Foreign exchange managers are looking to holistic reviews and new hedging strategies to maintain control in emerging markets.
FXMPG2 members agree that periodic reviews of hedge policies and strategies should be performed as a matter of course, but are particularly timely in light of the dollar shift in the last year. Our sponsors from Société Générale also provided valuable perspective on hedging emerging markets, and the cost of doing so.
1) The Impact of USD Strengthening on US Multinationals. USD earnings, USD debt and offshore cash generation are a triple threat in a dollar-strengthening cycle, highlighting the need to reduce this exposure.
2) Protecting Emerging Markets Risk. The cost of hedging ratio (forward points divided by implied volatility) will prompt hedging of some EM currencies that might go unhedged if only the forward points are considered.
3) Hedge Strategy Review and Ways Forward. VaR and a consideration of the relative cost of hedging can help determine an efficient frontier of hedging, but bear in mind the real-life factors that limit how close to the frontier any program can come.
Sponsored by:
Best Practices in FX Exposure Identification and Monitoring
How much forecast inaccuracy is acceptable? A hedge program is only as good as the exposure forecasts underpinning the hedge actions. One of the challenges is getting the forecast-relevant data from the businesses. The higher the hedge ratio, the less room for inaccuracy, but a lower hedge ratio doesn’t necessarily imply that there is tolerance for more. In the open forum, group members suggested the following:
- Create a feedback mechanism. If forecasts are off the mark, there should be a process to calculate the variance and a feedback mechanism for the forecast providers to get answers to what went wrong and why.
- Algos have their uses. Although widely used in equity markets, according to Société Générale’s Anna Faustini, Managing Director, Head of FX, Corporate Rates and Liquidity Investment Solutions, few corporates routinely use algorithmic trading in their FX hedge programs. They do have their uses, though, for example in large, potentially market-moving trades like acquisition settlements and the like. Broker/dealers offer very detailed reporting on the algo trades after the fact, which should lessen any fears that banks take advantage of their clients. A spread is negotiated in advance.
The Impact of USD Strengthening on US Multinationals
The vast majority of respondents in the pre-meeting survey said the stronger dollar had had a slightly negative impact on financial results so far (though a few said extremely negative). Antoine Jacquemin, Société Générale’s London-based Global Head of Market Risk Advisory Group, led the session on how the dollar has and could impact earnings and ways companies can mitigate this risk.
Key Takeaways
1) US MNCs have “triple USD leverage.” Mr. Jacquemin noted that the strong dollar is particularly challenging for US multinationals because of the triple leverage: on earnings (from volume impact, local profitability and translation effects), USD debt and cash generated offshore. Because of their “excessive” exposure to the USD, per a study by Mauldin Economics (2014), “a one percent move in the USD can have a two percent impact on the earnings of S&P 500 companies.”
2) Consider more funding in EUR. Companies that have liabilities in EUR (or other low-cost non-USD funding currencies, if any) can limit the negative impact of one of the “triples.” One way of getting there is to swap USD debt into other currencies to offset the cost of hedging higher-yielding currencies. However, consider the implications for important ratings-related ratios; see sidebar next page.
Outlook
Depending on whose prediction, US multinationals are likely in for at least a couple of years — or more — of dollar strengthening, and with more volatility to boot, resulting in many quarters’ worth of pain in the financials. Since hedging can only do so much to protect companies from the adverse effects of this trend — more time-buying than eliminating the effects — mitigating steps need to be taken in the business (manufacturing locations, contract currencies, etc.), as well as by treasury (funding currencies). This can help lessen the impact of the USD triple leverage highlighted by Antoine and create a more balanced exposure picture overall.
Debt Currency Mismatches Can Jeopardize Ratings
In discussing the pros and cons of shifting to a different, lower-yielding funding currency (see previous page), Mr. Jacquemin of Société Générale cautioned that careful analysis of the impact on important debt ratios versus covenants and agency ratings must be undertaken. He noted that S&P emphasizes the importance of a debt currency mix that matches the cash-flow currency mix (outright or via hedging), and that Moody’s view on exposures recognizes both the risk for temporary fluctuations in leverage depending on funding currency and economic risk from sourcing in other currencies than competitors do. Ratios like EPS, return on capital, leverage ratio and funds from operations as a percentage of debt can all be affected by FX fluctuations if not offset or hedged appropriately. Companies should consider which debt currency policy suits them best: (1) Functional currency approach, i.e., USD denominated debt; (2) Net investment approach, i.e., debt in the currency of net assets; and (3) Ratio approach, i.e., debt in different relevant currencies to limit credit-ratio volatility.
Protecting Emerging Markets Risk
Emerging markets are increasingly the growth engines for MNCs. Damien De Chillaz, Head of Market Risk Advisory for the Americas, Société Générale, led a discussion on volatility, hedging costs and handy instruments.
Key Takeaways
1) Volatility is back. After the May 2014 Fed “tapering” began, EM currencies were hit with new waves of volatility and depreciation. At the time of the meeting, the RUB was down 90 percent against the dollar since then; the BRL 74 percent. The unusually fast pace of dollar appreciation (versus previous strengthening cycles) has not helped matters.
2) A new perspective on the cost of hedging EMs. The high hedge costs stemming from high interest rate differentials and the often high volatility of EM currencies are challenging on a good day and more so in a USD strengthening trend. Mr. De Chillaz suggested that just looking at the interest rate differential (or the carry) and deciding it’s too expensive is not an effective decision model. After all, just a few months of crisis can erase years of carry gains. Other factors should be considered, such as the following:
- Cost of Hedging Ratio (CHR) — The CHR is the cost of hedging (forward points) divided by implied volatility. The lower this ratio, the better. If the current ratio is lower than the average, it’s a relatively cheap hedge. Using this ratio will provide a different and more relevant cost of hedging than the straight up and down forward points calculation, argued Damien.
- “Adjusted Cost of Hedging” — This takes into account the country’s growth and inflation rates, or your own expected volume growth and price inflation, and of course, your market views in general.
3) Try an Enhanced FX Swap. This 25 delta zero-cost collar was developed for asset managers, but the instruments are relatively vanilla and the strategy should be fine for corporates, too. The strategy benefits you when the USD appreciates most of the time and provides a stop-loss in instances of dramatic drops. At a pre-determined threshold, you can restructure to a forward and sell back the time value, which is an improvement on a regular forward’s performance. A key consideration is the threshold: If it is too tight, then it is too easily converted to a forward, and if it is too OTM against spot, the stop-loss doesn’t kick in soon enough.
Outlook
Many corporates take a relatively one-dimensional approach to EM hedging, i.e., they will only consider the interest rate differential (forward points) when deciding whether to hedge a currency. As Mr. De Chillaz argued, this does a disservice to the exposure, and implied volatility needs to be considered as well for a truer reflection of the cost of hedging and a hedge trigger that kicks in at a more prudent level.
FX Program from Soup to Nuts
One of the recurring favorites on the FXMPG2 agenda is the review of a member company’s FX program in its entirety. For this multinational pharma giant with nearly a quarter of its revenue in emerging markets, cash return commitment is an important hedge driver.
On the balance sheet side (product shipments, affiliate balances, interco funding, etc.), the company hedges “anything and everything,” i.e., 100 percent of BS risk through daily hedging (product exposures) and forecast hedging programs (non-product exposures; monthly or ad hoc).
On the cash-flow side, future product shipments are hedged using only forwards, in a program started in 2014, via the five largest currencies. The CF hedging is a proxy for earnings hedging and is only a fraction of the size of the BS hedge efforts. The CF hedges have two maturity streams (1 and 2 years) and are layered on and adjusted each month for updated forecasts. Layering strategies reduce the YoY FX variability in the earnings, thus reducing a non-core risk for the company. The hedging strategy does not promise to do better than the “no-hedge” scenario in any given period, only to reduce FX variability.
Hedge Strategy Review and Ways Forward
The executive director of treasury for the FXMPG2 meeting host, accompanied by his team, shared the process and conclusions from a recent review of the cosmetics giant’s hedging strategy, including VaR analysis and considerations for hedging high-cost currencies.
Key Takeaways
1) A review of hedge policies and strategies is called for periodically. However, what qualifies as a review differs in the group. Per the pre-meeting survey, some consider the annual review with the board (or appropriate committee) for the Dodd-Frank end-user exception “renewal” to be a review, while others say they review their policies and procedures on an ad hoc basis or every 2-3 years.
2) The “levers” of hedging are most commonly reviewed. Rather than wholesale change, many members reported they most commonly considered hedge instruments (91 percent), tenor (81 percent), underlying exposures to be hedged and related hedge criteria (76 and 52 percent, respectively), and hedge ratios (71 percent).
3) Take a holistic view of exposures. The company is taking into account diversification benefits (that its revenues and expenses are geographically well diversified) and may even proactively rearrange certain exposures to reduce them further.
4) With VaR as a measure of risk, determine “efficient frontier” of cost-effective hedging. After consulting with bank advisors, the company decided to use VaR to measure risk — despite its known limitations like underestimating tail events — and to calculate the most cost-effective manner to reduce FX risk by creating an efficient frontier curve.
5) Consider the real constraints to hedging your portfolio of risk. Similar to many companies, one of the restrictions for this member company is that its hedges need to qualify for hedge accounting; this limits the exposures that can be hedged (even if theoretically, they all could be). Analytics took into account both an unconstrained portfolio and a constrained one.
6) The efficient frontier is an unreachable goal. While it’s very useful to know where it lies, several real-life factors impede the achievement of the efficient frontier. For example, it’s not efficient from a tactical point of view to choose to hedge an optimal notional amount, and forgoing hedging of some high-cost currencies exposes the company to too much tail risk.
Outlook
While VaR is a useful metric in the toolkit used for understanding and quantifying risk, other key aspects of risk management help reduce the amount of exposure in the first place. Holistic approaches integrated into business processes play a large role, such as negotiating contracts in currencies that offset other exposures. It is also important to understand the shortcomings of VaR in tail-risk events, for example, as well as thoroughly understanding the limits imposed on the “ideal” hedge program, like hedge accounting requirements and the cost or complexity of hedging certain exposures or currencies.
CONCLUSION & NEXT STEPS
Amidst a dollar-strengthening cycle now in full swing and a potential two-to-three-year period of appreciation left to go, as some predict, the accompanying adverse effect on financial results highlights the timeliness of a review of the objectives of the FX program and how it performs in both good times and bad. Meanwhile, the growing importance of the emerging markets portion of MNCs’ FX exposures presents additional challenges in that the currencies are often much more volatile and vulnerable to shocks. Leaving them unhedged due to the high cost of hedging is increasingly untenable. We look forward to further discussions on these and other topics at the next event.