FX teams are grappling with currencies that are expensive to hedge and changes to hedge programs and transition challenges, in addition to the strong USD.
The FXMPG convened in September for its summer meeting against a backdrop of the continuing strong dollar cycle, and with some volatility added to the mix. Discussions included the need for periodic review of hedge policies and strategies, especially in light of the dollar direction, and earnings hedging as a potential alternative to other types of FX hedging.
1) FX Risk and Impact on Results — The Increase in FX Volatility and How to Mitigate the Risk to Earnings. Companies should consider the economic protection of average rate hedges versus the benefit derived (no mark-to-market) from an accounting-friendly but less economic hedge.
2) Hedge Strategy Considerations, Policy, and Decisions. With Dodd-Frank in effect, many review their programs as part of the annual end-user exemption approval. The most commonly reviewed items are tenor and the types of instruments used.
3) Hedge Decision Analytics and Process Support. Where policy leeway allows for choices on tenor, instruments and ratios, a new currency value tracker may be able to add perspective.
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Integrating FX Risk Management into Business Processes
One of the ongoing challenges for FX teams is to get the information it needs from the rest of the organization to be able to perform effective risk mitigation and hedging. When such information gathering is subpar, it is often because people out in the business lack a solid understanding of the nature and potentially costly implications of bad or late forecasts or neglected communication of critical events that affect FX exposures. Those with the best risk management outcomes often spend significant time educating their counterparts in the business to bridge this knowledge gap.
Any new approach needs to be thoroughly understood in the organization. FX management is hard enough to communicate in terms of how it works and the benefits it provides the company; if significant changes are made, an educational effort is required for them to have the desired long-term effect. Treasury at a global auto manufacturer engaged with business leaders directly by way of an international roadshow aimed at improving risk management of foreign currency exposures through better understanding and improved collaboration with business partners outside of treasury and financial planning.
Additionally, FX teams should promote understanding of short-term protection versus long-term risk mitigation through strategic business decision making. While hedging can mitigate shorter-term risks, longer-term risk can be mitigated with longer-horizon strategic decisions — based on better understanding and transparency of foreign exchange exposures, and improved corporate reporting and analysis — that reduce or eliminate FX exposures.
FX Risk and Impact on Results
The vast majority of respondents in the pre-meeting survey said the stronger dollar had had a slightly or very negative impact on financial results so far. Invited expert speakers from BNP Paribas, an FX strategist and an FX marketing executive, led the session. The FX strategist began with a look at the USD recent past and his outlook for it, and was followed by a corporate advisory take on how it has and could impact earnings and the ways companies can mitigate this risk.
Key Takeaways
1) The dollar hasn’t peaked yet; rate hikes will come, but not in a hurry. The dollar was still 9% off the 2002 peak at the time of the meeting, indicating that the next peak could still be 2-3 years away; however, the fast pace of the strengthening has surprised many. The “divergence theme” (US rates rising while other Central Banks lower theirs or keep them stable) is alive and well, but so far, the gap is due to foreign Central Banks rather than any action on the Fed’s part. The strategist noted noted that the Fed has never tightened when the dollar has been in a rapid rally: “The domestic economy ultimately prevails, but [a] stronger USD means the Fed will go slowly.” He thought the Fed might start raising rates in December 2015, a view that was borne out by the decision of the FOMC to take a pass on a hike in September.
2) Earnings hedging no longer just a non-IG firm concern. BNP Paribas’ FX marketing executive remarked that earnings hedging used to be more the concern of non-investment-grade companies but that investment-grade firms have also felt the pain of a stronger dollar and have begun doing it to protect earnings against this risk.
3) Average rate options match earnings risk better, but get no hedge accounting for this exposure. Average rate options provide a precise match to the translation exposure, given that income statements are translated at the period average rate. However, while they are eligible for hedge accounting if used as cash-flow hedges, they are not when used to hedge earnings translation (the exposure, not the hedge vehicle, determines the hedge accounting qualification). But with a better match, they also have lower mark-to-market (MTM) volatility, an additional benefit for hedges that are ineligible for hedge accounting; thus the P/L impact would be significantly lower than from a spot-path, dependent-forward hedge. Corporate hedgers should consider the economic protection of this kind of hedge versus the benefit derived (no mark-to-market) from an accounting-friendly hedge. The BNP slides contain useful primers on average rate instruments: options, participating forwards and collars.
Outlook
If the dollar keeps strengthening for another 2-3 years, as predicted by the BNP team, there will be quarter after quarter of negative FX impact on financial results to report before there is any relief in that regard. If earnings is the focus of most of the stakeholders and the highlight of external reporting, at what point does the volatility to EPS caused by FX outweigh the lack of accounting benefits (negatives associated with MTM on hedges) on hedging earnings translation? More and more companies seem to be taking on this internal discussion.
Performance Metrics and Reporting FX to Management
An evergreen question among corporate practitioners is how to demonstrate that the FX function is performing well, i.e., doing the right things and doing them right. The conversation continues on how best to measure FX management results, as well as how the department’s performance is reported internally to senior management and Board.
A simple metric can be very hard to achieve. One FXMPG member company, an equipment manufacturer with global reach, has a simply stated key metric for the success of the FX hedging program: Offset two-thirds of losses or protect two-thirds of gains versus annual budget rates. It compares gains/losses of FX contracts maturing in current year to the FX impact on cash-flow (measured versus annual budget rates). Hedging losses, thus, should be a third or less of any positive cash-flow impact from the underlying; hedging gains should be two thirds or more of any negative cash-flow impact from the underlying exposure. Only net cash-flow exposures are hedged and there is no minimum hedge ratio required. The member cautioned that even if the metric looks simple, it is not easy to achieve (although to date, the company’s FX team has been successful).
Hedge Strategy Considerations, Policy, and Decisions
Given the backdrop of the dollar appreciation, members discussed what changes to their programs would be appropriate, if any, and what kinds of considerations are important in periodic reviews of risk management programs.
Key Takeaways
1) A periodic review of hedge policies and strategies is called for. However, what qualifies as a review differs in the group. Some consider the annual review with the board (or appropriate committee) for the Dodd-Frank end-user exception “renewal” as a review, while others say they update their global standard procedures every 2-3 years as a matter of routine, albeit with an annual review.
2) The “levers” of hedging are most commonly reviewed. Rather than wholesale change, which 30% still said they were looking at, many members reported they most commonly considered longer hedge horizons and a change in hedge instruments (50% each) in their reviews of how best to respond to the stronger dollar.
3) Who should own the hedge results? Opinions vary on whether the results of hedging should be pushed down to the subsidiary level’s P/L or be kept at the corporate level. Even if FX gains and losses are considered a cost of doing business, different companies take different tacks. The important consideration is to make sure that incentives and compensation produce desirable outcomes in terms of reliable forecasts of exposures and cash flows, and a sense of fairness.
4) What do you use your VaR for? Although more and more members are using some sort of at-risk measure to quantify FX risk (or take more comprehensive looks at a portfolio of risks including interests rates and commodities, depending on their business), how far they take the use differs. One member uses EaR to underpin his entire risk management philosophy and hedge as little as possible to keep overall EaR under a certain acceptable threshold (except the cash pool, which is fully hedged); others use it as one more tool in the analytical toolbox to understand exposures, but it does not affect hedge decisions per se.
Outlook
Whether prompted by dollar strengthening or not, many members are in the midst of or have concluded reviews of their hedge programs, with or without substantive changes as a result. Regardless, it is best practice to perform periodic reviews and to update processes and standards to keep them from becoming obsolete, ineffective or not responsive to business or market conditions.
Dealing with Embedded Derivatives
Embedded derivatives that seem fine at the time of entering a contract can later become a huge risk. A global media company in FXMPG is working to find and eliminate embedded derivatives in its contracts. “We’re trying to get rid of them and reconstruct our contracts without them,” the member says. Outside auditors suggested the embeds could become an issue if they are big enough. Any of the ones the company has would then need to be made marked-to-market.
Treasury within the company also wants to redo all USD contracts where people don’t want to use the dollar but want instead to use local currency, which increases the company’s exposure. “We want to share the exposure with local entity, but now the risk is back with us. So we’re spending a lot of time on embedded derivatives … trying to find a way to hedge all the risks.”
Hedge Decision Analytics and Process
This session, led by Ron Leven, Proposition Manager and FX Pre-Trade Strategist at Thomson Reuters, touched on recent events in China, an important market for most in the group, and themes related to the hedge decision-making and execution process, including in emerging markets, using analytics and reporting to ensure transparency, and best practices in the FX workflow.
Key Takeaways
1) Why did the Chinese devalue? The devaluation of the RMB in August came unexpectedly, but Mr. Leven questioned why it was so small if, indeed, the currency was so overvalued. While too small to boost competitiveness, was it a signal to take its internationalization ambitions more seriously? However, the PBOC is also constrained by reserve drawdowns, which dampen M1 growth and monetary stimulus capacity.
2) There is growing use of CNH. Trade use and financial market use of offshore RMB is increasing, and a more internationalized currency appears to be priced in by the market. However, Mr. Leven argued that some PBOC decisions appear not to support internationalization, e.g., it sets reserve requirements for derivatives and intervenes frequently to support desired daily FX midpoints.
3) More volatility is coming. Mr. Leven demonstrated that low interest rates and bullish equity markets have dampened USD volatility. But with equity markets hiccupping and rates expected to rise, volatility will make its return, and with it, the case for more corporate hedging of exposures.
4) So, how to make the best hedge decisions? Mr. Leven introduced the Thomson Reuters EIKON Currency Value Tracker, which is designed to help assess whether volatility is relatively inexpensive and what types of hedging structures take advantage of the pricing surface of forwards and options.
5) Reporting for hedge execution performance is adequate for current needs. FX teams should also review their trade execution performance, reports for which are available in e-platforms like Thomson Reuters (aka FXall). Price (67%) and speed (42%) are the most commonly used metrics in members’ FX execution policies. Share of wallet is an important consideration, too. More than half (57%) say their current execution platform is comprehensive enough for their best execution policy, and the same proportion of respondents in the pre-meeting survey say their systems for execution reporting are robust enough for compliance.
Outlook
While members are satisfied with their post-trade reporting, there may be opportunities to find cost-of-hedging related information that could add to analytical support of hedge decisions, assuming there is enough leeway in the policy to allow for hedge choices on tenor, instruments and ratios.
Conclusion
Faced with a dollar headwind and its natural effect on results, it is timely to review what the FX program is supposed to achieve and whether there is any fine-tuning that can be done to make sure it is performing well in adverse conditions, as well as in the “fair weather” conditions of the almost decade-long dollar tailwind. With a potential 2- to 3-year-long period of strengthening left to go, according to BNP Paribas, it may also be time to consider the economics of a well-matched earnings hedge against the often preferred accounting-friendly hedge alternatives that most employ today. Regardless, proper decision analytics are always welcome additions to the toolkit, and metrics need to reflect the FX team’s objectives and policy leeway.