RMB internationalization, hedging on a portfolio basis, and when to use options.
Members of the Foreign Exchange Managers’ Peer Group convened in September at the Minneapolis headquarters of host Medtronic for their meeting sponsored by Standard Chartered. The day-and-a-half event started with members discussing their projects and priorities and the top questions they hoped to get answered at the meeting. After a global and emerging markets economic outlook, discussions delved into perennial challenges, such as when to use options to hedge FX exposures and the benefits of hedging FX portfolios holistically, using a VaR-based Standard Chartered framework. Here are three themes that emerged:
1) To Hedge or Not to Hedge. Corporate treasury can leverage resources by hedging on a portfolio basis. An FXMPG member explained his company’s approach to determining which balance-sheet exposures are worth hedging.
2) Forwards vs. Options: The Ongoing Conundrum. FXMPG members argued for focusing on forwards to hedge, although some noted that technology reduces options’ operational hurdles. Standard Chartered said that mixing in options reduces volatility.
3) Exposure Forecasting: Incremental Improvement. Figuring out who owns FX exposure forecasting at a multinational corporation and where local finance staff fit in is just the beginning of the road facing treasury. Further down the path: phantom balances.
To Hedge or Not to Hedge
What is the appropriate way of looking at FX exposures to understand and measure the true risk and make hedge decisions? Standard Chartered’s Anthony Ring led the session on a value at risk based framework, followed by a client and FXMPG member who explained how it’s applied at his company.
Internationalization of China’s RMB Continues
No matter what happens to the trade saber-rattling between China and the US, the inner workings of RMB trading and transaction execution are on track to modernization. The Chinese government wants to continue to open markets and internationalize the RMB. At the time of the meeting, given the trade conflict, there was pressure for China to maintain a stable exchange rate and not let the RMB depreciate too fast (keep it below 7.00) and risk escalating trade tensions further. Local banks were “quite firmly in the market” to support the RMB, Standard Chartered’s Anton Chan said.
Incentives matter. China wants to build the onshore options market, and one way to promote its use is to apply a lower reserve charge (mandatory interest-free PBOC deposit based on the notional trade amount) on options of 10%, rather than the 20% for forwards (no, no synthetic forwards using options are allowed). And because the charge is limited to one year, it also serves as an incentive to extend hedge tenors, which would build up liquidity in the longer tenors; the most common tenor now is one year or shorter.
Roll over! A corporate concern with the reserve charges is whether they apply when rolling over hedges. Mr. Chan said they do not; all you need to do is a new spot trade.
KEY TAKEAWAYS
1) A really big job is done by very few. Mr. Ring noted that while treasury practitioners increasingly spend time on strategic activities, the operational demands of the job haven’t decreased. Half of corporations responding to Deloitte’s 2016 FX survey said they are exposed to between 21 and 100 currencies, or more. That complexity and the increasingly strategic aspects of the job highlight the need for more skilled treasury professionals applying different thinking on hedge decision-making, especially since they are not enjoying an upswing in the number of people in their departments. Helpful hint: Any changes to improve a hedge program should reduce work, not increase it.
2) More risk reduction for less. Mr. Ring demonstrated that holistic consideration of all exposures, their notional amounts and their volatility gives a truer understanding of the risk each poses (individual VaR) as well as their VaR as a portfolio with correlation benefits taken into account. Given the cost to hedge each currency (forward points), this methodology can guide decisions on which currencies to hedge, and how much, along an efficient frontier that maximizes the risk reduction for each level of hedge expense.
3) Peace of mind with a portfolio option? Mr. Ring said the ideal hedge: avoids significant depreciations; has a low cost of carry; is operationally simple; has low transactional or rolling cost; and reduces the volatility of exposures. If you go with a portfolio approach, he suggests mitigating the worst-case scenario with a one-year option that floors the value of the portfolio 5% below the current value. Maybe it’s not a perfect hedge, but it buys peace of mind.
4) Hedge this currency, not that one. The member and Standard Chartered client described how the concept was applied to decide which currencies to include in his company’s balance-sheet hedging program. Any exposure currency above a certain VaR threshold must pass one of three tests: Is it free to hedge? Is the gain or loss potentially high? And does the cost to hedge provide a specified minimum of risk-reduction return?
OUTLOOK
Hedging all currency exposures is neither possible nor economical. Separating out emerging markets because they are too expensive to hedge won’t work, either, when volatility remains high and that’s where business growth is coming from. A smarter framework for choosing what to hedge not only gives a bigger risk-reduction bang for the hedging buck, but also reduces the workload for small FX teams with big mandates. The 30% of respondents to the pre-meeting survey who said they seldom, if ever, revise or update their FX policies may want to consider a review.
Forwards vs. Options: The Ongoing Conundrum
In a roundtable discussion, members presented a strong argument for focusing on forwards, given options’ premium cost and the operational challenges. Others, however, noted technology can reduce the operational hurdles, and zero-cost collars eliminate premiums.
Not All Commodities Are Equal
Some FXMPG members are also responsible for commodity risk, and while FASB’s new hedge accounting standard is supposed to make commodities easier to hedge, that may not be true for all. One member said his firm doesn’t have commodities in its hedging policy currently, but treasury will review that policy annually as the new guidelines evolve. The standard goes into effect at the start of 2019 for calendar-year companies, although some firms adopted it early.
Direct use or component? The new guidelines greatly facilitate hedging fuel costs because, as another member noted, companies consume the fuel and are hedging the entire cost; hedging components of the whole cost to produce a product is where the challenge lies. A member whose company uses plastic and precious metals said he found it difficult to get deferred cash-flow hedge accounting under the new guidelines.
Workarounds add complexity. Before the new hedge-accounting guidelines, and the ability hedge a fuel index, a member’s company added together fuel and ancillary costs, such as transportation, surcharges and port fees, into a single cost to hedge, and that would qualify for hedge accounting. “We needed to have a custom contract with the supplier,” the member said, adding it was a lengthy process to update the supplier contracts.
KEY TAKEAWAYS
1) Options: Allowed but not always used. In the pre-meeting survey, 74% of respondents said they are allowed to use both forwards and options in the FX risk-management program, but 56% are not currently using options. Members noted that often there’s no budget for options, and decisions are made on a case-by-case basis. About one-third are allowed to pay premiums and routinely use options in their programs. Only 26% “actively manage,” or move between hedge instruments over the life of the hedge.
2) How’s the view? Just over half of respondents consider their market view in the choice of hedging instrument. Members who rarely use options concluded that on those occasions, they had a view that the currency would move in a certain direction or were hedging a binary event.
3) How much work is it? A member noted instituting an options program when the Brazilian real and Russian ruble were weak. It was successful, but when the currencies strengthened, the program was discontinued and replaced by forwards. “It was so much easier to run the forwards program; we could do all the work on Bloomberg and it was less complicated for the back office,” the member said. This may be particularly true for emerging markets currencies.
4) Mixing in options in the layered hedging program lowers volatility more. Mr. Ring pointed out that the typical goal of cash-flow hedging is to reduce the volatility of cash flows and earnings from period to period. Most attendees agreed that layering forward contracts was the best way to do that, and Mr. Ring said that was his take as well—until recently. “We found that layering forwards and options further reduces volatility from period to period,” he said, adding that a study he conducted shows optimal impact when options make up between 25% and 50% of the hedging notionals and carry the same tenor as the forward contacts.
OUTLOOK
To up the ante on the effectiveness of a traditional layered cash-flow hedge program, consider mixing in a proportion of options instead of using only forwards. This can be done as systematically as a forwards-only program and there is backtesting showing the superior smoothing effect of the combination over the 100% forwards approach. The question will come back to a willingness to spend money on premiums.
Exposure Forecasting: Incremental Improvement
One of the perennial challenges facing treasury is to have a comprehensive overview of exposures at a level granular enough that they can be hedged in compliance with hedge accounting requirements. That means identifying what the exposure drivers are, when they’ll occur, how large they are likely to be, and how they’ll change over time. A free-range discussion yielded some notable nuggets.
TMS = Treasury Misery System?
Selecting a TMS is an exercise in optimism that over time morphs into an amalgam of realism, pragmatism and hopefully not overwhelming pessimism. In a cathartic projects and priorities session, members shared their concerns, complaints and coping mechanisms.
Get it in writing or on tape. One member recalled moving to a new TMS a few years ago on the advice of FXMPG members. While implementing the software went well, the sales pitch ended up being full of holes. “We recorded the pitches, and we’ve gone back to them time and time again to remind them what they promised,” the member said. If recording is not agreed to (or legal in your state), get everything that’s promised in writing.
Consolidation = service problems. Practitioners are understandably concerned when their TMS vendor gets acquired. Technical experts and relationship people leave, service declines, they sunset your software, etc. “They’ve had problems forever, and now it’s worse. When we have a problem now, they want to charge us to fix it,” a member said about an acquired vendor. For example, the first day of a recent close, an analyst had to work 18 hours because rates were not loaded correctly and treasury had to manually intervene. “It’s great when it works, but it’s not reliable. We don’t know why, and they can never explain,” she said.
KEY TAKEAWAYS
1) Who owns it? FX risk management is a highly centralized function, while the exposures are all over the world for large global corporates like the members of the FXMPG. This raises the question of who should own and be accountable for exposure forecasting. One member noted the significant training efforts to raise awareness of what revenue and expense data treasury needs from local finance resources and why it makes a difference for cash-flow hedge results. With frequent staff turnover, training has to be ongoing. Another member has found that having a treasury person doing the cash-flow forecast for the larger entities around the world is more accurate than having local finance people owning it, due to factoring and other forecast-moving items treasury can monitor better.
2) Can you even get a number? Balance-sheet forecasts are highly reliant on ERP data and if the relevant data resides in too many places, hedging balance sheets becomes impossible. One member said that until they get all their billing into one system, balance-sheet hedging is off the table. Another problem is the existence of “phantom balances” resulting in unexpected net remeasurement; they stem from accounting errors and they mess up the forecast. The dilemma: Should you hedge them, because they can have a real impact, or not, because they’re not real?
OUTLOOK
So what’s next in the continuing drive to enhance the process and accuracy of forecasting? Robotic process automation (RPA) and artificial intelligence (AI) are on everyone’s mind. One member noted an internal initiative to identify how bots can be used in treasury and whether a bot “could figure out the forecast.” But when mapping out exactly how the bot would achieve it, it looked like every system in the entire company would require some change or other. That sounds like automating an imperfect process, rather than perfecting the process first so it can be automated later. So can’t we just build a bot for this already? So far, probably not.