Currency Valuation and Strategic Hedging

The current weakness of the US Dollar versus major currencies has revived the debate around net investment hedging as well as earnings translation risk. Although North American companies’ hedging opportunities are now generally benefiting from favourable market conditions, European corporations may not have to shy away from managing these risks. A solid currency valuation assessment combined with a structured hedging framework can lead to a successful programme.

This approach however demands a slightly more dynamic methodology than is common in the corporate world. Unfortunately, between internal policy constraints and accounting regulation, most companies have chosen to be mostly passive, either implementing hedging strategies in a systematic manner or not at all but rarely taking into consideration market conditions in the decision making process. While it is fair for companies to state that they are not involved in the currency market to “punt” on the direction of exchange rates, it is also fair to say that hedging should not be done in a vacuum either. While understanding the mechanisms and characteristics of the FX market is key to a sound hedging policy, remaining aware of currency valuation and including it in the risk management process can add value to a firm in the long run. The issue of currency valuation however is a tricky one and three questions instantly come to mind:

1. What valuation model should be used?
2. Which hedging programme should be influenced by it?
3. How can a valuation model affect a hedging programme from a practical standpoint?

1. To the first question there are multiple answers; in general however one would consider using a model that identifies long-term equilibrium exchange rates between countries from an economic point of view. Taking into consideration fundamentals however is a complex task as numerous parameters come into play. To simplify this approach, one may consider using the Purchasing Power Parity (PPP) concept. Despite some of its obvious limitations, this model, modified to reflect the assumption that a currency pair has, on average, traded at fair value over the 20 years preceding the measurement point (1), offers some insight into the long-term behaviour of exchange rates and their tendency to mean-revert on an inflation adjusted basis. For example, Picture 1 below shows how the EUR/USD exchange rate has, over the past 14 years, hovered in a broad band around the PPP implied rate. One can observe that in this specific case the over or under valuation has never exceeded 30% since 1989. While this piece of information seems fairly vague in nature, it is however very valuable when looking at hedging strategic exposures. This is especially true when trying to implement an opportunistic approach to hedging risk such as foreign currency denominated net investments or even earnings translation. Obviously this model is better used in conjunction with tactical instruments, as debt does not provide enough flexibility for this kind of an active management approach. Using this methodology, the current spot rate of 1.24 makes the euro over-valued by 9.3% or so versus the US dollar.

Deviation from Purchasing Power Parity: US and Euroland

Of course, one can always assume that the euro has the potential to appreciate up to 1.48 (using the current PPP implied rate of 1.1350 as of Jan 31 and a possible over-valuation of 30%). This means that the hedging approach cannot be an “all or nothing” approach but that the mix of instruments used must be progressive in nature. More generally it is also interesting to observe how exchange rates evolve over time from various levels of currency valuations. Table 1 (1) below displays the average change in spot for six currency pairs: AUDUSD, USDCAD, USDCHF, EURUSD, GBPUSD and USDJPY following five valuation levels. These levels are classified between strongly undervalued (20% or more), somewhat undervalued (between 10% and 20%), fairly valued (within +/-10% of the PPP rate), somewhat overvalued (again, between 10% and 20%), and strongly overvalued (over 20%).

The striking observation here is how extreme levels of valuation get corrected almost entirely over long periods of time, a very valuable piece of information when designing a valuation based hedging programme.

PPP however may not be an appropriate valuation technique for developing countries. In this case, one may want to use the Real Effective Exchange Rate (REER) instead (2). This trade-weighted index measures the inflation-adjusted strength/weakness of a specific currency versus a basket of 16 others.

Graph 2

Picture II: Over-/Underevaluation against REER Trend (1985-2003)

Using a regression analysis, one can define a trend and quantify the prevailing deviation of the exchange rate versus that trend, using a simple percentile ranking method to identify extremes. Picture II displays how this approach has worked in the case of the SouthAfrican rand since 1985. Such a valuation technique is actually extremely useful in the case of emerging market currencies, especially when the interest differential means a substantial implicit hedging cost. In fact, companies are often reluctant to hedge this risk for this very reason, despite a comparatively high level of uncertainty surrounding these currencies. Note that this method can also help when hedging foreign currency denominated debt recorded on the local books while trying to preserve the benefits of a lower funding scheme. It does however imply a fairly flexible hedging policy that accommodates for opportunistic decisions as well as a more active approach to risk management. This being said, we find from experience that many companies do to some extent time their hedges, either for operational reasons or because of the decision making process itself (involvement of a risk committee for example).

2. As far as the second question is concerned, one can reasonably think of at least two hedging programmes that would benefit from a currency valuation model approach: for net investment and for earnings translation.

– The net investment segment is the most obvious one. While companies may use an asset/liability model to tackle this problem and balance the currency mix in their debt portfolio as a function of their net holdings abroad, they may also be tempted by a more tactical approach for cost or flexibility reasons. Historically, companies may have used forward contracts to hedge net investment to smoothly subsidy their income by amortizing favourable forward points linearly through P/L. This was a possibility before SFAS 133 but is no longer. Forward points must now be either marked-to-market through the Cumulative Translation Adjustment account (CTA) or through income. This however is a one-time election. In any case, income can now only be supplementedif willing to tolerate some potential volatility in P/L. Nevertheless, whether hedging net investment for performance enhancement purposes or for debt covenant reasons, the main issue with using tactical instruments is the potential negative cash flow implication. This situation could occur because the underlying risk does not generate any cash flow while the hedge instrument gets settled at maturity. Consequently, a loss on the hedge would only be offset by a gain on the net asset from an accounting point of view but not from a cash flow perspective. Note that a cross-currency swap with principal exchange at maturity would have similar implications and that a longer tenor does not eliminate this problem; if anything, the negative cash flow impact is postponed but may actually be even bigger. For this reason, a reliable currency valuation model can help significantly limit negative cash flows’ impacts by improving the market entry level or by allowing to efficiently tailor the hedging mix depending on the prevailing market level at inception of the hedge.

– An earnings’ translation hedging programme can also benefit from using a currency valuation model. Although in most cases companies’ declared hedging objective is to reduce FX induced volatility in EPS, more often than not it is truly to reduce the negative volatility. A sure sign of this situation is the decision several corporations made, as the euro appreciated against the Dollar, to halt their anticipated net revenue or their earnings-hedging program. This in itself proves that leaving FX opportunities on the table is acceptable only to a certain point. Giving up large favorable currency moves can be detrimental not only from an accounting perspective but also, and more importantly, from a business perspective as well. Unfortunately, such decisions are generally trend induced and the absence of consistency over hedging programs may be extremely counterproductive in the long run, especially if the decision is reversed at the wrong time (which does tend to happen). In any case, the utilization of a currency valuation model here also can help, if only by providing the risk manager with a sense for how much upside potential may be given up when hedging with an inflexible instrument such as a forward contract.

Beyond these two main types of risks, some others, less visible but no less important, would also benefit from being hedged with the help of a currency valuation model. Competitive risk for example would fit the bill extremely well. The reason there is that a company in a highly competitive environment will want to protect against an adverse FX move but will need to ride a favorable one to intensify the pricing pressure on their competitors. As margins may be tight, the ability to use flexible instruments such as options may be limited; the timing of market entry is therefore even more important.

3. The third and last question is probably the most crucial of all. The concept of using currency valuation techniques in the hedging decision is often assimilated to the idea of speculation. As it turns out, we are not recommending here that companies use such an approach to decide whether to go it naked or not! What we are suggesting instead is to implement a methodology that optimizes the hedging mix used in a program to reflect the valuation of a currency at inception of the hedge. The idea is really to increase the proportion of flexible instruments in the mix when the currency is under-valued (when long) or over-valued (when short) so that the company can benefit of the move when the currency returns to its implicit equilibrium level.

To illustrate this approach, we used the example of a long EUR/USD exposure and compared various hedging methods, including a PPP based one. The PPP technique consisted in implementing different hedging mixes depending on the distance between the spot rate at inception of the hedge and the PPP implied rate. Table II summarizes the methodology and Table III displays the historical findings over a 1993-2004 period.

Note that the PPP thresholds we used were decided arbitrarily for the sake of simplicity. Some optimization could possibly be done at the risk however of data fitting.

Looking at this table, a few observations come to mind right away.

Firstly, the ATMF option solution provided the best average effective rate amongst the three techniques evaluated. Its performance however was only marginally better than our PPP based approach; furthermore, this short lead came at a price: a 50% greater upfront cost that cash sensitive companies will certainly be receptive to. It is worth noting that, on our 117 observations sample, both strategies showed a performance almost 1% better on average than that of forward contracts.

Secondly, although forward contracts on average best protected the inception spot, our calculation of the worst hedging performance at a 95% confidence level showed that our PPP based solution worked pretty much as well as the forward did, and in any case much better than ATMF options. This is certainly something to be sensitive to in the context of hedge effectiveness.

Thirdly, when it comes to the average cash flow generated by the hedge, the PPP based strategy is second to ATMF options by only a slight margin and well ahead of forward contracts. More interesting even is the ability of this strategy to limit negative cash flow implications, improving the forward’s performance by 43%. In this domain however purchased options unsurprisingly perform best by a fairly substantial margin.

Overall though, the PPP based approach should be attractive to hedgers concerned with hedging costs, protection effectiveness and cash flow impact. Although it is second best in all areas tested, this technique offers some substantial improvements over more passive methods when hedging exposures such as net investment or earnings translation risks. Certainly, many other strategies could be analyzed that may enhance our PPP strategy even further. One thing to keep in mind however is that a PPP implied rate is not static as it evolves with inflation and economic conditions.

In conclusion, currency valuation modeling can help improve hedgers’ performance specifically in the areas of hedging costs and cash flow impacts, two issues especially important when dealing with translation types of risks. At the end of day, efficiently managing a financial risk such as foreign exchange implies working with market conditions. Ignoring them will most likely translate into hedging inefficiencies, opportunity costs and possibly liquidity implications. The approach developed in this article has the advantage of offering a structured alternative to the passive management of certain types of exposures. It improves on traditional hedging strategies while avoiding discretionary decisions that would be unacceptable in a corporate environment.

As history has shown, currencies’ strengths and weaknesses, especially in the majors, tend to be cyclical. The current weakness of the US Dollar makes hedging translation risk much more attractive to North American companies than to their European counterparts. This should not however discourage the latter from managing these risks, just make them more aware of the environment and complement instrument choices with a sound valuation analysis.

References:

1. F. Del Vecchio: Currency Issues for Asset Managers No 21 – August 2003: “A Fresh Look at Purchasing Power Parity”
2. S. Knauf: CitiFX Economics – January 04: “Using Over and Under-valuation Signals to Hedge ZAR Revenues”

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