Up until a couple of years ago FX hedging was all about smoothing out volatility but more recently it has been more about managing the impact of the steadily rising value of the US dollar and of course, volatility in emerging market currencies, notably the renminbi.
For big companies, particularly those like engineering and construction firms embarking on major projects, these factors create three types of FX and commodity risk including, (1) cash-flow and commodity price risk; (2) balance-sheet FX risk; and (3) translation in consolidating FX risk. But in terms of strategies for managing them, cash-flow and commodity price risk are perhaps the most dangerous (and least visible). Here are a few strategies to mitigate them, as discussed at the spring meeting of The NeuGroup’s Engineering and Construction Treasurers’ Peer Group.
Hedge all to project end and unwind. This strategy calls for “entering into a single hedge out to the expected end-date of the project with a notional equal to the total project’s FX exposures and unwind a portion of the original hedge as the revenue is received or payments made.” This strategy is easy to implement, easily accommodates changes to exposure timing, and is simplified because all derivative cash settlements occur at the end of the project. The downside is that the initial hedge may be credit-intensive and could be less feasible with less liquid currencies.
Individual hedges aligned to cash-flow strategy. Enter into a series of hedges to the best estimate date as to when the payments on the project are going to be made and adjust/unwind the original hedges as the payments are made. The advantage of this strategy is that cash settlements of derivatives will match the FX exposure if the exposure timing does not change. The disadvantage is that if the timing does change it will require adjustments to the hedges.
Rolling strategy. “Hedge on rolling short-term basis (e.g., monthly) and adjust the notional of the short-dated rolling hedges as the payments are made (e.g., start with a notional equal to the total project’s FX exposures and decrease the notional of the short-dated rolling hedges as the payments are made),” one E&C practitioner suggested. The advantage here is that the hedges are easy to manage and not credit-intensive. The disadvantage is that quarterly cash settlements create cash mismatches between FX exposure and derivatives.
Among commodity prices, one of the biggies, oil, is expected to remain relatively low, by recent standards, for at least a couple of years. Meanwhile FX volatility is expected to remain higher than normal. A couple of members of E&C group have looked at the correlation of oil and currency and have also concluded that the natural correlation is not sufficient to cover the risk. Consequently, anyone else considering this exercise can now be spared the time. Meanwhile, independent hedging programs for each asset will need to be maintained for business as usual.