Many companies have been made comfortable with the risk-return insurance aspect of using options.
As the members in The NeuGroup’s two FX Managers’ Peer Groups gear up to convene for their biennial FX Summit in Los Angeles next week, the use of options tops the agenda, and for some specifically the ability to justify spending money upfront on option premiums. It follows that the “new normal” of higher volatility – while much lower now than at the height of the financial crisis – would test FX managers’ inclination and ability to hedge with the resulting higher-cost options.
Thirty-two members of FXMPG groups 1 and 2 completed all or part of a pre-meeting survey, which revealed that 40 percent of them are either not allowed at all to use options as part of their arsenal of risk-management tools (25 percent), or are required to use only zero-cost options structures (15 percent). Of those who are permitted the use of options at a cost, far from all have a budget with a fixed dollar number on it. The rationale varies but the more likely scenario is that option hedges are considered and approved on a case by case basis. Those with a budget have it reviewed annually and the number is based on factors like historical premium spend, cash-flow forecasts, target hedge-coverage ratios, FX plan rates, forward curves, interest rates and FX volatility levels.
So, what can the “have-nots” learn from the “haves” to advance their case for a future option premium budget?
Make sure senior management has the risk/opportunity trade-offs defined quantitatively
Many senior management teams have been made comfortable with the risk-return insurance aspect of using options: protecting the downside while allowing for gains on the upside. Some use VaR to define the risk. One member said he explains how derivatives can help protect foreign-currency denominated cash flows from a multi-year appreciation of the USD while still allowing for the upside in the event of USD weakness; this preserves the ability to continue strategic spending like R&D even in periods of USD appreciation.
Promote comparability
A premium seeker might also argue that, if the market is efficient, the expected NPV from hedging with options over time would be $0, just as with forwards or not hedging. The use of options, however, allows for comparability to peers that hedge with forwards during extended periods of USD strength and comparability to peers that do not hedge during extended periods of USD weakness.
Reported earnings impact is not as scary as thought. For those concerned with volatility of reported earnings, premium spenders say that, once options hedging is underway, only the year-over-year changes in hedging cost impact earnings (this assumes the hedges qualify for hedge accounting and excludes the impact of payouts on in-the-money options).
An investment in shareholder value creation.
Finally, academic research indicates that companies that hedge cash flows have a valuation premium over companies that do not hedge cash flows. While not an endorsement of options exclusively, you can always “scare them with forward- points cost,” as one FX pro suggested.