Taking a Holistic View of Risk

The Deutsche Bank-sponsored summer 2014 meeting zeroed-in on rules-based hedging and taking a view on FX. 

When members of The NeuGroup’s second group for foreign currency managers, the FX Managers Peer Group 2, met in San Diego in September 2014, it was revealed, among other things, that several member companies have new CFOs, which may prompt changes to the risk management direction or at least reviews thereof. Growth means more focus on adding currencies to the hedge program, like China’s, for the first time for some. Problems continue in markets like Turkey, Venezuela and Argentina. Further highlights from the meeting included:

1) Regulatory Update. Sponsor Deutsche Bank updated the group on regulations. One key takeaway: NDF liquidity has dropped during New York hours due to mandatory SEF execution. Outside of the US, banks can transact with both SEF and non-SEF counterparties, which has created bifurcated liquidity. Corporates should weigh the cost and basis risk of using more standardized contracts.

2) Hedge Implementation and Rules-Based Hedging. This session focused on taking a holistic view of risk and determining if a rules-based model incorporating VaR and other factors could ensure more bang for the hedging buck. If you agree that there are systematic returns in FX, you should be open to a systematic, rules-based approach to medium-term hedging, meaning stepping away from “no-view,” market-neutral hedge decisions.

3) Designing a Share-of-Wallet Calculation. A look at the key components of a model (in development) for estimating one member company’s total treasury wallet and building a process for how to use it with its banks. When reducing the number of partner banks and developing deeper relationships with them, it is key to know all the sources of business in the enterprise and how profitable (if possible to estimate) those flows are to the banks.

4) Emerging Markets Hedging. One member discusses his company’s reassessment of emerging markets hedging and hedging in general. This company’s business has grown and changed so much since the program’s inception; key to the review is a full understanding of the nature of the company’s exposures, and how to measure them and the impact of hedge actions in a meaningful way.

What to Know: Dodd-Frank and EMIR

Deutsche Bank gave a state-of-play of some regulatory issues and their potential impact on markets, hedge behavior and cost.

KEY TAKEAWAYS

1) More jurisdictions are regulating derivatives. Not only is Dodd-Frank’s reach long and EMIR reporting requirements are in effect, but MiFID2 is coming too, as well as likely reforms in Switzerland and Singapore, for example. Over 80 percent said in the pre-meeting survey that they hedge for Swiss-domiciled entities, and over 50 percent for Singapore-domiciled ones. In addition, treasury will likely have to deal with some aspect of FATCA compliance.

2) Regs’ effects are beginning to be felt for real. Deutsche Bank predicts and has observed the following effects of current regs on the FX markets:

• Collateral and capital requirements will be the key determinants of cost evolution; costs in general around transacting FX will increase, particularly with longer-dated uncollateralized derivatives.
• Fragmentation of liquidity between the cleared and non-cleared worlds. Geographic fragmentation may also occur if regulators fail to recognize cross-border clearing regimes.
• The introduction of mandatory electronic execution of NDFs over a SEF has resulted in a drop in liquidity during New York hours. Outside of the US, banks can transact with both SEF and non-SEF counterparties, which has created bifurcated liquidity.
• Corporates in particular may have to weigh higher transactions costs arising from bilaterally traded, bespoke hedges, against the basis risks and costs of transacting standardized contracts.
• Potential for greater product standardization, which will reduce transaction costs but potentially lead to basis risks. Greater adoption of listed derivatives could lead to gamma concentrations at discrete points.

OUTLOOK

Corporate end-users are exempt from many of the onerous requirements in Dodd-Frank, including margin requirements, and the exemption looks likely to extend to in-house banks and treasury centers as long as they are not incorporated as banks or commercial lenders. As rules get finalized, it is looking like there is political appetite for making sure that the corporate community does not get too squeezed by the regulations in a direct way. Of course, the indirect pressures emanating from the heightened regulatory framework that banks are subjected to will trickle down in terms of compliance burdens and costs, regardless.

Hedge Implementation and Rules-Based Hedging

This session began by looking at the benefits of currency diversification and correlation effects, and whether the no-view-on-FX-rates approach should be reassessed in favor of a rules framework that allows hedge decisions to take into account factors like PPP and FX rates’ reversal to mean to determine hedge tenor, ratio and hedge instrument.

KEY TAKEAWAYS

1) Cost does not equal value. Measuring the cost of hedging does not show its effectiveness or value. Instead, it was suggested, for example, that members consider risk reduction at given levels of option premium spend. To decide what level to hedge/spend, a company must have a clear view of its risk tolerance: a quantitative framework should be able to be calibrated for whether, for example, upside should carry less weight than downside.

2) How many currencies should you hedge? Instead of an exposure thresholdbased hedge program, the speakers are more in favor of a VaR model incorporating diversification and correlations effects, but also how each individual currency’s contribution to overall risk is affected by its volatility. Applying value-at-risk modeling to this analysis, one can identify the greatest risk-reduction bang for the hedge buck. At least one member saw this session as timely because they have been requested to significantly reduce the number of currencies it hedges. Adapting this model to its situation might go a long way in figuring out which currencies to no longer hedge while still obtaining acceptable risk reduction.

3) Please do take a view. If you agree that there are systematic returns in FX, as was proposed, you should be open to a systematic, rules-based approach to medium-term hedging, meaning stepping away from “no view,” market-neutral hedge decisions. Signals to look for are (1) PPP and reversal to the mean (the example used was in the last several decades, the EURUSD has trades within a 20 percent band of PPP 71 percent of the time, and periods outside of that have been short-lived); (2) carry, i.e., high-yielding currencies don’t depreciate as much as the implied forward indicates; and (3) momentum, meaning the past trend is likely to continue in the short-to-medium term. Each company can weight these three factors differently in the rules that will determine hedge decisions. A caveat: Don’t “over-optimize” based on historicals: consider in-sample/out-of-sample choices, and recognize that volatility is a blunt instrument and that there are more ways than PPP to measure the long-term fair value of a currency.

OUTLOOK

As FX risk management becomes more sophisticated, more companies are shedding the approach of hedging exposures over a certain threshold in favor of a more effective “at risk” model, or are analyzing how to go about a transition. That should not mean a departure from a strict to a loose framework (not a hit at the board level), but rather one that is more holistic both in its look at the company’s total exposures, risk tolerance and risk management budget, and the factors contributing to risk, as well as what combination of mitigating actions is most effective.

Designing a Share-of-Wallet Calculation

In preparation for next year’s credit facility renewal, one member’s treasury has been charged with coming up with a model for estimating the company’s total treasury wallet and building a process for how to use it with its partner banks. Overall, the company is reducing the number of banks and bank accounts, and seeks to have fewer but deeper relationships with best-in-class partners as a result of the next credit renewal.

KEY TAKEAWAY

1) Where is money going from your company to banks? In the pre-meeting survey, members cited service fees, FX trading volumes, cash management volumes, investment volumes, debt activity, M&A services, share buyback commissions, letters of credit and guarantees, 401k fees, credit card fees and retirement plans as items that get included in wallet analysis. Members also think that the liquidity you have with a bank through deposits or cash-management flows should be assigned some value, at least in the MMF yield range.

2) FX is not always given to credit banks. In the pre-meeting survey, competitive pricing and counterparty risk were much more common determinants (over 90 percent) for allocating FX business to a bank than debt-facility participation (about 60 percent). Many other things play a role in allocating FX business, and credit is a ticket to the dance, not a guarantee for business. Certain currency pairs can be the expertise of a non-credit bank, for example. Counterparty risk concentrated with just a few banks may also prompt a trade to go outside the bank group.

OUTLOOK

In the continuing shake-out of corporate-bank relationships (where increasingly the emphasis for corporates is on partnerships and finding the banks that will fit their needs, and for banks to do business with them in a profitable way), both sides are taking a more granular look at what the relationship looks like, what it costs and what value it brings. As a result, share-of-wallet analysis and performance-tracking have been subjected to closer scrutiny in recent years, and will continue to be valuable tools in doling out the treasury wallet appropriately.