FX Supplement 2014 | Corporate Hedging
The recent surge in foreign exchange volatility may be catching some corporate treasurers by surprise after the currency market’s prolonged lull.
“Over the last year and a half, volatility has returned [to the foreign exchange markets],” notes Karl Schamotta, director of FX strategy and structured products at Cambridge Mercantile Group. “We’ve seen the emerging markets run into troubles, and now the majors are adjusting quite dramatically, as well.”
Schamotta links the currency moves to “a rebalancing in the global economy,” as growth in China slows while economic activity in the developed world, particularly in the United States, picks up steam. “What we’re seeing is central bank policies, economic growth and simply the flow of capital—the expectations of those things are shifting in different directions right now.”
People have become well aware that the house is on fire again.
~ Schamotta, Cambridge Mercantile Group
A lot of corporate treasuries were relatively unprotected as they headed into the renewed volatility, Schamotta says, citing the low implied volatility on options on major currency pairs earlier this year. “Buying insurance on currency movements was relatively cheap,” he says. “That really reflected that there wasn’t a lot of demand, there weren’t a lot of people looking to protect themselves. Many corporates simply said, ‘Let’s focus on the underlying business and leave the currency markets to do what they will.’”
Whether companies cut back on FX hedging while volatility was subdued likely depended on each company’s policy, says Krishnan Iyengar, a vice president at treasury and risk management solutions provider Reval. Iyengar says that some companies give hedging managers the latitude to modify the amount of exposure they hedge. “A very common approach companies use is, they allow their risk managers a policy band to hedge within, depending on external market factors,” he says.
Nevertheless, any complacency among companies has now evaporated. “People have become well aware that the house is on fire again,” Schamotta says. “Treasurers are looking at putting trades in place. Unfortunately, the reality for many is that they’re reacting too late.” He adds that some people with large euro and yen receivables who had thought they were “sitting in the sweet spot” have taken substantial losses, while others are looking to lock in the gains they’ve achieved using forward contracts.
FOREIGN EXCHANGE SUPPLEMENT 2014 | SECTIONS
TURNING TO OPTIONS
Although corporate treasuries have traditionally employed products like forwards, spots and swaps to hedge their foreign exchange exposure, Iyengar notes an increasing interest in options. “We are seeing a pickup in companies trying to get budget for option products in the last couple of quarters,” he says.
Options “are primarily used from an insurance perspective on extreme moves in the market at some time in the future,” says Iyengar, explaining that there is increasing interest in option structures because companies view them as cheap, based on historical comparisons, while sensing a future rise in volatility.
Schamotta also cites increased use of currency options. In particular, he says, companies worried about extreme market moves in the wake of the 2008 financial crisis are using options to implement currency collars, a structure in which a company buys a put option while selling a call option. A collar limits the company’s gain if the market goes in its favor and limits its loss if the market goes against it. “If the markets go really crazy, you are protected,” says Schamotta.
The biggest driver in hedging foreign exchange risk at the moment is actually regulation.
Association of Corporate Treasurers
Iyengar says that companies using a collar “would typically be buying insurance on rates moving in one direction and financing that premium by selling the counterparty an option that, if rates went below a certain point, the company would pay the counterparty.”
“The company wouldn’t care if rates went down because they would pay their suppliers less,” he adds. “The benefit they would gain by paying their suppliers less would make up for the payment to the counterparty.”
Companies are also starting to employ a portfolio approach to forex hedging, according to Iyengar. “Rather than looking at each currency pair discretely, they’re looking at their entire exposure on a portfolio basis, looking at which currencies are highly correlated or inversely correlated, and isolating the net risk on a portfolio basis,” he says, explaining that the approach involves the use of more sophisticated models. “Once they’ve isolated their risk, they can then make certain decisions on how to hedge that risk.”
FOREIGN EXCHANGE SUPPLEMENT 2014 | SECTIONS
Increased volatility makes hedging more expensive, but it shouldn’t alter the effectiveness of a company’s hedging program, says Luis Montiel, assistant treasurer at Jabil Circuit, a contract manufacturing company based in St. Petersburg, Florida.
The keys to hedging effectively are understanding the company’s business and the data associated with its business flows, Montiel says, adding that knowing the business relates to understanding how the cost of goods sold moves through the supply chain: “If you don’t understand what you’re hedging, it becomes extremely difficult to say you’re effective at it.”
Companies also need to have a clear handle on the information flows associated with transactions. “If you were to sell in euros today and wait three to four days to book that into your enterprise resource planning system, that lag of time doesn’t allow you to have the real-time data to say, ‘I just sold X amount in euros that needs to be hedged,’” says Montiel. “That is the type of data visibility that companies need to have an efficient program.”
VOLATILITY VERSUS REGULATORS
James Lockyer, director of development at the Association of Corporate Treasurers, argues that regulatory change poses a far greater challenge to corporate FX hedging than market volatility.
“The biggest driver in hedging foreign exchange risk at the moment is actually regulation,” Lockyer says. He cites new reporting requirements related to Dodd-Frank in the US and the European Market Infrastructure Regulation in Europe, as well as new bank capital requirements.
The capital adequacy and liquidity requirements that are part of Basel III are resulting in banks’ charging more for long-term hedges, because they have to hold more capital against them, and are affecting “the maturity of trades which corporations can enter into with banks,” he says.
Montiel describes the regulatory environment as “quite a large burden” and says that, from Jabil’s perspective as an end user of derivatives, it’s often “not transparent and extremely clear what we are supposed to be doing” to comply with regulations. But he adds that compliance with regulations is just another one of the risks that companies have to deal with in their hedging programs, as is market volatility: “There’s not a risk that we don’t address on a continuous basis.”