Fast forward 11 months, and the rouble has declined by about 45% against the euro. In retrospect, that 7% hedging cost doesn’t seem so expensive, and largely due to its Russian exposure, Carlsberg’s share price has collapsed by almost 30% (Russia is the source of about a third of Carlsberg’s profits), despite the fact that European equity markets (including other major brewers like Heineken and SABMiller) are up over the same period.
Carlsberg’s FX headache has been mirrored at many other companies this year, as currency volatility has made a dramatic comeback. This is particularly true for US multinationals, with the US dollar strengthening against most currencies in 2014, including an increase of over 12% against the euro.
It is fascinating that both the rouble and the euro have weakened this year, as the strategies being employed by their respective central banks are at opposite ends of the monetary policy spectrum. The Russian Central Bank (RCB) has been aggressively raising rates (including the recent 10.5 percentage point hike), while the European Central Bank (ECB) actually dropped one of its key rates (the deposit facility rate) to below zero (-0.2%) in September.
Clearly, currency traders are worried by both the RCB’s ultra-tight monetary policy (which may be viewed as an extreme incentive to hold a currency facing severe longer term challenges) and by the ECB’s ultra-loose monetary policy (which makes the currency unattractive due to its lower, or negative return).
Whilst, from the perspective of a corporate treasurer facing significant currency risk on overseas earnings or investments, this distinction may seem unimportant, it has a very real impact on at least one important factor: the cost of risk mitigation.
For companies exposed to the euro, the extremely low interest rates in the Eurozone mean that the ‘cost’ of hedging isn’t actually a cost at all. Instead, for USD-functional companies, hedging the euro provides a net gain; in effect, they are getting paid to take risk off the table. This impact can be significant – for a USD-based corporate, hedging the euro one year forward currently yields a net benefit of over half a percentage point. Hedging two years out increases this pick-up to over 2%.
On the other hand, trying to hedge a long rouble exposure is extremely expensive. The 7% annualized cost of hedging referred to by Carlsberg’s Jensen has since almost tripled to just under 20% (due to the RCB’s aggressive rate hikes, designed to discourage the private sector from selling, or hedging, the rouble). Hedging out two years would now cost in excess of 30%.
While the cost of hedging – or, indeed, the cost of any insurance programme – can often seem high until you need it, and in hindsight it can seem like a bargain, it is very hard to imagine a scenario where a cost of hedging approaching 20% per year would be palatable. In fact, managing currency exposure in a high-yielding currency susceptible to downside shocks (which is the case for many emerging market currencies) may be considered the ‘Sophie’s Choice’ of the corporate treasurer.
Options for Treasurers
So what options are left open for companies facing material exposure to the rouble or other emerging market currencies? The first is to try to identify operational methods to dampen the impact of a weakening currency, such as price hikes and/or the creation of natural hedges to match the currency of costs with that of revenues. Another operational risk mitigation technique is to embed currency clauses into customer contracts – a hedging technique which can often avoid the need to crystallize massive hedging costs right away.
A second approach is to hedge dynamically; using a low hedge ratio initially, and looking for tactical opportunities to layer in hedging as and when the currency strengthens. Using a disciplined approach, with specific trigger levels, can ensure that protection is built up over time at more attractive rates, at least partially offsetting the high cost of hedging.
A third approach involves structuring derivative solutions, using market conditions to lower the net cost of hedging. For example, hedging structures which sell rouble volatility (which has recently spiked dramatically, to over 40%) can be used to moderate the forward point impact. One way of achieving this is to use knock-outs (which clearly carry their own risks – i.e. that they can get knocked out), however, the protection rates that can be achieved are attractive. For example, in USDRUB, a one-year hedged rate of just above 53 (compared to a spot rate of 54.65, or a one-year forward of 62.55) can be achieved by incorporating a knock-out at 100, well above the recent high. Whilst many treasurers will understandably be reluctant to employ complex hedging structures – especially ones which incorporate features like knock-outs – this may be a case where the value of an adaptive and flexible approach to hedging is justified. As Albert Einstein once wrote: “The measure of intelligence is the ability to change…”
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