil prices are low, but not further up the curve.

We often find there is also an element of commodity basis risk. Corporates often do not hedge their entire exposure – frequently on the grounds of availability of suitable instruments, a lack of clarity where they might uplift bunkers, or because the cost of a matching instrument is prohibitive.

Hedging strategies in currency markets can generally be split into two main areas: FX exposures arising from purchases/sales (‘trading’) and exposure to foreign currency debt. Historically, many Asian companies have not hedged, or (for those that have hedged) under-hedged their FX exposure from trading activities. In some cases, this was because they were actively taking a position on future currency movements. In others it was due to inadequate forecasting capabilities; if a corporate cannot reliably estimate the extent of their currency exposure in any period it is often prudent to scale back hedging activities. Those companies that have hedged tend to use simple instruments – swaps and forwards. We are, however, seeing more companies at least considering options-based products, particularly those dealing with RMB.

Finally, in 2016, we hope to see a slight change in the mind-set of some companies, typically those new to hedging. These companies tend to view the success of their hedging based on whether or not they achieved a better rate. Instead, treasurers need to measure their hedging strategies based on whether it achieved their objectives, regardless of whether a hedge ‘won’ or ‘lost’. For example, did they ‘fix’ their cash flows successfully, so they had certainty? There is a lot that can be done to manage ongoing volatility; it’s largely a question of making sure decisions made in the name of risk management are being made for the right reasons.

Tony Marrinan

Head of Financial Sales, APAC

The Asia Pacific region has suffered from a significant amount of volatility in recent years. Within treasury departments, companies are having to adopt new strategies to manage these volatilities – and even look to ways to profit from them. We are seeing companies respond in a couple of different ways. At a higher strategic level, companies are having to re-evaluate their hedging policies and strategies and on a tactical level, they are attempting to view and manage their risk holistically across the enterprise.

Strategic reviews are being undertaken by many companies attempting to better define the risk/return profile of the enterprise. These endeavour to ensure that all risks are identified and quantified before policies are formulated to manage these risks. Increasingly, these policies are becoming a matter of consideration for the board who need to agree on the nature and structure of hedging strategies. Factors for consideration in a strategic review include: minimising year-on-year cash flow volatility, protecting financial targets, managing financial risk within a board approved risk management framework, maximising the use of increasingly tight bank counterparty credit risk and available credit lines, approving an appropriate budget for option premiums and defining the size of mark-to-market position of derivatives. Corporates will, of course, also be looking at competitor hedging strategies.

Tactically, one of the hurdles to effective hedging has been that many businesses place a distinction between currency hedging and commodity hedging. Traditionally, commodity hedging has taken place in the procurement department, while currency hedging is carried out by the treasury. However, there is increasing recognition that there is correlation between these two risk areas, and effective risk management cannot be pursued while these are siloed. Most businesses recognise the most effective hedge is the natural offset. Therefore, corporates need a holistic view of commodity price risk, FX exposure risk, and liquidity (interest rate risk) to maximise the benefit of possible offset. This can be hard to measure and control when commodity hedging is managed by procurement, FX risk by treasury, and liquidity risk by finance.

Consequently, more and more companies are bringing these risk areas together under a single management – risk management, treasury or finance. This presents many benefits, including: improved risk management across the enterprise by enabling complete visibility to correlated risk factors, maximised value of hedging expenditure by eliminating ‘double hedging’ and improved decision-making by enabling integrated risk modelling, simulations and analytics reporting. Corporates can also measure pre and post trade hedge effectiveness to minimise earnings volatility. This enables the enterprise to automate hedging rules and methodologies to ensure that hedges are being correctly designated. This benefits finance by giving reassurance that earnings statements are being correctly reported and subject to minimal volatility. Finally, being able to measure hedge effectiveness and minimise earnings volatility enables the business to automate the application of hedge accounting rules and methodologies to ensure hedges are being correctly treated. It also provides reassurance that earnings statements are being correctly reported.

Globally, we are seeing the rise of corporates with considerable exposure to commodity and currency risk through their supply chain evaluating solutions to best help them hedge and manage considerable input price changes to their business.

Next question:

Since the financial crisis, corporates in emerging markets (EMs) have been able to borrow increasingly cheaply in foreign currencies, leading to record dollar denominated bond issuance in Asia. Where should EM corporates focus their funding strategies following the rate lift-off recently embarked upon by the Federal Reserve?

Please send your comments and responses to qa@treasurytoday.com

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