The New Foreign Exchange (FX) Hedging Mindset
Traditionally, corporate treasurers focused on looking at forecasts to decide whether to hedge their currency exposure and how best to do so. They spoke with their relationship banks’ foreign exchange (FX) strategists and economists, particularly if it was a smaller company, to help determine the direction the currency was headed and what action to take.
However, more recently the hedging decision has been evolving. In 2012 alone, market participants saw continued volatility, sovereign downgrades, and some countries relaxing currency controls while others applied them, making the hedging decision far more complex. That said, treasurers have more analytical tools and access to more information than ever before, enabling them to make more informed hedging decisions – whether by themselves or still in partnership with a bank. Once they decide to hedge price transparency can now provide optimal execution and consistent fair market valuation, making the stand-alone route more attractive.
When determining the optimal FX hedging strategy, today’s corporate treasurer has to consider the underlying business activity that generates the exposure the hedge is designed to protect. To offer a few examples, it could be a long-term decision such as hedging the net equity of an overseas investment; a medium-term hedge for a supply contract; or a short-term hedge for a three-month revenue stream. Perhaps a more fundamental consideration includes analysis of the FX market, to determine where markets are currently trading and whether the underlying fundamentals are in fact supportive of those levels. These are factors that influence what terms to negotiate for that long-term supply or services contract, or the timing of a spot currency transaction designed to close a merger and acquisition (M&A) deal.
In the past, a corporate treasurer would have relied on forecasts supplied by the company’s relationship banks to make such decisions, but a new hedging mindset is now essential in today’s volatile, interconnected and hyper-transparent world.
Macroeconomics: No Longer a Reliable Indicator
Historically, relying on the macroeconomic outlook for a country helped to determine where currencies would trade but the global turmoil of recent times has seen the risk appetite cycle tighten dramatically, creating a more complex hedging landscape. Market reaction to various events, enacting a risk-on or risk-off strategy, has made it crucial to watch hot money flows in and out of various asset classes, assorted ‘safe havens’ or emerging market countries. Whether the market reaction is to buy or sell a currency itself to exercise a view on risk, or buy or sell a different asset class where FX is necessary to facilitate this trade, corporations are increasingly staying informed of investor flow. For Asia specifically, this investor flow has greatly influenced the recent strength of its regional currencies.
Figure 1: Bloomberg FX Information Portal, Providing an Overview of Asian Markets.
Gauging Market Sentiment
While the trading environment has become more complex and volatile, multinational corporations (MNCs) can draw on a wide variety of analytical tools, many of which use price data and can therefore be used to formulate market forecasts. An example of such an approach is the use of non-deliverable forwards (NDFs) to provide an analytical alternative to traditional macro forecasts for key emerging market (EM) currencies.
An analysis of NDF markets in EM Asia [the Indian rupee (INR), Indonesian rupiah (IDR), South Korean won (KRW) and Chinese renminbi (RMB)] provides multiple examples of the divergence in currency views expressed by the analyst community and those actually managing market risk.
The use of option volatility data provides yet another example of the use of price signals – in this case the 25-delta risk reversal – as a gauge of market sentiment. The observable changes in the relative supply or demand for a currency’s puts, versus its calls, can provide useful trading signals for risk managers.
NDFs and risk reversals are most useful when crafting a risk management strategy for a short to medium length exposure, such as three months. Yet another market-based approach uses the changes in weekly futures market positions to inform risk strategy. For those actively-traded currencies, the changes in the net open positions (the difference between short and long positions) can offer an important insight into how a market is positioned in the short to medium term.
Back-testing Your Hedge
Traditionally the job of bank structuring desks, increasingly corporations are now themselves embracing the ability to objectively test how their FX options strategy performed versus hedging using an outright forward. Many corporations, which historically have not been users of FX options, are now considering them as a hedging tool. They can now quantify in money terms the opportunity benefit, or cost, of having chosen one strategy over another.
A hedge’s effectiveness is also relevant from an accounting perspective and corporations are increasingly adopting tools which allow them to track how a hedge performed against the underlying exposure. With new hedge accounting rules in Asia expected to be rolled out in 2014, this trend is expected to continue.
Greater Transparency in Pricing
As any corporate treasurer will attest, the introduction of electronic trading (e-trading) has narrowed spreads and enabled them to track the banks with which they do most business. As more products, such as FX options, become commonplace on these platforms, the treasurer will likely continue to benefit from the increase in price transparency.
Furthermore, additional pre-trade analysis now enables the treasurer to make optimal decisions as to which market to trade electronically. Corporate treasurers can now compare whether it is better to borrow or lend in the money markets of a given currency, or if an arbitrage opportunity exists that they can access via the money market in an alternative currency. They can also access both onshore and offshore pricing in emerging market currencies, which further enables smarter and more timely investment decision making.
Determining Long-term Currency Valuation
For long-term projects and financial commitments, risk managers are increasingly requiring tools that seek to analyse a currency’s fair value over the course of the economic cycle. These approaches employ techniques such as purchasing power parity (PPP) and real effective exchange rates (REER) in an effort to determine whether a country’s underlying economic fundamentals support current valuations, or whether the currency is a candidate for significant appreciation or depreciation.
The PPP approach uses a common basket of goods across multiple countries and then examines the price ‘differences’ in the basket to determine the extent to which a particular currency may be overvalued or undervalued. The REER approach analyses a basket of a country’s trading partners to determine whether its currency is over or undervalued, not on a bilateral basis, but against this basket. Yet another approach to valuation, primarily used for countries with significant natural resource exports, is to create a basket representing these exports and then track a currency’s performance vis-à-vis the basket. Whichever approach is favoured, corporate treasurers now have the tools available for long term currency valuation.
Figure 2: Based on Purchasing Power Parity (PPP) – aka the ‘Big Mac Index’ – the Australian dollar Remains Overvalued while Asian Currencies are Undervalued.
Assessing Sovereign and Counterparty Risk
In the wake of the credit crisis, corporate risk managers must also focus on counterparty risk. Traditionally, risk analysis was all one-way; banks analysed their corporate clients risks’ and determined credit limits. For any exposures over and above that predetermined limit they required margin and collateral to be posted under a credit support annex (CSA).
In today’s environment, this process has become a two-way street, with corporate clients equally concerned about their counterparty’s risk profile and prospects, including its bank risk. To gain more insight into their sell-side counterparties, corporations can employ several approaches, one of which is credit default swaps (CDSs). By virtue of its liquidity and price action, a CDS provides the risk manager with instant feedback on how the market views the creditworthiness of their counterparties.
While risk managers have also relied on the traditional ratings supplied by a few credit ratings agencies (CRAs) globally, this approach has always had drawbacks in terms of the lags inherent in the process. A rating is placed on review and only changed after a period of weeks or months – far too long a lag in today’s rapidly-changing environment. A more market-based approach to ratings is the default risk probability model (DRSK), which generates an independent estimate of a counterparty’s financial health using both fundamental data and quantitative models. It provides automatic transparent daily estimates of a counterparty’s creditworthiness, including default probability for one year, and an implied CDS spread. It is a transparent approach with all input values and methodologies available for historic analysis. Users can also override current market and fundamental data to stress a company’s financial health on a real-time basis.
Figure 3: Example of as Default Risk Probability Model (DRPM).
Conclusion and Outlook
When it comes to global financial markets, changes due to evolving technology and regulation are inevitable. As more traditionally non-FX industry players increase their activity in the FX markets, the analytical tools which they are accustomed to, and which may be mandated by regulation (transaction cost monitoring and centralised clearing of certain transactions), will become more widely available.
Corporate treasurers will only stand to benefit from incorporating such tools into their decision-making process, while adopting a new hedging mindset that takes into consideration market volatility and risks. The biggest risk is being left behind: those slow to adopt and incorporate these analytics into their hedging decisions risk lagging their peers in running a more effective hedging programme, which in a globalised environment can also mean giving away an unrecoverable competitive advantage.