To hedge transaction exposure, companies use various hedging strategies with different levels of complexity. Hedging programmes can range from a ‘zero-hedge’ strategy (the exposure is left un-hedged) to a more complex layered hedge strategy. Assuming a constant exposure at the end of each quarter, this section describes four different hedging programmes:
- Unhedged: Exposures are left unprotected and are converted at the spot rate prevailing at the end of a quarter.
- Rolling hedge: At the beginning of each quarter, the exposure for the quarter is hedged using a 3-month (M) forward; this is repeated each quarter.
- Static hedge: At the beginning of each year, hedges are executed for the full annual exposure using 3M, 6M, 9M and 12M forwards.
- Layered hedge: Hedges are executed to fulfill a defined hedge ratio for different future exposure dates: 25% for Q4 exposure using the 12M forward, 25% for Q3 exposure using the 9M forward, 25% for Q2 exposure using the 6M forward rate and 25% for Q1 exposure using a 3M forward. At the end of each quarter, another hedge ‘layer’ is added to the hedge horizon. This will lead to a blended rate on realisation of the exposure at the end of each quarter.
The primary goal of any hedging programme should be the reduction of the realised hedge rate’s volatility – not achieving an optimal realised rate. The latter is more akin to speculation than to corporate hedging. Whether using the ‘rolling hedge’ strategy or the unhedged strategy, companies achieve no reduction in volatility as the effective hedge rate of the rolling programme is solely a function of the spot rate and forward points prevailing at the hedge execution date in the previous quarter.
Specifically, in the case of the EUR/USD and its flat forward curve, the ‘rolling hedge’ strategy leads to an almost equal projection of spot rates at the hedge implementation date to the end of the quarter. As a result, the hedge doesn’t help protect future results and leaves the position very similar to an unhedged position. The upshot is that there is little predictability of outcome or protection against the impact of currency movement on the bottom line.
The ‘static hedge strategy’ fully removes risk within a year, although significant jumps can still occur from one year to another. This means that the volatility of the achieved hedge rate can be reduced compared to the unhedged and rolling strategies but still remains high. By locking in the rate for the full year, the company has full certainty of cash flows but fully limits the potential to participate in favourable exchange rate movements.
Moving to a Layered Approach
Increasingly, companies are using a layered hedge approach whereby they add layers of hedges each quarter as exposures become clearer. Companies can achieve the best result using a ‘layered’ hedge strategy because the effective hedge rate achieved for each quarter consists of an average of four different rates from four different points in time, which leads to a less volatile outcome. The example in this article only extends into a four quarter horizon, although companies can move farther out the hedge horizon. By extending the hedge horizon to six or eight quarters, treasury can further smooth the achieved hedge rate.
In the context of the layered hedging strategy, treasurers should also take into account other considerations such as hedge ratio bandwidths and the decision making model to assess timing of hedge execution. Figure 3 below summarises the simulation results of the four hedge strategies in terms of the standard deviations (representing volatility) around the achieved average hedge rates for a EUR/USD time series from 2010-2014.
Figure 3 – Achieved Average EUR/USD Hedge Rate and Standard Deviation per Strategy:
The recent move in the EUR/USD has different impacts depending on the currency position (long/short) a company holds.
Euro functional Entity
An exporter invoicing customers in USD (long USD) needs to sell USD against EUR. Therefore, given the EUR depreciation, the exporter is able to convert the USD receipts at more favourable rates in the absence of forward based hedging strategies. In case the exporter uses forwards to hedge his exposure, the potential to participate from the EUR depreciation is limited or zero.
However, an importer invoicing in USD needs to sell EUR and buy the USD to settle the invoice. Therefore, given the EUR depreciation, the importer needs to convert EUR into USD at less favourable rates in the absence of forward-based hedging strategies. Using forwards to hedge its exposure, the importer can avoid conversion at these unfavourable rates but the strategy limits the potential to enjoy favorable conversion in case of an appreciation of the EUR.
Managing exposures using forwards as hedging instruments also means that – depending on the target hedge ratio – there is limited participation in favourable market movements. Figure 4 below shows different hedge instrument strategies for a short USD position and their payoffs corresponding to the market movements. Compared to the unhedged strategy, cash flows are certain with the 100% forward hedge strategy limiting both the up and downside to zero. In case of lower hedge ratios (e.g. 50% forward hedge) some up and downside chance/risk remains.
Figure 4 – Payoffs from Different Hedging Instrument Strategies for Short USD Position:
USD Function Entity
Conversely, a company that is USD functional has been experiencing a decline in earnings over the past few quarters as the depreciation in the EUR translated into lower USD results. That applies across all exposure types: transactional, translational and economic. On the transaction side, recognised and unrecognised exposures – if left unhedged or hedged on a rolling basis only – produced fewer USD each quarter in real terms.
An exporter who invoices in EUR (long EUR) has to convert those EUR into USD. Therefore, given the EUR depreciation, the exporter ends up converting the EUR into USD at a much lower rate, in the absence of a hedge programme (or in the case of a simple rolling hedge).
In both cases, an alternative to forwards hedges are hedging strategies involving options. Instead of covering an exposure position with a forward contract, an option retains the upside potential if rates move favourably while fully protecting against the downside.
This asymmetrical payoff comes at the cost of an option premium. Many companies are loath to pay the upfront premium on a purchased option. Plus, in recent months, volatility in the FX market has inched upward after a long period of low vols. That does make the cost of options higher, as implied vols rise. That is why many corporate treasuries opt for zero cost collars or risk reversal strategies, which provide a cost neutral alternative. By simultaneously selling and buying an option at different strike prices the exposure is hedged at a known worst-case rate while retaining limited upside participation.
Option hedging strategies are also often used when certainty of cash flows is limited. For many companies, when hedging anticipated exposure, the 3-4 quarters forecast can be murky. By using options, the company is able to have more flexibility.
Companies on both sides of the EUR/USD relationships are facing growing challenges as the exchange rate shifts, on a transactional, translational and economic exposure levels. To reduce vulnerability from FX market movements, companies must first identify the different exposure types they face and measure those exposures to assess the potential impact of further declines in the EUR/USD rate, depending on the company’s functional currency.
This means corporates have to carefully consider if their hedging programmes produce reduced volatility of achieved hedge rate outcomes, or if their strategy aims solely at achieving an optimal hedge rate. That often means trading predictability of outcome for the ability to participate in favorable currency moves. Forward hedges lock in a rate, with layered hedging programs producing the most favorable results. However, options hedges, particularly zero-cost collars, can help companies achieve risk protection while maintaining their ability to benefit from favourable market moves.
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