Options reduced

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The dollar has more or less encountered one-way traffic over the past year. With the Federal Reserve raising interest rates 14 times from June 2004 – most recently in January, when it raised its benchmark rate a further 25 basis points to 4.5% – the dollar has had a virtually unchecked bull run, strengthening nearly 15% against the yen and more than 12% against the euro over 2005.

But dealers say the direction of the dollar in the coming year could be a little more uncertain. Analysts are more or less unanimous in their views that new Fed governor Ben Bernanke will lift rates again this month, but opinions differ over whether that will be the final hike in the cycle. At the same time, there’s growing speculation that Japan will end its zero interest rate policy at some point over the next 12 months.

It could mean that, far from the one-way trend of 2005, the coming year will see greater uncertainty in the currency markets. In fact, volatility has already begun to creep up in some currency pairs. In January, three-month implied volatility on the dollar/yen hit 9.1% – its highest level since March last year – after hovering at around 8% for much of the past 12 months (see figure 1). Although implied volatility might not yet be at the levels seen between September 2003 and June 2004, when it was regularly above 10%, many traders say it could pick up in the coming year.

“Yen volatility this year is clear cut,” says Neil Mellor, vice-president of global markets at Bank of New York in London. Carry trades played a major part in the dollar’s rise above ¥120 at the end of last year, with investors taking advantage of Japan’s low interest rates to borrow money in yen and then invest in other currencies where rates are higher. However, a rise in Japanese interest rates, combined with an easing cycle in the US, could prompt unwinding of these trades.

If volatility in the currency markets does increase, it could create a more difficult operating environment for companies with forex exposures. A recent Citigroup survey of forex risk management strategies at 98 of its corporate clients across the US, Europe and Asia-Pacific found that 74% of dollar-based companies and half of euro-based companies have exposure to the yen. Corporates, therefore, need to ensure they have the right hedging strategy in place.

Munich-based auto manufacturer BMW says it is not worried by the current trends in the international currency markets. “At least for the past few months, we haven’t seen any volatility in the main currencies,” says Marc Hassinger, a treasury official at the German manufacturer. “But we don’t do predictions here at BMW. In any case, it wouldn’t affect our currency hedging because it is a long-term strategy.”

Currency hedging at BMW has remained constant over the past few years, says Hassinger.

Some 80% of the firm’s foreign currency risk relates to euro/dollar, euro/sterling and euro/yen, and most of the fluctuations are managed through natural hedges within the firm’s operations. Any remaining exposure is hedged with a mix of options and forwards.

Netherlands-based electronics firm Philips also hedges its exposure using a combination of options and forwards. According to its annual reports, Philips has kept its currency hedging strategy steady over the past few years. “The Philips policy generally requires committed foreign currency exposures to be fully hedged using forwards. Anticipated transactions are hedged using forwards or options, or a combination thereof,” says the latest report.

Didier Hirigoyen, global head of Citigroup’s corporate risk advisory group in New York, says companies are right in sticking to the strategy that has worked for them in the past, despite the recent pick-up in currency volatility. “If the process is good today and good for your business, then the market is kind of irrelevant,” he says. “Consistency is key. It will condition the whole strategy that you use, but once you identify what your risk management priorities are, then there is no reason to change your strategy if the euro goes up or down.”

But despite some corporates reporting that their hedging strategies remain constant, many of the banks they deal with say there has been a marked change in the way companies use derivatives, with increased reliance on forwards and swaps, and less use of options.

One of the key changes affecting the use of derivatives over the past year has been the introduction of new accounting standards in January 2005. European firms are close to finalising their first annual results using International Accounting Standard 39, under which derivatives must be marked-to-market at each accounting period, with changes in the value of the derivatives reported as a profit or loss. Derivatives can qualify for hedge accounting treatment if they satisfy stringent hedge effectiveness tests – but while this is relatively straightforward for swaps and forwards, it’s more difficult to demonstrate on an ongoing basis that options are effective as hedges.

As a result, European corporates have been shifting away from options for some time, mirroring what happened in the US after the introduction of FAS 133, say dealers. According to the Citigroup report, almost six times more companies globally use forwards than those that use options to hedge against forecast currency transactions. “Before FAS 133, US corporates did use options,” says Hirigoyen. “But after FAS, one of the changes was that you could use forwards and get the forecast cashflows. Now they massively use forwards contracts, with options taking a back seat.”

In the US, the Financial Accounting Standards Board introduced DIG issue G20 in the middle of 2001, following complaints from market participants about the accounting treatment of options. Under DIG issue G20, when a purchased option is used in a cashflow hedge and the terms of the option (notional, expiry, etc) are identical to the underlying, the hedge is considered effective and changes in the option price can be deferred until expiry. The European rules do not provide the same leeway, and as a result Hirigoyen expects that European firms may be even more reluctant than their US counterparts to use options. “Under IAS 39, time values have to be marked-to-market with no DIG issue G20 involved, meaning the time values of options have an impact on accounting.”

According to Barclays Capital, the accounting issue has brought about a polarisation of clients into two camps – those willing to adopt specialist structured products moulded around the new guidelines, and those unwilling to do so because of a possible impact on earnings figures.

Citigroup’s Hirigoyen agrees that the accounting rules have changed corporates’ use of derivatives. “What you find is that most companies state that their goal is to stabilise or minimise earnings volatility and are focused on year-on-year volatility of the operational currency,” he says. “The tenor has probably increased over the past few years, as companies have attempted to hedge over the fiscal year.”

The Citigroup survey found that, in terms of forecast foreign currency transactions, nearly 70% of its customers use forwards contracts and 85% hedge for periods of less than 12 months, fitting neatly within the financial year.

“Accounting regulations are affecting the ideal forex hedging strategies to a certain extent,” continues Hirigoyen. “We did find that concern around accounting was certainly greater in North America than in Europe – 80% compared with 50%. Companies need to concentrate on the economic parameters of their risk, and as soon as they are forced to concentrate on other parameters, this can’t be good for risk management.”

Jim O’Neill, head of UK corporate forex sales at Barclays Capital, agrees: “Most people won’t have a hedge on in the period in London. “Banks are becoming creative around solutions that are more accounting-friendly. And as knowledge becomes more widespread throughout the industry, I think we’ll see more of a take-up.”

But others say commercial pressures can be a burden on corporates, with some reluctant to stand out from the crowd and do anything different from their competitors. “Share price really is important and you will be penalised if you do something different from your peers,” says Brian Tomeo, head of corporate sales for currency and commodities at investment bank JP Morgan in London. “And most corporates hedge according to what their peers are doing.”

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