Only about half of companies with interest-rate, FX or commodity exposures use derivative hedges, according to a study released by Chatham Financial in mid-October. Meantime, a sizable majority of these companies employ hedge accounting to minimize earnings volatility.
The study of 1,075 publicly listed companies arrives five years after the financial crisis and the ensuing record volatility which, as the study notes, greatly elevated risk management in the eyes of companies’ top executives.
The Chatham study, “The State of Financial Risk Management,” found that 89 percent of companies analyzed have exposure to interest-rate risk and only 43 percent of those companies manage the risk using derivatives, an unsurprisingly low percentage it attributed to the historically low interest-rate environment in recent years. More surprisingly, 75 percent of companies have exposure to FX risk but only half use derivatives to hedge it, while just over half acknowledged exposure to commodity risk but only 43 percent of those managed that risk using financial derivatives.
Those risks can be mitigated without using derivatives. For example, a US company could pay its Brazilian employees in dollars and eliminate its exposure to swings in the real’s value; however, convincing those employees to accept payment in US dollars is clearly not practical, said Amol Dhargalkar, who heads up Chatham’s risk-management team serving corporates.
Mr. Dhargalkar noted that suppliers typically can be paid in dollars, but that may be changing; Chinese suppliers, for example, are increasingly asking to be paid in renmimbi. Other tools to reduce FX risk, such as reducing the number of intercompany loans, tend to provide partial solutions that can be challenging to implement.
Mr. Dhargalkar said one reason companies are using fewer derivative hedges than might be expected, particularly in the currency and commodity realms, is that applying such hedges effectively requires a deep understanding of a company’s businesses and its exposures. Then “stakeholders” must be educated and incented to provide the necessary information. “There are a fair number of cross functional challenges to run any meaningful cross currency or commodity program,” Mr. Dhargalkar said.
Further complicating matters is that it’s not always clear whether the responsibility lies with the treasury or procurement departments, and then whether derivatives or supplier contracts, or a combination of both, is the most effective approach. Mr. Dhargalkar said a best practice is “to take a step back at the senior management level to define what the key objectives are, then create a hedging committee comprising senior management in areas including procurement, accounting and treasury, to create a program that makes the most sense.”
Seventy-seven percent of companies using interest-rate hedges also apply hedge accounting, with 81 percent of companies employing cash flow currency hedges seeking such treatment and about 60 percent of companies hedging commodity risk doing so.
“There’s an expectation from public investors that a company will apply hedge accounting, especially for interest-rate and FX risk,” Mr. Dhargalkar said. “The question then becomes, if investors expect that, hedge accounting then becomes a universal requirement based on investor expectations.”
He added that applying hedge accounting can be very nuanced, requiring expertise and careful interpretation of accounting standards, and it typically requires the treasury and accounting functions to work together and to identify goals and how best to achieve them. Hedge accounting may be applied least in the commodity realm because it requires treasury officials to develop a deep understanding of the company’s businesses.
Besides hedge accounting challenges, the Chatham study said, implementing and maintaining active risk management programs can create hurdles for viewing exposures across the organization; thus developing a coordinated risk-management program can be challenging.
In addition, “Multiple divisions within an organization may have responsibility for financial risk management, such as procurement for commodities or regional managers for their own P&Ls, resulting in disparate understanding of exposure and financial risk management options,” the report said.