FX managers consider hedge programs as dollar surges, then plunges.
The Foreign Exchange Managers’ peer group kicked off its first 2017 meeting in early March.The group heard Société Générale’s views about the dollar’s prospects and Fed actions, and an expert update about changes to hedge accounting requirements, and they had several topical discussions, including the option vs. forward choice and best FX trade execution. Here are three key takeaways:
1) As the Dollar Turns. SocGen provided a list of factors that supported a stronger USD, but a rocky start to president Trump’s administration has caused it to weaken since.
2) Finding a Risk Identification and Mitigation Approach that Fits. A member case presentation covered risk management goals, exposure ID and measurement, and which actions mitigate the most risk—“best value”—for the cost of hedging.
3) Options on Members’ Minds. Members view options as beneficial in unpredictable markets, but aren’t always sure about what kind of framework will determine when to choose them over forwards.
Best Practices in FX Trading and Execution
In an increasingly uncertain and volatile environment trading and execution takes on renewed importance. Members and the SocGen team shared experiences from their respective sides of the trade.
Best price isn’t always best execution. With a corporate policy to always seek best price, a member said “best price” at any moment can be proven using e-platform records, while steady deterioration of pricing over several executions may not fit management’s definition of “proving” what kind of price you got. And, best execution and diversification of counterparty risk are competing priorities that sometimes prevent trades with the bank with the best offer.
Banks may raise the price when provided with the same order twice because of the elevated risk faced by the losers of the first round; they don’t know the number of banks or the amount of capital bidding on the second. Splitting the trade into smaller pieces or using e-platforms, where banks can see if they are in competition, often improves pricing.
Challenge your banks, but work with them too. The distrust that sometimes prevails can prevent best-execution assistance from your FX bankers, but with mutual understanding of needs, good communication can bring rewards. And, with appropriate tracking and reporting, treasury can ensure that trades are fair and problems can be discussed based on data instead of suspicions.
As the Dollar Turns
At the time of the meeting, the USD was at record strength against virtually every other major currency. A senior economist and member of Société Générale’s Americas research team noted the factors supporting a still stronger USD, but he also explained why that was unlikely to happen. A senior US rates strategist argued that the biggest driver of interest rates wouldn’t be the “Trump reflation trade” but actions by the European Central Bank (ECB).
Key Takeaways
1) Lots of ‘yes’ factors. SocGen’s economist noted that the most topical events likely to strengthen the USD tend to be US related, but overseas developments could also push the greenback higher. Tax reform would be bullish for the USD, but half of the survey respondents saw that as only somewhat likely in 2017, and another quarter said more likely later. SocGen anticipated the Chinese economy slowing later this year as stimulus measures peter out.
2) But PPP and others are ‘no’ factors. The purchasing power parity theory, while a poor indicator of currency movements, indicated USD over-valuation while the euro and Japanese yen were significantly undervalued, suggesting currency-moving events were already priced in to make further USD strengthening a stretch. And, while a continued strong dollar could halt the Fed’s anticipated hikes, SocGen viewed it as more important if the ECB tapered its asset purchases, thereby bolstering the euro. They also saw Fed, ECB and BoJ policies as more likely to converge than diverge.
Outlook
If the economy continues to expand into 2018, it will be the longest expansion ever. What that as well as the possibility of major legislative initiatives impacting the economy will mean for the dollar and interest rates is up for debate. It behooves FX managers to make sure their hedging programs have a robust design that can withstand some volatility while having the mitigating effects they are designed to deliver.
Defining an FX Program that Aligns Strategy to Policy Objectives
FXMPG conversations often touch on setting hedge-program objectives and designing a program that achieves them successfully. A member shared how he identifies, quantifies and mitigates FX cash-flow risk.
Key Takeaways
- Have clean and straightforward goals for your process. One goal is to give straightforward analysis to upper management and the board, starting with how much of the bottom line is attributed to FX on a year-over-year basis.
- The limits of constant-currency analysis. The company’s “constant currency analysis” identifies and calculates the FX impact between different periods. But, while it’s a simple tool to adapt to different rate scenarios, it doesn’t show the changes due to volume differences. Nor is it a risk measure because of its backward-looking and static nature.
- How do you quantify the risk? By adding risk measures like standard deviation, VaR and conditional VaR, combined with Monte Carlo simulation to the analysis, forward-looking metrics can be derived. The company uses “at risk” metrics on FX-denominated operating profit to calculate the maximum economic value P&L could lose due to FX movement during a certain future time period at a given confidence level. The company found that while a variance/co-variance method is easy to implement and works well with certain hedging strategies, a more complicated Monte-Carlo simulation worked well with laddering, rolling and layering strategies and can sometimes be combined with constant-currency analysis.
- What price mitigation? Once FX risk is identified and quantified, should it be hedged? For example, in cases of low liquidity, small margin exposure, diminishing returns or little correlation between currencies, or high volatility, the hedge may become too expensive. As a result, a company may choose to only hedge a small number of currencies, or at lower hedge ratios. Due to correlation changes or change in circumstances, the chosen approach should be reviewed regularly.
Outlook
Defining the goals of a hedge program, and measuring how successful it is in achieving them is something most treasuries review from time to time, especially if significant changes have happened in the underlying business, e.g., mergers, divestitures, growth in new markets (new currencies), or because new management has a different philosophy on risk management and wants either to redesign it or validate it with a thorough review.
Net Investment Hedges: More Flexible than Intercompany Loans
Whether companies have an active net investment hedge (NIH) policy, or use it occasionally, what are the key factors when evaluating whether to use it?
NIHs hedge the FX risk to parent-level financial statements stemming from translating assets and liabilities of non-dollar functional affiliates. The change in the subsidiary’s net asset value sits in OCI until the risk expires (sub is disposed of or a dividend is paid). The SocGen bankers who led the discussion noted that corporates hedge this risk far less than they do operational and financial risks, instead achieving their desired level of exposure by extending an intercompany loan to the subsidiary and hedging it with a derivative. But, this exposure may be hedged just as effectively using often more-flexible NIHs, either by raising debt in local currency or synthetic debt using short-term FX swaps and long-term cross-currency swaps.
There are two approaches: The asset approach defines the NIH amount to cover the entire asset; the asset is fully hedged and there is no impact on equity. The ratio approach uses the NIH as a flexible tool to reach the ideal leverage the company wants in the specific currency, enabling it to stabilize ratios it considers key, for example to maintain a certain credit rating.
The Options vs. Forwards Decision
In a lively round-robin, the group examined decision parameters for determining which instrument best serves the hedge objective, generally or at a given time. Options are increasingly considered, but members don’t have a reliable decision model for when to use them.
Key Takeaways
- Budgets unfriendly to options, but OK for uncertainty. Cost of hedging is a serious concern, but so is cash out the door, which explains why many choose to lock in hedge results—even negative ones—with forwards instead of paying options premiums (see illustration on page 7). However, many do pay to use options for binary events, whether the Brexit vote or bid-to-award risk and M&A.
- Reduce cost of hedging with options. SocGen bankers suggest options to avoid forward premiums while remaining hedged. For instance, if there is a fair correlation between spot and forward, strike the put of the collar close to the spot level and the call to protect at a decent level. Selling options can help subsidize high hedge costs for currencies like BRL (only permitted in collars for most).
- Use options for high-carry, depreciating EM currencies. A member’s management recently suggested treasury explore devoting 25%-30% of its balance-sheet FX hedging program to long-term hedges using options for African currencies that will likely continue to depreciate.
- Back-test your program to gauge viability of another approach. To present a business case for using options for the currencies that cost most to hedge, a member performed a 10-year back test based on quarterly results, comparing forward one-month rollovers to a systematic program, using implied volatility levels to guide the choice of a forward vs. an option. The program produced losses in 2015 but has since been successful.
- Timing the switch. Another member said her group had developed a model (which could take into account a variety of factors like market conditions and “view”) to determine when to use options or forwards, but struggled with the timing of the switch from one approach to another for fear of later second-guessing.
Outlook
With all eyes on cost of hedging, there is a case to be made for options in uncertain circumstances, or to maintain upside when forward points are against you. Members are increasingly working on models to determine when to choose what instrument mix to get more bang for the buck and to loosen up rigid attitudes against paying premiums. Thorough back-testing is helpful.
FASB Facilitates Getting and Keeping Hedge Accounting
The Financial Accounting Standards Board (FASB) is projected to deliver its changes to hedge accounting in late June. These are expected to greatly ease operational burdens to achieve hedge accounting on cash flow hedges. An expert from Bloomberg updated the group.
As long as companies can reasonably assume that the relationship between an asset or liability and its hedge remains between 80% and 125% effective, routinely performed quantitative analysis and documentation will no longer be necessary under the new rule, reducing the cost and complexity of monitoring hedge effectiveness. Other benefits include fewer hurdles to pursue partial-term hedges, and the ability to hedge a component of risk instead of the entire purchase price, making it much easier to hedge commodity risk. There will be similar flexibility for interest-rate-risk hedges.
The effective date for the new guidance will likely be in 2019, but calendar year companies can adopt early (2018). Early adoption provides more time to develop new risk-management procedures and benefit sooner from the new rules.