Evaluating Hedging Programmes and Strategies

How can corporates prioritise their hedging strategy in the wake of the global financial crisis and the approaching upturn?

Events in global financial markets over the past year or so have highlighted the fact that hedging your organisation’s financial exposures is now more important than ever. Counterparties that existed in 2008 and early 2009 may no longer be around, or may exist in an entirely different form. Markets that were once deeply liquid are only now showing signs of thawing. Instruments that you once used without reservation may now come with new restrictions, limitations and costs that they did not carry in the past. The landscape approaching 2010 is vastly different from anything we have seen in recent memory.

Not all is doom and gloom, though. Signs of recovery are springing up around the globe and consumer sentiment appears to be rising along with it. Eurozone industrial production appears to be recovering more briskly than the experts predicted. Japanese manufacturing sentiment has been rising at a better-than-forecast pace. The rate of job losses in the US has slowed. Although the recovery is tepid, its causes and level of sustainability create room for much debate, one cannot ignore that we are in a better place now than we were even a few months ago.

With this recovery seemingly underway, global commerce will pick up and your need to manage your associated risk will once again grow. Despite the aforementioned changes and uncertainties, one thing has not changed - your need to protect your organisation’s bottom line while freeing yourself to focus on running your business. This will be possible once you are convinced that your risk is properly managed with the appropriate parties, and that even unlikely events have been taken into account.

Your motive for hedging should be to minimise the loss not grow the profit. Hedging should not be a roll of the dice. The whole reason for formulating a hedging strategy when entering into transactions of this nature is to protect your organisation’s bottom line.

The tools that are available to you to manage this risk, although not very different on the surface, are worth discussing and examining more closely. Now is a good time to evaluate your past success with hedging instruments and see if there is anything you should change.

• If you had the chance to do it again, would you lock into those exotic (and expensive) options?
  
• If you use options, confirm the inputs. Interest rates and volatilities are less transparent than spot foreign exchange (FX) rates, but should not be left up in the air for determination.
  
• Are the forwards you are considering detrimental to your working capital, tying up an undue amount of funds in margin or collateral deposits? If opportunities arise that you want to pursue, will you have to reject them because your funds are tied up as margin or collateral deposits? Will you have the capital available to pay a margin call deposit in the event that you are required to?
  
• Are you consolidating all of your banking needs in one place? If that provider goes under, will you lose your operating accounts, FX hedges and credit lines?
  
• Are you assuming avenues that were available to you in the past will remain so? Many providers may now limit the duration of hedges or limit the currencies in which they will hedge. They may impose minimum or maximum amounts required to enter into a hedge.
  

It would even be worth taking a step further back and examining the counterparties with which you enter into hedges.

• Banks, in particular, are under more scrutiny and face more restrictive capital requirements. You can expect that you will get the same treatment when dealing with them.
  
• Be wary of ‘fly-by-night’ organisations offering pricing and terms that sound too good to be true. If they are eager to extend generous terms sight unseen, then assume they are offering these very same terms to other, less creditworthy, companies. Their risk is now your risk.
  

Conditions may change significantly from when you enter into your hedges and when your hedges mature. You could a very well-informed decision maker at the time the hedge is entered into, but if that is where it ends you are doing a disservice to your shareholders. Constantly monitor the health of your strategy. Take a periodic ‘temperature check’ to make sure your hedges are still intact and appropriate.

Strongly consider external events and your expectations for what lies ahead. As mentioned earlier in this piece, signs of recovery abound, but few predict that we are out of the woods. Some are even suggesting that the worst of the crisis lies ahead because the US economy is still suffering, despite government stimulus packages.

With this in mind, what will happen to your hedges in the event of a return to conditions of months past. Solicit opinions from experts, ask your customers what they think, listen to both sides of the argument and determine for yourself what is best for your business. No one knows what conditions must exist for the success of your organisation better than you do. Be informed so that you can make educated decisions for the benefit of your company, customers and shareholders.

These points are by no means exhaustive, but it should give you an idea of some things that you should be prioritising when evaluating your hedging strategy. Despite a significant change of scenery, as long as you continue to follow the key steps along the path to successful hedging, you and your company will be well protected.