FX risk management has moved to the top of treasurers’ agendas in the last year, and for good reason. The almost decade-long slide in the value of the dollar, accompanied – for USD reporting companies – by favorably translated earnings and offshore cash balances, reversed last year. This dollar recovery is creating earnings headwinds and has already caused US companies FX losses. And since this cycle could last several years, it has put a spotlight on whether corporate FX management does its job well enough or if it can be done in a way that mitigates more of the negative impact of the strong greenback.
With dollar strength estimated to be sticking around a while, it’s time to reassess hedge policies and strategies, according to takeaways from The NeuGroup’s Treasurers’ Group of Thirty-3 (T30-3). Citing fundamentals like the relative strength of the US recovery vs. other countries and regions, many experts predict that the dollar strength is not going away anytime soon (as in years). In addition, there are structural shifts, such as FX becoming an asset class of its own, meaning FX swings are no longer as correlated to other asset classes, i.e., “the asset allocation decision no longer determines the currency decision.”
A strong USD also has a negative impact on the economic value of foreign-denominated monetary assets, cash, revenues, sales margins, profits and accounting presentation of companies reporting in USD. If hedge policies and strategies were designed during the dollar-weakening cycle, they may no longer produce the desired risk mitigation – which is indeed borne out by a spate of reported FX losses in recent earnings releases – and should be reassessed. Among the T30-3 members, several are in the process of evaluating whether to institute cash-flow hedge programs.
But what if the dollar doesn’t remain strong? Members agreed that building in flexibility is key. USD current-account deteriorations have halted dollar rallies in the past; the USD has rapidly gone from undervalued to overvalued according to commonly used valuation models; and – with a US interest-rate increase somewhat priced-in already – history has shown the USD to fall in the period immediately following the first rate hike. With these risks to the outlook, it is prudent to allow more flexibility in the choice of instruments (options and option combinations over forwards) to protect the downside, while allowing upside if the dollar rally reverses, temporarily or not. Options are also beneficial when hedging acquisition deals that may or may not close, or bid-to-award risk.
Another suggestion from T30-3 members: clearly define your hedge objectives. Not all risk-management objectives (volatility reduction, tail-risk protection and budget-rate outperformance) can be satisfied with one hedge approach, and this calls for clear prioritization and balancing when making decisions on hedge instrument, tenor and hedge ratio. The competing objectives may be even starker when it comes to emerging markets due to market conditions.
It might also be a good idea to use natural offsets. One of the “first lines of defense” in FX risk management is to offset foreign-denominated assets with liabilities by borrowing in non-USD. Local bank loans or intercompany loans in local currency have long been ways to reduce foreign subs’ exposures, and indeed, interest in non-USD bond issuance has increased as the USD has embarked on its current bull cycle.
Corporates by far favor cash-flow and balance-sheet hedging, but in strong-dollar periods, swings in earnings translations and net equity become much more visible, though only a small minority hedge these, noted Ivan. Because of hedge accounting treatment (unfavorable), they are typically hedged indirectly via revenue hedging, for example (cash-flow hedge treatment).
Many T30-3 members have recently found that it is important to distinguish what works all the time from what works better in a dollar-weakening vs. a dollar-strengthening cycle. Efforts are afoot in companies across multiple NeuGroups to use all the flexibility current policies allow, or propose policy adjustments, for tenor extensions or ramping up hedge ratios when it makes sense to lock-in favorable rates, or when choosing a different hedge instrument. As the Federal Reserve gets closer to its promised rate hike, it is likely we’ll see more such assessments and adjustments of FX policy and strategy.