With so many disruptive events over the past 12 months, it is small wonder that people are so reluctant to take a firm view on where things may head next. While price remains important to investors, what they really want is a way of responding to changes in the market quickly and adjusting direction if need be.
HSBC wins currency house of the year because the bank has been able to provide cost-effective strategies to its clients that offer the flexibility they need to meet the challenges of an uncertain world.
The events that have rocked currency markets during the past year are numerous: the devaluation of the Chinese currency in August 2015, the decision by the US Federal Reserve to raise interest rates in December, the move by the Bank of Japan to cut negative rates (inexplicably strengthening the yen), and finally Britain's decision to leave the European Union.
"This has been a year of unintended consequences," says Christophe Bouculat, head of foreign exchange structuring for Asia-Pacific at HSBC.
One senior manager within group treasury at a company in Malaysia says that, in such uncertain times, the customer service and the versatility that a bank offers can be more important than the price.
"HSBC has been proactive in talking to us, running training seminars and explaining to us the benefits and risks of their derivatives products," he says. "Their pricing isn't always the lowest but it is competitive and, if they are going to include flexible structures such as loans or credit lines, then pricing becomes less important."
An example of the flexibility that HSBC has been able to offer its clients is embedded in a derivative structure that the bank sold to a client for managing the financing risk inherent in the purchase of a gold mine.
Although gold is a precious metal, it is typically treated and managed as part of a currency portfolio rather than a commodity portfolio. This is because of the difference in use and the resultant correlation with other commodities. Gold is commonly used as storage of value and therefore often has a close relationship with those factors that impact currencies' strengths rather than those which drive other commodities. The derivatives that HSBC used for this particular trade involved crossing the exchange value of gold with that of the US dollar.
"The value of a gold mine is principally the value of the gold in the mine. Using the spot value of gold to price the loan would have been unsatisfactory given the difficulty in predicting where the price of gold would be by the time the money needs to be repaid," says Tortrakun Satayaprasert, Hong Kong-based associate director in the foreign exchange structuring team.
The simplest way to hedge against any fall in the price of gold is by going to the forwards market. However, this would have not only have protected against a further drop in prices, it would also have capped any potential upside.
"This simply wouldn't have worked for our client. The reason that people were looking to buy gold mines last year was that gold was cheap and they wanted to be able to benefit from a sudden increase in value," says Satayaprasert. "A gold mine isn't like other business assets, where its value can be significantly increased by improving management and opening new branches. Its value is mostly about the price of gold and the amount of it inside the mine."
At the time of the purchase, gold was trading at around $1,150 per ounce, having fallen from a high in 2011 of more than $1,800 per ounce. Although there was widespread expectation that the gold price would rebound – which is in fact what happened – there was also the danger that it could decline further. The price of gold now stands at just over $1,300 per ounce.
The hedging solution that HSBC eventually came up with combined standard forwards, options and targeted cap loss forwards. The use of options was kept to a minimum, as these commanded a high upfront premium, so much of the structure relied on the cap loss mechanism.
While a traditional cap loss forward sets a hard floor on the potential loss at each of the settlement dates, this solution lacked the flexibility the client needed. Instead, HSBC proposed basing the cap on the accumulated loss of the transaction.
This meant that, if the market suddenly spiked up and remained at a particular level for a while, the hedge would terminate, allowing the client to return to the market at this higher rate. The exact amount of time that markets had to remain at a certain level before the hedge kicked out depends on the total tenor of the hedge, but would generally have to last at least a few months. This structure allows the client to enjoy the upside from the investment while keeping the overall upfront hedging premium payment low.
HSBC says it was one of the few banks that was able to offer this product on the market.
"This is not something that can just be replicated perfectly through the options that are traded in the market," says Satayaprasert. "You need to have a robust pricing model in place, as well as an advanced in-house product risk management model."
The key to the product is to be able to model the shift in the probability of early termination and do dynamic hedging via market-traded options.
HSBC's global footprint also helped in the delivery of the solution.
"As a universal bank we are exposed to a wide range of problems and solutions across the world – debt capital markets, leverage acquisition finance, project export finance. Product experts like us might be aware of the transaction need in the first place, but the structuring capability might only exist in another part of the bank. We have a very collaborative model," says Bouculat.
In another transaction, HSBC made use of a client's own flexibility in order to deliver the most cost-effective solution possible.
The client was an Asian conglomerate which needed to shore up some of the cross-currency risk inherent in refinancing part of a euro-based loan into local currency. The loan, secured initially for a year, had been obtained in order to purchase some euro-denominated assets. Since the owner of these assets was based in Europe, the loan was denominated in euro.
The transaction was further complicated by the fact that the total delta size of the hedge (which HSBC prefers not to disclose) was above normal daily trading volumes and therefore had the potential to disrupt the market. The markets were especially thin given the time of the transaction, which took place just ahead of the UK's referendum on leaving the European Union.
The underlying acquisition was already public at the time of the refinancing hedge, and so the markets would have anticipated some kind of transaction taking place.
The client only wanted to switch part of its loan into the local currency, and use its assets in Europe to service the rest of the loan. Since the client wanted to get the best price possible, it retained the option to use more of its Europe-based assets should the rates cost implied by the exchange rate turn out to be less attractive than expected.
"If the client got a fantastic hedge rate, then they would be more than happy to refinance in local currency, but if the rate was not so good then they would rather use more of their euro assets to offset this," says Satayaprasert. "In the event, because of the low-delta transaction that the client put on with us, we were able to hedge a very good amount at a very attractive price compared with what he would have otherwise achieved in the vanilla markets."
HSBC was able to lower the delta of the transaction through a combination of accrual and calendar forwards. According to Bouculat, this reduced the overall delta of the hedge by between 50% and 60%, and meant that the markets were able to absorb the transaction with little difficulty.
Although the client had the option to use its euro cash reserves to convert some of the debt into equity should the Thai refinancing rates be unsatisfactory, the hedge rate ultimately turned out to be much better than the market forward rate at the time.
The other key theme this year has been depreciation of the renminbi and, like many other global banks, HSBC has been there to pick up the surge in demand from Chinese corporates.
"When the reminbi started to depreciate, property developers with foreign debt naturally started to take a greater interest in hedging their exposure. There wasn't much activity at first but this has increased markedly," says Desmond Suen, head of corporate treasury solutions for Greater China.
At first, companies would hedge between 10% and 20% of their foreign assets, just to show shareholders that they are taking some action, but HSBC reports that hedging ratios of more than 50% are becoming increasingly common, particularly after the UK's vote to leave the EU.
With everyone doing this, winning market share is about being able to offer an attractive proposition to clients.
"It's all about being able to time the market correctly and offer an attractive price," says Suen.
For one head of capital markets at a Chinese property developer, this strategy is certainly working. In order to mitigate counterparty risk, the property developer banks with a number of global banks, but says it is HSBC they do most of their renminbi hedging with.
"HSBC's pricing is generally quite favourable and they also allow us to attach flexible conditions to the transactions, such as extending credit lines to us. This has helped us a lot in managing our business in difficult market conditions," he says.
The week on Risk.net, September 8-14, 2018Receive this by email