Time for a rethink

Foreign exchange

A drastic decline in the value of the dollar and increased implied volatility in the foreign exchange markets has left some corporates battling to keep their budget rates afloat, while simultaneously mitigating sizeable mark-to-market losses on currency hedges.

The twofold problem, which has mainly hit US-based companies with foreign currency liabilities and non-US corporates with dollar revenues, has led firms to increase their use of derivatives and, in some cases, implement more complex cost-reduction hedging strategies. While some companies have been able to do this without incurring undue stress, the situation for others has not been so straightforward.

In the past few months, the value of the dollar has fallen to its weakest level for several years. It slumped to a historical low of $1.602 against the euro on April 22, before recovering slightly to reach $1.5625 against the euro on June 20 - but that still represents a 7% depreciation from the start of the year.

The dollar also weakened significantly against the yen in 2008. The Japanese currency started the year at Yen111.79 against the dollar, but had strengthened by 14.3% to touch Yen95.76 in intra-day trading on March 17. Although the yen retreated to Yen107.37 by June 20, doubts remain over the short- to medium-term strength of the dollar.

Recent currency movements have had a marked impact on volatility. Thirty-day implied volatility in the euro/dollar market spiked at 11.88% on April 24, before dropping back to 9.60% on May 14, according to Bloomberg. On May 22 last year, implied volatility was at just 4.81%.

Unsurprisingly, the sustained period of volatility has affected a number of corporates that hedge overseas revenues and liabilities. New York-based IBM, which operates in 170 countries, derives 60% of its $98.8 billion revenues from outside the US. The company reported a loss of approximately $880 million on its currency hedges in 2007, more than twice the $350 million loss recorded in 2006.

IBM issues local currency bonds through its foreign subsidiaries as a natural hedge for offshore investments. As of December 31, 2007, IBM had $3.76 billion worth of debt outstanding issued in non-dollar currencies, $2.78 billion of which had been designated as a hedge for the company's foreign currency investments. Beyond this, IBM uses forwards, futures and swaps to hedge the net difference between assets and liabilities. At the close of 2007, the company had liabilities of $937 million in derivatives used as net investment hedges. IBM attributed much of its hedging losses in 2007 to an asymmetry in hedge accounting, which does not require the hedged item to be marked-to-market on the financial statement (Risk April 2008, pages 76-77).

According to some observers, the extent and pace of the currency movements took many corporate treasurers by surprise. "These changes have taken place in a short period of time, and with a movement that the corporates could not have imagined," says Pascale Moreau, global head of interest rate and forex derivatives at Societe Generale Corporate and Investment Banking (SG CIB) in Paris.

When volatility first began to spike last August, some corporations had anticipated a mean reversion and were consequently slow to implement changes to hedging strategies. "Initially, corporate clients across the board were not very interested in making changes as they felt this was a temporary weakness," says James Davison, head of derivatives strategy in the corporate solutions group at BNP Paribas in London.

But with the dollar weakening continuing into 2008, some corporates ditched the mean reversion assumption and started to look for new solutions to mitigate forex risks, say dealers. "By February, mid-sized companies had begun to believe in a consolidated move to a higher spot price and started to adopt strategies that would help them recapture budget rates and fix their current hedges," adds Davison.

Some of these approaches involved corporates becoming more active in derivatives markets. "Between January and May, we have seen twice the volume of structured derivatives used among our corporate clients compared to the same period in 2007," says Davison.

The increase in activity has come from both existing clients and new users, including some companies re-entering the market after a long period of absence. "We are seeing companies return to the market having not used derivatives for 10 years," says Jason Shell, global head of foreign exchange sales to corporates at Deutsche Bank in London.

Many of the strategies being employed are focused on capturing otherwise unattainable off-market budget rates and fixing current hedges at favourable market levels, says Shell. Other market participants have also alluded to a higher degree of sophistication in terms of the products being used. "We have seen companies that simply used outright forwards move to vanilla options, and those that were using vanilla options move to second generation options and more exotic structures. Many are now looking at target redemption forwards," says one London-based head of forex options trading at a global investment bank.

Essentially, target redemption forward (TRF) contracts are structured to allow users to sell one currency against another periodically - usually monthly - over a certain hedging horizon at more favourable rates than could be attained using vanilla forwards. If the sum of positive cashflows realised on the hedge equals or exceeds an agreed target amount, the contract is terminated.

In one example, a European company hedging against dollar depreciation on a notional amount of $36 million over a one-year horizon was able to lock in at a rate of $1.46 to the euro on a TRF contract earlier this year. A vanilla forward contract under the same circumstances gave the corporate a strike slightly above $1.50, according to Davison.

However, there are significant downside risks to using TRFs. In particular, the monthly notional amount the corporate will transact depends on whether the spot price is below or above the company's desired exchange rate. In the example of the European company hedging its dollar exposures, the firm would be hedged at a notional amount of $3 million a month on a TRF contract for as long as the dollar/euro rate is above $1.46. But as soon as the spot price moves below this level, the losses on the hedge are calculated at twice the monthly notional. As such, if the dollar appreciates beyond the strike rate, the embedded leverage may result in a company hedging over the required notional at a rate significantly worse than that available in the spot market.

Popular exotics

According to dealers, exotic strategies have proved particularly popular among medium-sized unlisted companies. "The typical company that has used more complex derivatives of late is the mid-sized corporation, with annual revenues of about EUR100 million or less," says Davison.

One reason for this is that unlisted companies are less constrained in their use of derivatives by accounting rules, specifically International Accounting Standards (IAS) 39 or - in the case of the US - Financial Accounting Standards (FAS) 133. Although listed companies are usually required to adhere to these rules, the decision of private firms to adopt them depends on their investors' requirements and the jurisdiction they operate in.

IAS 39 and FAS 133 rules require companies to recognise all derivatives at fair value as either assets or liabilities in their financial statements. For those derivatives that do not meet strict criteria to qualify as hedging instruments, any gain or loss is recognised as earnings in the period of change. As such, if derivatives incur mark-to-market losses, this will have an impact on profits, placing treasurers in the difficult position of explaining how the firm lost money on such strategies to irate shareholders.

Consequently, for some larger corporations, solutions to the recent currency movements have proved especially challenging. "Larger companies are mainly putting on plain vanilla outright forwards, and purchasing low-delta options for a premium of between 35 and 40 basis points as cover against extreme spot moves," says Davison.

This is more expensive than what a corporate would have paid at the same point in 2007, when the equivalent option cost around 20bp. "Many large listed corporate clients have opted to live with the pain caused by adverse currency movements because of the problems of derivatives reporting under IAS 39," asserts Davison.

Other corporates, however, have sought to reduce costs by combining forwards with embedded options. "Over 50% of corporations would be looking for zero-cost strategies - that is, buying a vanilla option, and selling a vanilla or an exotic option in the direction of the hedge," explains Udi Sela, director of product support at pricing, trading and risk management company SuperDerivatives, in London.

If, as many expect, the recent volatility experienced in the currency markets continues, even those corporates that had been hoping to ride out the storm will come under increasing pressure to adopt sophisticated approaches to managing forex risks. "If companies do not move fast enough, they will find it very difficult to explain to shareholders why they did not adequately hedge the volatility," concludes SG CIB's Moreau.