Using Hedgebook to make smart fx hedging decisions

Has anyone told you lately that they know where the currency is going? Lots of people think they know if it is going up or down but the reality is that no one knows where it is going in the next 5 minutes, 5 days or 5 years. We might all be able to have an educated guess but that is all it is – a guess.

As a former risk manager I know how hard it is to advise corporates on the risks around fx management. I can remember going to a potential client and explaining to the owner of the business the importance of having a treasury policy and why you should follow it. We could add value in helping with the strategic decisions and the instruments to use but by the way we can’t pick the currency because no one really knows where it is going and we don’t try to. After listening to all this sage advice the owner turned to us and asked what use were we to him if we didn’t know where the currency was going? End of meeting.

It is true no one can pick where the currency is heading. What is important is:

  • Understanding the impact on your business when foreign exchange rates move.
  • Knowing the impact on budget rates or costing rates when foreign exchange rates move.
  • Knowing whether the business can afford to not cover i.e. if exchange rates go any further against you are you losing too much margin or indeed are you out of business.

Having the ability to compare the amount of foreign exchange hedging in place with the impact of exchange rate movements on the uncovered portion is vital information in making rational decisions in an irrational market.

Whilst we can’t pick currencies at Hedgebook (we are still working on that one) we can tell you the impact on your business if rates go up or down. We can tell you in dollars and cents what the impact will be  on unhedged foreign cashflows, what the exchange rate needs to be to achieve the budget or costing rate and what the value of existing hedges are.

Today’s fx risk management isn’t about picking exchange rates but about giving businesses greater visibility over its foreign exchange position. This allows for smarter foreign exchange hedging decisions using all available information. Sometimes the information isn’t what you want to hear but at least you don’t need to hope that things go your way. You can avoid the knee jerk decision – and chuck out the crystal ball.

Hedge accounting fx options: time versus intrinsic value

FX options make up an element of many companies fx risk management strategies. FX options lock in the certainty of worst case exchange rate outcomes while allowing participation in favourable rate movements. In my experience, companies are often reluctant to write out a cheque for the premium so for many the preferred strategy is collar options. A collar option involves writing, or selling, an fx option simultaneously as buying the fx option in order to reduce premium, often to zero.

After transacting the fx option, the challenge comes for those that are hedge accounting and the requirement to split the valuation of the fx option into time value and intrinsic value. IAS 39 allows the intrinsic value of an fx option to be designated in a hedge relationship and can therefore remain on the balance sheet. The time value of the fx option is recognised through profit or loss.

The intrinsic value of an fx option is the difference between the prevailing market forward rate for the expiry of the fx option versus the strike price. We can use an Australian based exporter to the US as an example. In our example the exporter forward hedged US$1 million of export receipts six months ago (the USD income is due to be received in three months’ time). At the time of hedging the AUD/USD rate was 0.8750 and the nine month forward rate was 0.8580. The company chose to hedge with a nine month zero cost collar[1] (ZCC). Six months’ ago the ZCC might have been as follows:

  • Option 1: Bought USD Put / AUD Call at a strike of 0.9000
  • Option 2: Sold AUD Put / USD Call expiring at a strike of 0.8000

AUD USD

The intrinsic value of each leg of the collar will be determined by the difference in the forward rate at valuation date versus the strike rates. For option 1, the bought option, if the forward rate is above the strike of 0.9000 then the fx option will have positive intrinsic value i.e. it is “in-the-money”. It is important to note that the intrinsic value of a bought fx option cannot be negative. The purchaser, or holder, of the fx option has all of the rights and would not choose to exercise the fx option if the market rate was below the strike price. They would simply choose to walk away from the fx option, let it expire worthless, and transact at the lower market rate.

For the sold fx option the opposite is true. If the forward rate is below the strike price (less than 0.8000 in our example) then the exporter, as the writer of the option, will be exercised upon and the difference between the market rate and the strike rate will be negative intrinsic value. Intrinsic value of a sold fx option cannot be positive.

The time value of an fx option is the difference between the overall fx option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the fx option. The longer the time to expiry, the higher the time value as there is a greater probability of the fx option being exercised. A purchased fx option begins life with positive time value that decays over time to zero. A sold fx option begins life with negative time value and tends to zero by expiry date.

When hedge accounting for fx options the splitting of intrinsic value (balance sheet) and time value (P&L) does not have to be a time consuming exercise. At Hedgebook we like to make life easy so as part of the FX Options Held Report the valuations are automatically split by intrinsic value and time value. The screen shot below shows the HedgebookPro output using our Aussie exporter example. With the significant weakening of the AUD in the last six months we see the zero intrinsic value of the bought option at a strike of 0.9000 and very little time value as there is little chance of the AUD strengthening to above 0.9000 by the time the option expires by 30 June. The sold fx option has a large, negative intrinsic value. The exporter will be exercised upon and have to convert the US$1 million of receipts at AUD/USD 0.8000 versus a market rate of closer to 0.7600. There is a small amount of negative time value.

HedgebookPro FX Options Held Report  

FX Options Held Intrinsic_Time

HedgebookPro’s easy to use Treasury Management System calculates fx option valuations split into intrinsic and time value. This simplifies life for those that already use fx options and hedge account, whilst removing obstacles to hedge accounting for those that perceive the accounting requirements as too hard.

The IASB is looking to remove the requirement to split fx option valuations into intrinsic and time components which will simplify the hedge accounting process further, however, currently this appears to be a 2018 story, unless companies choose to adopt early. In the meantime, HedgebookPro provides an easy to use system to ease the pain of hedge accounting fx options.

[1] Premium received from the sold option offsets the premium paid on the bought option.

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions. http://bit.ly/1at7pk0

It’s risk management stupid

The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.

The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?

Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.

Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.

Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.

As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.

Rate Differentials and Expected Policy Action by the RBNZ Keep the Kiwi Looking Up

Reserve Bank of New Zealand Governor Graeme Wheeler currently faces a problem. On one hand, exporters are losing their competitive edge as the New Zealand Dollar has strengthened. Industrialists have called for the RBNZ to try to keep rates pointed lower in order to weaken the currency. Certainly, ever since the Federal Reserve suggested that it might begin to normalize policy, New Zealand government bond yields have increased.

Given the implications of the Fed removing liquidity from global markets, bond markets have been under pressure. Considering that investors had piled into those assets with any yield over the past few years, these same assets – including New Zealand government bonds – have seen their yields spike higher faster than their policymakers can deal with (as seen in emerging markets).

Bond spread_NZDUSD

Over the past several months, the results of the Fed’s taper speculation have provoked the NZ-US 10Y yield to widen to their largest differentials all year. This will be important for future Kiwi strength: widening interest rate differentials are supportive of a stronger currency. The recent divergence could be due to the broader repricing of risk assets to compensate for a slower easing Fed. But domestic New Zealand data is pushing rates up higher naturally.

Rate increases_NZDUSD

Over the past three months, RBNZ Governor Wheeler has used his press conferences not to make a concerted attempt to weaken his currency but rather to highlight the optimistic points on the economy. In fact, currency swaps traders are near their most bullish on the New Zealand Dollar all year, with respect to the number of basis points priced in. If this pricing mechanism exceeds 90-bps, it will be closing in on its most bullish reading since the New Zealand Dollar peaked in the summer of 2011.

Why is this information useful for hedging? If the swaps market is pricing in future rate hikes by a central bank, it might be an appropriate time to hedge against further upside risk in the currency.


Weakening Correlations Suggest Time to Diversify

As we know, risk correlations tightened up (became increasingly positively correlated) during the financial crisis, where we saw very many near-perfectly positive correlations (>=+0.80) among the major asset classes: AUDUSD and Gold; NZDUSD and SPX; USD and DJIA; and JPY and US Treasuries among others.

In recent weeks (especially since the 2Q’13), we’ve since seen these correlations break down – perhaps the NZDUSD relationship with U.S. equities and New Zealand equities best serves this example:

NZDUSD correlation breakdown with equities

NZDUSD correlation breakdown with equities

 

Why does this matter? When correlations tighten up towards being perfectly positively or negatively correlated, there’s little benefit to diversification. IE, there’s no reason to invest in the NZDUSD if I’m long a basket of equities/S&P 500 as it’s essentially the same trade already. However, when risk correlations break down, the benefits of risk diversification increase. IE, there’s reason to trade the AUDUSD if you are long a basket of equities/S&P 500 because it reduces overall portfolio risk (general Markowitz/modern portfolio theory).

Thus, equity traders may find it appropriate now to start looking for ways to diversify, or hedge, risk. For the better part of the past few years, the NZDUSD has had a strong positive correlation with equity markets at home and abroad – the NZX 50 and the S&P 500 recently saw 52-week rolling correlations against the NZDUSD above +0.80 early in the 2Q’13.

As U.S. yields have risen thanks to a less dovish Federal Reserve and overall strengthening economy, the strong NZDUSD-equities correlation has eroded. In fact, for the week ended September 6, the NZDUSD-S&P 500 correlation fell to -0.47 and the NZDUSD-NZX 50 correlation fell to -0.35. This means the New Zealand Dollar may have some value as a speculative investment vehicle going forward – it retains yield despite losing correlation with equity markets. Recall from an earlier post that the New Zealand Dollar has seen increasingly strong yields:

NZD-USD Yield Spread versus NZDUSD fx rate

 

By reducing your profile’s overall correlation, you actually stand to reduce risk to your overall portfolio and capture greater returns. Now may be the right time to hedge away equity risk – by diversifying into the New Zealand Dollar, the highest yielding major currency alongside the Australian Dollar.

 

 

 

Why Timing is Key for Hedging!

Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!

Take the NZDUSD pair from January 2003 to December 2009:

NZD/USD Spot Rate

In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).

For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!

The next blog post will illustrate how market positioning can be used in timing.

Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.

Explaining Different Types of Exposure Risk

Importers and exporters alike face foreign exchange risk, or currency risk, when engaging in economic activity outside of their domestic currency. As explained in an earlier blog post, currency risk materializes for exporters when exchange rate volatility results in the company repatriating fewer revenues abroad, when the domestic currency strengthens relative to the foreign currency. For importers, this risk is the exact opposite: currency risk materializes when the domestic currency weakens relative to the foreign currency.

When shifts in foreign exchange rates are not hedged against, firms unnecessarily take on transaction exposure, or FX risk that negatively impacts cash flows. Typically, small- and medium-sized firms do not hedge against transaction exposure, despite the negative impacts it may have on profitability. Consider the FX relationship between two closely knit economies, Australia and New Zealand: the AUDNZD exchange rate has been as high as 1.3277 (December 2011) and as low as 1.2370 (October 2012) over the past year.

blog 2 image

This exchange rate volatility demonstrates why hedging is necessary. Let’s say that a New Zealand firm sold A$100,000 worth of product in Australia in April 2012, when the AUDNZD traded at 1.2600. Given the exchange rate, the New Zealand firm would expect to receive N$79,365 in return. However, if hedging wasn’t utilized, and the New Zealand firm repatriated its funds in July 2012 when the AUDNZD traded at 1.2950, it would only receive N$77,519 in return. By not hedging, the New Zealand firm cost itself N$1,846.

There are two other main types of currency risk posed to importers and exporters: accounting exposure and economic exposure. Accounting exposure comes about when firms have liabilities overseas, and must convert the foreign denominated liabilities back into the domestic currency. Unless exchange rates remain stable (a less common occurrence over the past few years), the liability conversion results in either gains or losses. Economic exposure tends to be limited to firms only operating domestically. For example, if a New Zealand firm only sells at home, but the New Zealand Dollar gains in value, consumers might look to competitors overseas given increased purchasing power; despite not being a participant in international markets, the shift in exchange rates could still have a negative impact on business.

The next post will discuss why it is thus important to hedge, and what the necessary steps are for a company to manage its foreign exchange risk.

Hedging Basics: Hedging Using Interest Rate Futures Risk Reversals

Exposure to the interest rate markets can be hedged with many financial instruments. One of the more flexible is the risk reversal.  A key benefit of the risk reversal is that it does not exposure the hedger to immediate gains or losses (similar to a swap or futures contract) as it allows the hedger to create a range in which their exposure is un-hedged.

Futures Contracts
A futures contract is an obligation between two parties to purchase or sell a physical or financial product as some date in the future.  Interest rate futures are traded on exchanges such as the Chicago Mercantile Exchange and provide a clearing platform for traders that eliminate credit risk.

Hedging
The strategy of a risk reversal for a hedger that is looking to mitigate downside exposure to the interest rate market is to purchase a put on an interest rate futures contract and simultaneously sell a call on an interest rate futures contract.  The strike price of the call and the put are generally a certain percentage away from the current spot price, creating a range above and below the current price where the trader is not hedged.  If the price of the futures contract falls below the put, the trader receives a payout.  If the price of the futures contract rises above the call, the trader needs to make a payment.