One Approach to FX Risk Management
“Nothing is more constant than change”
There are different definitions, but we will define risk as simply an exposure to change. Therefore, ‘risk management’ is obviously the administration, direction and control of exposures to change. In a treasury context, we are talking about managing financial exposure to changes in FX, interest rates, stocks, bonds, balance sheets, liquidity, credit, etc. In a purely FX context, we are talking about:
1. Transaction Risk – resulting from known or accounted for currency cash flow, purchases, sales financing transactions, intra-group dividend payments, etc.
2. ‘Economic’ Risk or Expected Transaction Risk – resulting from an anticipated or forecasted currency cash flow, purchases, etc.
3. Translation Risk – arising from the translation of overseas assets and liabilities into domestic currency for accounting purposes
4. Contingent Risk – arising through bidding on contracts, merger & acquisition plans (good communication from other business areas such as the procurement department to treasury is crucial here!)
Implicit in risk management is hedging. The textbook[1] definition of hedging is an action which reduces risk, usually at the expense of potential reward and typically made by approximately offsetting transactions that will largely eliminate one or more types of risk. You may ask yourself, but what is the true purpose or ultimate outcome of hedging? In a treasury context, it is to reduce the volatility of earnings and cash flows by setting predefined limits on any losses. What does this really mean? I think most of us would agree that the CFO wants to keep the CEO happy and the CEO wants to keep the various boards happy and they all want to keep the shareholders/investors/stakeholders happy. Therefore, effective risk management equals happy shareholders/investors/stakeholders.
For the sake of simplicity, there are two basic approaches; one could be called static hedging and the other dynamic hedging. As their names imply, static hedging is fixed and unchanging and dynamic hedging is active and changing.
This depends primarily on the risk management policy of the company. If the company does not have a risk management policy, or at least does not have guidelines incorporated into some sort of treasury policy, please let me know the name of the company, I would like to buy a put option on their stock, if publicly traded.
Let’s back up a step first. The textbook[2] definition of dynamic hedging is a technique of portfolio insurance or position risk management in which an option-like return pattern is created by increasing or reducing the position in the underlying (or forwards, futures, or options on the underlying) to simulate the delta change in value of an option position.
For this article, I will use the term dynamic hedging in a broader sense, meaning any hedging that is done on an active and changing basis, not necessarily using options, although in most cases options are involved. Some people might call this trading the hedge around.
What is the textbook definition of a static hedge? Well, I didn’t find one so we will have to stick with my definition of a fixed and unchanging hedge, which is put on until maturity and forgotten about. This is considered a cost of hedging and works great for treasuries that operate as a cost center.
Risk management or treasury policies determine how a treasury will behave, either as a cost center or as a profit center. Seemingly, a cost center has lower risk and therefore, lower volatility of the treasury profit /loss account (p/l) and a profit center is the polar opposite with a lot of risk and more p/l volatility. I believe that the best way to maximize risk-adjusted returns is not at these two extremes, but somewhere in the middle. We can call this a ‘treasury center’ approach. (See graph below.)
Cost Center or profit Center?
Why is a ‘treasury center’ approach the best way to maximize risk-adjusted returns in most cases? Unlike a cost center, a treasury center using dynamic hedging is able to take advantage of opportunities as they arise, according to a clear and expressly written risk management policy agreed to by the Treasury Head, CFO, CEO and the rest of the Executive Board and Board of Directors.
This policy stipulates in no uncertain terms, the limits, reporting, control, risk management procedures, p/l budget, counter-parties, compensation of traders, etc. And unlike a pure profit center where traders are encouraged and compensated to make as much money as possible – whereby risk and volatility increase and risk-adjusted returns decrease – a treasury center seeks a balance between profit and risk. For example, the traders are not compensated on absolute returns, but on risk-weighted returns, or they work with tight stop-loss and take-profit orders, etc. And the attitude and modus operandi are at neither of the two poles: being a ‘risk cowboy’ or being a ‘risk coward’, but rather being a ‘risk gentleman and scholar’.
Here is an example of dynamic hedging in a treasury center environment. A Swiss company called Schoggi Alp AG is short 20 million USD/CHF due to a daughter company in the USA who has a bank credit with no chance of being able to pay it back due to the financial dire straights they are in. This company does not want to hedge at any cost and forget about the position, but rather manage it dynamically and prudently according to their risk management policy to maximize their risk-adjusted returns.
Trader Hans is on the case and comes up with six strategies:
1. buy a USD call option
2. put on a risk reversal by buying USD call and selling USD put
3. buy USD call / step payment option (zero-cost-upfront)
4. buy USD spot and bank it or pay back the loan now
5. buy USD forward or future
6. do nothing and check out sports scores in Reuters
Trader Hans’ personal favorite of the six strategies was #6, but he thought the Head of Treasury and the CFO would prefer #3: buy USD call / step payment option. Why?
A picture says a thousand words, so let’s check out the following pay-out/break-even graph (Strategy 3) presenting the net position of the underlying short USD position and the USD call step payment option and then meet on the other side:
Strategy 3
The zero-cost-upfront payout structure of the step payment option (also called mini-premium and contingent premium option) is by far the best one of the six strategies. These options are essentially one-touch binary options, also known as American binaries, which are combined with other options. The premium is only paid when certain spot prices are touched in the FX market. The buyer chooses where he wants the step levels, which, of course, influence the price of this exotic structure. The farther away the steps are from the current spot rate, the cheaper the one-touch binaries and the less likely it will be to have a zero-cost-upfront structure, as you are buying a standard call option and selling the one-touch binaries.
In our USD/CHF example, we had an eight month expiry, 1.4000 USD call with a strike of 1.4000 and steps at 1.3300, 1.3100 and 1.2900 (zero-cost-upfront). Schoggi Alp AG is short USD/CHF at 1.4500. (strikes and steps were obviously calculated before the recent USD plunge and therefore prices, etc. should be viewed as strictly theoretical).
If the USD goes down, Hans has to pay a premium per step level of CHF 0.0253 (253 pips in trader jargon) on the face amount of $20 million, but he makes money on the underlying position and the maximum profit is virtually unlimited on the USD downside. If the USD goes up he makes money on the USD call but loses money on the underlying, locking in a maximum profit of CHF 1,000,000.- on the upside. Everyone at the company agrees and the strategy is accepted and implemented. If nothing else happens until maturity, then this would be a static hedge. However, they want to be dynamic about it as they have chosen the treasury center approach.
Miraculously, the US trade deficit and budget deficits are massively reduced, the Dow Jones Index keeps rising and therefore the USD rises. The company now has the view that the USD will continue to rise due to various economic fundamentals and the strong upward trend of the USD, but will remain volatile before consolidating in a range. Therefore, Hans, with the approval of the CFO, plans to take profit on a part of the USD call option and gets prices to buy back the first step payment at 1.3300. It is still too expensive as implied, market-traded ‘volatilities’ have risen due to the huge move up in the USD, so he waits. USD /CHF spot keeps moving up and eventually the implied volatilities used to price the step payment option come down, making it relatively cheap to buy back one of the steps, so he does this.
The latest accounting report suddenly shows that the actual underlying USD position has been reduced to only short $10 million, so Hans looks at his new pay-out/break-even chart and gets very excited at his p/l. He also notices that his net delta and the other ‘greeks’ on the aggregate position have been changing with every step he takes (a part of dynamic hedging). He can choose a delta target or a range of deltas that he wants to stay in and trade the position accordingly. He can also track the gamma of the position to see how much his deltas will change relative to a move in spot – and then there is tau or vega to consider which measures the value of an option relative to a 1% move in the implied volatility market. And let us not forget that changes in underlying positions, spot prices and implied volatilities are not the only things that change the delta and mark-to-market value of a net position or portfolio, there is also time decay, interest rates, supply and demand, liquidity, etc. to contend with. Below is a summary graph of most of the main and ever-changing risks good ol’ treasury trader Hans has to juggle.
Many risk factors affect the Treasury portfolio’s value…
Trader Hans then sells another part of the long USD call option with a nice profit. Now he is still more or less hedged on the $10 million underlying, reducing the number of steps to two from three, and has already banked a nifty little profit. And it is important to note that Hans tracks his open/closed positions which are with various counterparties and may or may not be netted at one given counterparty.
If the USD should drop and hit the next step level, he would pay the premium and then could buy the USD very cheaply, locking in a profit compared to where he is short USD on the books. And so on and on and on… the possible scenarios are unlimited and obviously, if Hans is not on the ball, losses can occur.
The above scenario would have been more or less passed over in a static hedging environment, but with dynamic hedging or trading the hedge around, one can seize the moment and exploit opportunities as they come along. They must, of course, be in full compliance with the risk management policy and have approval of the CFO according to a predefined information and control procedure. The flexibility of a treasury center approach enables this maximization of risk-adjusted returns through dynamic hedging, providing conditions are right and there is agreement from management. And remember, nothing is more constant than change and our exposure to change.
Bibliography
1,2 “Dictionary of Financial Risk Management” by Gary L. Gastineau
