Hedging and Risk Management Using Options
Options provide corporations with a powerful strategy to protect themselves from the potential negative affects of market fluctuations. Despite their reputation for being expensive or risky, options, when used properly, can serve as a cost effective and economical practice to hedge against market exposures. No wonder that the use of derivatives, especially by non-financial companies, has continued to soar with more than 80% of the Fortune 500 companies using derivatives of at least one asset class.
In contrast, the practice of buying or selling futures or forwards has proved to be an inflexible way of dealing with a dynamic and ever-changing market as they do no more than lock a company into a set rate.
The main strength of options is their flexibility. They can be tailored to provide payoffs that match end users’ exposures more closely, and also suit their tolerance to risk, mirror corporate policy as well as satisfy their accounting and compliance requirements.
Additionally, options can reflect users’ general outlook on the market. Options could enable users to benefit from a favourable market move while being fully hedged against an undesired market fluctuation. All this can be done cost effectively and, frequently, at a lower final cost than using forwards.
One of the business risks that corporate treasurers must manage is unexpected fluctuations in the cost of funding the company’s operations through debt financing. This financing is typically done through bank loans where the company is borrowing money from a bank or corporate bonds, i.e. the huge universe of fixed income investors. In either case, corporate treasures will often wish to benefit from lower debt service costs in falling interest rate environments, and likewise hedge against higher debt service costs in rising interest rate environments. This hedging can be achieved through the use of interest rate derivatives.
The basic corporate interest rate hedge is an interest rate swap (IRS), which is simply an agreement between two counterparties (in this context, between the corporation and a swap dealer) to exchange interest payments over a predefined period of time. Often, one of the counterparties in the swap pays a fixed rate of interest, while the other counterparty pays a floating rate of interest. The use of IRS’s enables a corporation to ‘swap’ fixed interest rate payments it owes on corporate debt for floating interest rate payments, or vice versa.
To illustrate this, let’s consider corporation XYZ Corp, which has recently borrowed €100m from a bank. XYZ Corp must make interest payments every three months for the next five years that are calculated based on the three-month Euribor rate. This rate resets every day based on average rates at which banks will lend euros to each other; the corporation therefore does not know what its interest costs will be over the life of this loan. It will benefit if interest rates go down – conversely, its interest costs will go up if interest rates rise. To protect against potentially rising interest rates, XYZ Corp enters into an interest rate swap in which it agrees to pay interest for five years on €100m at a fixed rate, and in return its counterparty agrees to make floating interest rate payments to XYZ Corp, which are equal to the payments XYZ Corp must make on its debt. Through this transaction, XYZ Corp has transformed unknown future interest costs into known (and limited) future interest costs, thus allowing better forecasting and management of financing costs.
Another popular interest rate derivative used by corporate treasurers to manage the cost of their debt capital is the interest rate cap option. In buying an interest rate cap, the corporation limits its debt service cost while retaining some of the benefit of potential falling interest rates. Using the same example, let’s assume that XYZ Corp purchases a five year 5.50% interest rate cap on three month Euribor on a notional amount of €100m, rather than entering into the IRS. What this means is that XYZ Corp’s interest cost will never go above 5.50% no matter how high Euribor goes. If Euribor fixes at 7.00%, for example, the cap seller would pay XYZ Corp 1.50% (Euribor minus the cap rate) while XYZ Corp pays 7.00% on its loan – resulting in a net interest cost of 5.50%. XYZ Corp must, however, pay for this option: the corporate treasurer must decide if the risk of higher interest rates, and thus higher debt service cost, is great enough to justify spending the premium for the hedge.
Beyond these two basic hedging strategies, there are many other methods used by corporations for hedging. Hedges can be constructed that both meet hedge accounting requirements and are specifically tailored to match the treasurer’s view of potential market risk. For example, if XYZ Corp believes that it is likely that interest rates rise moderately but very unlikely that rates will rise by a large amount, it may purchase a cap that limits its debt service cost to 5.50% as long as Euribor does not go above 6.50%, in which case it will have no protection at all (this is called a ‘knockout’ cap because the protection afforded by the cap knocks out if interest rates rise above 6.50%). This knockout cap would be considerably cheaper than the standard cap described above. This is just one example of a more advanced, tailored hedge for corporations.
If a corporation has market exposures as a result of its operations or financing activity, it would be wise to strongly consider using options to hedge those risks. The availability of both bespoke (over-the-counter – OTC) and exchange-traded options provides a wide choice of strategies; any CFO or treasurer should always evaluate various hedging alternatives.
More market-making banks are now catering to smaller corporations, offering them highly competitive prices, even for those options and structures that would have been considered out of reach until recently.
The availability of platforms with asset class specific modules makes it easy to analyse hedging alternatives and get information on the true market cost of options. The advent of real-time pricing and analytics applications has brought more transparency and liquidity to the market, which has definitely helped increase option trading volumes over the past few years.
Some platforms provide corporate treasuries the ability to rapidly price and analyse many different potential hedging strategies, to manage their portfolios of funding trades and related hedges, and to negotiate with derivatives dealers from a position of strength by knowing the market value of the hedges they are contemplating purchasing.
There are numerous reasons why corporations, independent of their size, should always consider using options as part of their risk management strategy. Now that they can easily price them accurately, monitor their fair market price, measure their risk properly and perform flexible ‘what-if’ scenario analysis, including on the most complex exotic OTC structures.
It is important that treasurers have an integrated platform that can manage pricing, execution, deal capture, market-risk monitoring, portfolio life-cycle, reporting and hedging-compliance – as well as all the audit tracking associated with managing all derivatives activity.
Once compiled, treasurers need to carry out on-going management of derivatives trades, including mark-to-market and sensitivity analysis for the deals, as well as automated life-cycle management events, such as triggers that have been hit and expiry dates that have been reached.
But before starting to build up a derivatives portfolio, corporations should know where they stand vis-à-vis market makers regarding options pricing. In this regard, fully integrated platforms can give corporations an edge by letting them accurately price the kind of strategies they want to pursue with the same precision and accuracy as the market makers themselves. If the true market price of an option or option strategy is known, corporations are naturally in a far better position to receive better rates from their chosen counterparties as well as feeling comfortable to use derivatives as a hedging tool.
The IAS 39 and FAS 133 accounting standards make it mandatory for corporations to record the fair value of derivatives on their balance sheets. Corporations have to be able to measure hedge effectiveness and need access to real-time accurate pricing. They require tools that will let them match up any hedges that have been initiated with exposure, such as anticipated payments and receipts in a foreign currency. This will help provide easy monitoring of both the hedge and the underlying, facilitating compliance with hedge accounting.
Corporate risk management platforms can be integrated with existing corporate Enterprise Resource Management or accounting systems, which contain all necessary information pertaining to the underlying business activity. Examples of such business records include cash flows with an indication of the actual transaction, the level of probability of incoming and outgoing payments, resource flows such as fuel and raw materials and their inter-related cash flows, and debt repayments. As a result, the platform can analyse market exposures and recommend hedging strategies, enforce corporate hedging policies and enable after-the-fact hedging-compliance reporting.
The platform and deal capture process automatically enforce the corporation’s hedging policy. When a derivative is entered into the system, it must be matched to an existing underlying exposure, and validated against both corporate hedging limits, such as the largest allowed position in a specific currency pair, and external accounting standards, such as IAS 39 and FAS 133.
Reports required for accounting compliance can be generated by the system with a few clicks. The report templates and preparation logic have been designed together with leading accountant firms, and contain all the required information in the correct audit-ready format.
Finally, in order to be eligible for hedging accounting compliance, any system has to offer tight controls towards complying with various internal and external operational standards, such as Sarbanes-Oxley (SOX) Section 404. Privileges and permissions must be easily definable and enforceable reflecting corporate structure, operational and financial-risk limits. And of course, a full audit-trail must be readily available to assist in internal and external audits and reviews.
The two main factors for driving corporate usage of derivatives in the future are:
Corporate treasurers will be looking for one tool to support the entire workflow, encompassing exposures, price discovery, deal capture, mark-to-market, simulation tools and reporting. This, together with increasing government regulation and compliance requirements, make the solutions I have discussed attractive for corporate treasures in need of cost-effective risk management.