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.

The Benefits of Hedging, and Managing FX Risk: Part 2

Managing this FX risk faced by importers and exporters all over the globe today is a three-step process: identify FX risk; develop a strategy; and utilized the proper instruments/strategies to hedge the risk.

Identify FX Risk

As explained in the previous blog post, the most common type of risk faced by firms is transaction risk. For a New Zealand exporting company paid in Australian Dollars, measuring FX risk entails determining how many Australian Dollars it expects to receive over the coming quarter (whatever the period of business may be), versus the money the New Zealand firm will need to make payments in Australian Dollars over the same period. Simply put, this difference is the amount that needs to be hedged.

Developing a Strategy

Developing a hedging strategy necessitates that the following questions be answered: when should FX exposure be hedged; what tools/instruments are available under the current circumstances; and how will the performance of the hedge be measured? Developing a strategy is contingent on where in the process a firm is (see flow chart below).

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Using the Proper Hedging Instrument

Implementing the proper hedging strategy involves a review of the company’s policies as well as the intentions of the hedge. Hedges can vary from something simple like purchasing the foreign currency, to more round about ways like purchasing commodities in the country where the company’s products are sold.

We will discuss different types of hedges – what the proper hedging instrument is – in the next post.

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.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Hedging Basics: Average Price Currency Options

Late last year we started a series of educations posts relating to the fundamentals of currency hedging. This latest post covers the basic workings of Average Price Currency Options.

The currency markets are volatile markets in which movements between currency pairs can be swift and choppy, changing the direction during political uncertainty or during statement by central banks on monetary policy.  Many treasurers have significant exposure to the currency markets, and hedging using daily operating currency rates can be a significant help in smoothing a corporation’s cash flows.

Average Price Option
An average price option, which is also known as an Asian option, is a financial instrument in which the payout is calculated based on the average price through a specific period.  The period in question can range from a couple of days to multiple years.  Average price options help a treasurer hedge their exposures to the currency markets on a daily basis, removing the daily volatility associated with currency fluctuations.

Average Price Option Payout
Average price currency options generate a different payout profile when compared to European and American style options.  An average price option is calculated by averaging a specific currency rate either using the end of the day price or a mutually agreed upon point, over the period in which the option is active.  For example, a monthly average price option would use the daily average of the trading days during the month.  This level is compared to the strike price, and the difference when multiplied by the volume generates the payout.

Understanding Central Bank Liquidity Swaps

This is part 7 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 7, we illustrated how companies use swaps in the global market place, but on a company-to-company basis. In part 8, we’ll explain the purpose of swaps on the central bank level and when they’re used.

As established earlier in this series, a currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the U.S. Dollar) for principal interest and fixed interest in another currency (i.e. the Euro). 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.

Banks and companies aren’t the only parties using currency swaps. A special type of currency swap, a central bank liquidity swap, is utilized by central banks (hence the name) to provide their domestic country’s currency (i.e. the Federal Reserve using the U.S. Dollar) to another country’s central bank (i.e. the Bank of Japan).

Central bank liquidity swaps are a new instrument, first deployed in December 2007 in agreements with the European Central Bank and the Swiss National Bank as U.S. Dollar funding markets ‘dried up’ overseas. The Federal Reserve created the currency swap lines to assist foreign central banks with the ability to provide U.S. Dollar funding to financial institutions during times of market stress. For example, if the Federal Reserve were to open up liquidity swaps with the Bank of Japan, the Bank of Japan could provide U.S. Dollar funding to Japanese banks (just as the Bank of England would provide liquidity to British banks, etc).

As the world’s most important central bank (next to the Bank of International Settlements, considered the central bank for central banks) in one of the world’s most globalized financial markets, the Federal Reserve has a responsibility of keeping safe financial institutions under its jurisdiction. Thus, when factors abroad (such as the European sovereign debt crisis) create funding stresses for U.S. financial institutions, the Federal Reserve, since 2007, has opened up temporary swap lines.

Generally speaking, currency liquidity swaps involve two transactions. First, like currency swaps between banks and companies (as illustrated in part 7), when a foreign central bank needs to access U.S. Dollar funding, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for U.S. Dollars at the current spot exchange rate.

In the second transaction, the Federal Reserve and the foreign central bank enter into agreement that says the foreign central bank will buy back its currency at a specified date at the same exchange rate for which it exchanged them for U.S. Dollars. Additionally, the foreign central bank pays the Federal Reserve interest on its holdings.

Unlike regular currency swaps, central bank liquidity swaps are rare and only occur during times of market stress. The first such occurrence, as noted earlier, was in December 2007, as funding markets started to dry up as the U.S. economy entered a recession as the housing market crashed.

More recently, on November 30, 2011, the Federal Reserve announced liquidity swaps with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank, after the European sovereign debt crisis roiled markets throughout the fall. These swaps are set to expire in February 2013.

What necessitated the Federal Reserve’s most recent round of central bank liquidity swaps? The ongoing crisis in Greece, which in fact was onset by a series of ill-advised interest rate swaps with U.S. bank Goldman Sachs.

In part 8 of 10 of this series, we’ll discuss the role of interest rate swaps in more recent times: the Euro-zone crisis (as well as answer the question in part 5 about Goldman Sach’s role with Greece’s demise).

When to use zero-premium FX collar options as the method of hedging

For importers and exporters managing trade-related transactional FX exposures, the choice of hedging instrument is just as important to overall performance as tactical/strategic risk management decisions to position at the minimum or maximum of hedging policy limits. Increased volatility in many currency pairs over recent years has naturally increased option premium costs, however it is not wise to always hedge via zero-premium collar options and never consider paying premium to buy outright call and put currency options. The choice between these option instruments and straight forward exchange contracts normally comes down to the following considerations:

  • If the home currency spot rate is at an historical low point against the export receipt currency (say based on long-term average rates) and the lead-indicators point to a greater probability of appreciation of the home currency than further depreciation, the choice of hedge instrument is going to be heavily weighted to straight forwards.
  • If the home currency spot rate is at an historical high point against the export receipt currency (based on long-term average rates) and the lead-indicators point to a greater probability of depreciation of the home currency than further appreciation, the choice of hedge instrument is more likely to be buying outright call options on the home currency.
  • When the currency pairs are trading closer to long-term average levels and there is no clear indication on future direction either way, collar options fulfill the objective of being hedged at an acceptable rate (the cap), however leaving some opportunity to participate in favorable market rate movements at least down to the collar floor level.

In some respect, hedging with collars is akin to having permanent orders in the market to deal at more favourable exchange rate levels with protection on the other side along the way. Whilst zero-premium may appear attractive, FX risk managers should always examine the trade-off’s of paying some premium to widen the gap between the floor and cap strike rates to provide greater opportunity of participation in favourable rate movements. In a similar vein, opportunities should be taken to restructure collars over the course of their term by buying back the sold cap or floor, or alternatively converting the collar to a straight forward if original target hedged rates are achievable. An active mixture of hedging instruments within policy limits should provide greater opportunity to beat benchmark and budget exchange rates.

Roger Kerr is widely regarded as one of New Zealand’s leading professional advisers and commentators on local/international financial markets, the New Zealand economy and corporate treasury risk management. Roger has over 30 years merchant and investment banking industry experience, and has been closely associated with the changes and development of New Zealand’s financial markets since 1981. Roger advises many Australian and New Zealand companies in the specialist areas of foreign exchange risk, interest rate and funding risk and treasury management policy/governance matters.

Roger has provided daily market and economic commentary on the 6.40am slot at radio station NewstalkZB since 1994.