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Risk Management

The Case for Dynamic Hedging

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February 13, 2019

Dynamic hedging offers a flexible way to minimize exchange-rate risks

Fri Currency in Gears SmallWhile several FXMPG members over the years have stuck with static hedging, most members continue to stay flexible with a dynamic approach. And recently, supported by rigorous analysis provided by the bank sponsor of NeuGroup’s second group for FX managers, FXMPG2, members considered the argument for ditching a completely static FX hedging program and having a hedge toolkit that includes options.

In most hedge programs, the hedge ratio, tenor and instrument choice are the levers that allow flexibility (or not). So when thinking about static vs. dynamic hedging, it should be noted that it actually comes down to the instrument choice. A static hedge program is consistently applied regardless of market conditions. A dynamic systematic program is a rules-based framework that uses mainly forwards and collars and whose hedge ratio is determined by market-based triggers like volatility and forward premiums; it may consider currency trends or momentum triggers. This kind of program can result in considerable savings in hedge costs (or more risk reduction for the same cost) over time, while still having the guardrails of a well-defined frame-work.

A dynamic or opportunistic program allows decision-making on a case-by-case basis based on currency, exposure, timing and market levels, and can include options and option combinations. But be clear on the trade-offs in terms of the volatility of returns in these strategies.

So how do you make that decision? And which is better a forecast or market trend? Bank forecasts are more often right than wrong on the direction of a currency in a 1- and 2-year time frame (69% and 74%), according to Bloomberg, since fundamentals are big factors over that horizon. But short term, it’s anyone’s guess. So is the trend your friend? Can the 30-day average spot rate help indicate which hedge instrument to choose in a decision framework that takes market conditions into account? Using the example of a long EUR exposure, if the EUR appreciates by more than 1.5% in 30 days, indicating a bullish trend, the better instrument choice is a collar, while a depreciation of more than 1.5% (bearish trend) would point to a forward.

The decision to use a dynamic hedge comes to resources and time. That’s because a dynamic approach requires a lot more effort. However, according to at least one FXMPG2 member, it pays off in the long run. Still, whether treasury is adding value by having a more dynamic hedge decision framework needs to be considered. Does the extra effort pay off enough? Or are there other things treasury would be better off spending its time on?

Although the savings from algo trading justified the added effort at one member company, each company needs to decide where the “justified effort for the gains vs. too much effort for not enough benefit” line is drawn when it comes to adding options and going more dynamic.

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