More than four years on from the 2008 financial crisis, the global macroeconomic situation remains extremely uncertain. The US economy is achieving slow growth, but wages and unemployment remain problematic. In Europe, other than in Germany and the Netherlands, the debt crisis appears almost unsolvable. Post-bailout Greece still owes more than 170% of gross domestic product (GDP) despite debt forgiveness, Spain’s unemployment rate is over 25%, with its banking system nearly insolvent and so far refusing help.
In response to this uncertainty, exchange rates have remained quite volatile, creating large earnings uncertainty for companies doing business internationally. Figure 1 shows the euro/US dollar (EUR/USD) for recent years; its volatility illustrative of most G8 currencies.
Figure 1: EUR/USD Exchange Rate.
Source: Currency Risk Management.
Examples abound of mismanaged or unmanaged FX risk impacting earnings. A search of Form 10Qs easily turns up large FX losses. Even when losses in one year are offset in another, earnings volatility is anathema to chief financial officers (CFOs), while studies correlate an increase in earnings volatility with decreased company valuation. This makes sense as a key investor metric is the Sharpe ratio, the volatility-adjusted return on investment.
It’s not only earnings and company valuation that are affected by FX volatility. Cross-border mergers and acquisitions (M&As) and leveraged buyouts (LBOs) are vulnerable. Foreign asset value such as real estate, foreign liabilities including pensions, and cash flows from the foreign entity servicing home currency debt are among the potential risks to deal valuation between terms and closing. Also cash flows associated with an LBO often extend over many years, so typical short-term tools such as forwards and options are impractical to hedge the FX risk and other tools must be used.
FX Risk Measurement
Measuring FX risk – either balance sheet or income statement – is a complex task. Transactional risk occurs when a company has transactions denominated in a foreign currency. Translational risk (aka accounting risk) occurs when a company has net assets denominated in a foreign currency. Many small- to mid-sized companies use economical, home-grown spreadsheets, but these are difficult to maintain and error-prone. Whether to use the temporal or current method, determining which is the home currency, which is the functional currency (not necessarily the home currency) and which is the foreign currency are among the complexities the spreadsheet maintainer, often the cash manager, must stay on top of. In addition, they are often only updated on a monthly basis. Even among larger companies, almost half still rely on spreadsheets and only 20% use a treasury management system (TMS).
Software as a Service (SaaS) systems, an excellent solution to accurate FX risk measurement, are available from several vendors including Reval, Fincad and FiREapps. These systems integrate with enterprise resource managers (ERMs) such as Oracle and SAP, updating risk metrics on a continuous basis. Being cloud-based, they do not require a company to maintain and upgrade the system regularly, and can instantly reflect regulatory or accounting changes.
FX Risk Management
There are several possible responses to FX risk. One school of thought assumes FX rates will even out and revert to the mean purchasing price parity (PPP). Mean reversion does occur, but only over decades, and most company’s reporting periods are shorter than that. Another response is to force the other party to take FX risk by denominating the transaction in their domestic currency. This approach eliminates direct FX risk but adds many operational risks, and the law of unintended consequences will prevail – foisting risk on to your customer is not very business friendly.
Passive or ‘natural’ hedging can partially offset FX risk. Companies with income in a specific currency look for offsetting liabilities in the same, or other highly-correlated, currency but this is not always possible.
For the remaining risk, active FX hedges using derivatives can effectively hedge the exposure in a foreign currency asset or liability, a firm commitment, or a forecasted (highly-probable) transaction. Hedging with derivatives is a de-risking strategy, codified by the Financial Accounting Standards Board (FASB) and generally accepted accounting principles (GAAP), and used by more than 72% of US public companies.
Financial Instruments Used for FX Risk Management
Forwards: A forward is a contract to buy or sell an asset such as a currency at a certain price (the forward rate), on or before a certain date. It is made between the hedger and a counterparty, typically a large bank, and thus is over-the-counter (OTC). A company can take either a buy position, for example a contract to buy EUR and sell USD or sell position (such as selling EUR and buying USD) to offset their exposure, as contrasted in Figure 2.
Figure 2: Buy and Sell Positions.
Source: Currency Risk Management.
Figure 3 below shows how a forward might be used to offset a long (i.e. receivable) EUR exposure. The blue line shows the exposure. If the EUR/USD rises above the contract rate, the net profit and loss (P&L) increases above the net zero axis. If the EUR falls below it, the net P&L falls. The light blue dotted line shows the forward which would offset the exposure, a sell EUR/buy USD contract. The net result is shown in red – a completely unchanged P&L with respect to the spot rate. Note that it is not necessary to forecast the spot rate – the forward is a mathematically perfect hedge no matter what the spot rate does.
Figure 3: Example of how a Forward Might be Used.
Source: Currency Risk Management.
The forward rate cannot be set exactly equal to the spot rate of the sales contract. It must be offset by ‘forward points’, calculated from the difference between the deposit rates of the two currencies. If the forward rate were equal to the spot rate a riskless arbitrage would be possible from the different deposit rates.
Because the forward contract may lose value (in the above example, when the EUR rises) the counterparty may require an up-front margin or collateral of 4-6% of the notional. This requirement can often be met with the company’s other business deposits at the same institution. Other counterparties may underwrite an FX letter of credit (L/C) and require no margin, so choose carefully.
Forwards are best suited to:
- Certain exposures that include contractual exposures and historically-consistent forecast cash flows. If the exposure does not come to pass, the hedger is still responsible for his side of the transaction and the hedger may have to purchase the currency on the spot at unfavorable rates.
- Long duration hedges. The cost of forwards rises more slowly with time than other derivatives.
- Currencies with low interest rate differentials. For example, a four month EUR/USD forward is only 16 basis points (bps), while a four-month USD/Brazilian real (BRL) forward costs 321 bps.
The expiry date can be easily and inexpensively extended if an expected cash flow is delayed, by use of a swap and new forward.
Futures: FX futures are available on the Chicago Mercantile Exchange (CME) and other exchanges. They are similar to forwards in that they represent an obligation to exchange currencies at a certain future date, but there the similarity ends. As exchange-traded contracts are standardised, they are only available for certain dates of the year and for round-number notionals. That is, a hedger cannot precisely match their exposure for date and notional amount and this poor match will leave him/her either still exposed, or over-hedged and still at risk. In addition as futures are not an exact match for the exposure, derivative accounting may not be invoked.
Additional disadvantages of exchange-traded derivatives include a higher rate, making them more expensive and unlike the forward, which is settled only at maturity when the hedger has the funds to deliver, futures are settled daily. This means potential margin calls throughout the duration of the hedge.
Options: An alternative to forwards are options. Options are the right to buy (a call) or sell (a put) an asset at a certain price (the strike), for a certain period of time (the tenor). The cost of this right (the premium) depends on those factors. Strike prices which put the option in-the-money, or long tenors naturally cost more. Calls and puts can be bought (a long position) by obtaining the right from the counterparty, or they can be sold (a short position), conferring the right to the counterparty. Figure 4 illustrates these relationships.
Figure 4: Call and Put Options.
Source: Currency Risk Management.
Figure 5 below illustrates how options might be used to hedge an exposure and shows a long underlying exposure and a long put. Combined, we see that the downside risk is limited to the premium paid, and the hedger gets to participate in upside currency movements. Because there is a premium paid, there is a break-even point before this participation happens.
Figure 5: Potential Use of Options.
Source: Currency Risk Management.
The prior bullet point of a USD/BRL forward costing 321 bps seems to throw a wrench into neutrally-hedging exposures in emerging market (EM) countries with high deposit rates. Here is where options come into play. Options are most powerful – and more economical – when used in combinations. For example, a synthetic forward can be achieved by buying a call and selling a put. The call premium can be largely, if not completely, offset by the put premium received. Because options are priced largely mainly on tenor and volatility, the effect of a forward can be achieved without the expense.
Selecting an optimum hedge structure is complex, but done properly it can save big dividends. Structuring hedges for high profit margin versus low, high interest or low interest rate environments, or designing a series of swaps for performance payments on long-duration contracts (while keeping bank margin requirements to a minimum) are just some examples of when to engage an FX hedging consultant.
Although beyond the scope of this article, long-term exposures of two years or more present a special challenge. When might this arise? Funding a cross-border LBO is one example. Another might be a company desires to borrow in a foreign currency as the interest rates are far lower than domestic ones. Because both forward points and option premiums are dependent on tenor (term), very long hedges are impractical. In addition, most banking counterparties will not execute very long term forwards or options. In this situation, cross-currency interest rate swaps and money market tools can be used to effectively hedge long-term FX risk.
Alternative Hedge Methods
FX corporate-to-corporate (C2C), or peer-to-peer (P2P), is a very new alternative to the traditional FX market, banks and brokers. At this time, I know of one P2P platform, Kantox, which is the source of the following information. Theirs is a web-based platform where corporations can buy and sell foreign currencies to other corporations. In other words, if corporation A looks to sell US$1m forward, it can offer it on a platform where corporations B, C and D can make a request to buy the USD. The mid-market rate is used, offering no disadvantage to either party. The platform is transparent so that corporations can research the counterparty credit. For each transaction, an OTC contract is signed between the hedgers, and clearing is performed through the platform, with segregated bank accounts, on a payment versus payment basis.
There are three benefits to P2P hedging:
- Transparency regarding rates and fees: Fees on each transaction are charged as a percentage of the amount traded, not as a spread. For many companies, FX C2C hedging can often be cheaper than banks and brokers.
- Lower collateral requirements: The platform is divided in two sub-segments, one with collateral and one without. In other words, some companies may require collateral by posting cash deposit to back the trade, while others may have an existing relationship and are comfortable trading without collateral – usually companies which know each other.
- Diversification of counterparty risk: Hedgers can spread their risk amongst multiple counterparties, and select credits that meet their requirements. This may actually produce a lower counterparty risk than dealing with a single bank.
Liquidity is currently lower than in the traditional FX market but is increasing. Also, accounting requirements for credit adjustments will be more complicated in P2P hedging. FX C2C is something new and disruptive, so only time will tell if it is a true alternative.
FX derivatives must be marked-to-market on the balance sheet at each reporting period. Because the underlying hedged item may be amortised or otherwise not completely reflected on the balance sheet at every reporting period, this creates a timing mismatch in terms of when the hedge impacts earnings and when the hedged item impacts earnings. FX hedge accounting allows the hedged item to be matched to the hedge, further reducing the earnings volatility caused by exchange rates.
Hedge accounting must be explicitly selected over typical accounting treatments. However, only hedges that meet stringent documentary requirements may be treated under these rules. Those designated for special hedge accounting fall into the main categories of fair value hedges for firm commitments, cash flow hedges for forecast cash flows plus a third category for net investments in a foreign entity. The initial and continuing efficiency of the hedge derivative must be demonstrated through effectiveness testing; using approved techniques for measuring hedge efficiency (including dollar offset method, regression analysis and value reduction). Selecting the most advantageous technique is complex, but can make a difference in the ability to maintain designation of hedge accounting. If the effectiveness measure fails to meet the minimum criteria, then the hedged items revert to typical accounting and earnings may be negatively impacted.
Evidently hedge accounting is a highly complex subject. For US-based corporations, the Financial Accounting Standards Board’s (FASB) FAS 52 and FAS 133 discuss the requirements and implementation of hedge accounting. For non-US based companies, International Accounting Standards (IAS) publishes IAS 39. In addition, specialist companies such as hedge trackers can help a company properly account for their hedging programme.
A Regulatory Explosion
Since the financial meltdown of 2008, a host of new agencies and regulations have been created to forestall a repeat. They include Dodd-Frank and the Financial Stability Oversight Council (FSOC) in the US, the European Market Infrastructure Regulation (EMIR) and the European Systematic Risk Board (ESRB) in the EU, and in the UK the Financial Policy Committee (FPC).
Lest one think that the risk has abated four years on consider the US$437 trillion in interest-rate derivatives and the US$49 trillion in FX derivatives extant today; both larger than in pre-Lehman days. Many new regulations and requirements have sprung from these regulatory agencies, mainly addressing financial entities (systemically important banks), but also end-users of derivatives such as corporate hedgers. These agencies have focused on moving transactions away from OTC to exchange trading and centrally-cleared transactions. Unfortunately for hedgers, exchange-traded derivatives are less effective than OTC derivatives as they cannot be customised to specific dates and notional size. This may adversely affect FAS 133/IAS 39 effectiveness measures. Also, transition to exchanges will increase margin requirements. Worse, if the company employs a mix of central and OTC swaps, they cannot net exposures across the two types of swaps, which will demand a higher margin overall.
Fortunately, non-financial corporate entities get an ‘end user exception’ when used to hedge commercial risk. A corporation is an end user if:
- It is not a financial entity.
- It hedges its own commercial risk.
- It notifies the agency of how it meets financial obligations of swaps that are not cleared.
This distinguishes true risk management from speculative trades. The nature and scope of this exception is still being debated in courts.
Most corporations hedge FX exposure with a combination of natural hedges and derivative hedges. An effective hedging strategy lowers risk and earnings volatility and raises valuation. The use of derivatives in hedging existing FX exposure is a de-risking strategy, generally accepted accounting principles (GAAP) and Financial Accounting Standards Board (FASB) compliant, with many obvious advantages. As the regulators make derivative use more onerous, new, disruptive techniques such as P2P hedging may catch on.
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