Hedge simple

Extreme shifts in foreign exchange rates have forced corporate treasurers to reconsider their hedging strategies. With currency volatility expected to remain high, many are shifting away from complex structures towards simpler approaches. By Ryan Davidson

Corporate treasurers have spent much of the past year with their eyes glued to foreign exchange rates. Currency markets have leapt around violently, with the dollar appreciating strongly from the middle of last year. For many firms, this sharp reversal of fortune has had a material effect on company results - with some even reporting millions of dollars in mark-to-market losses on failed hedges.

With volatility expected to remain high in 2009, some companies have begun reassessing their hedging strategies. And, as a general trend, hedgers are shifting away from more complex, cost-reduction strategies in favour of plain vanilla products such as forwards and options. The key driver is that companies are prepared and protected against further shifts in currencies - and treasurers are willing to pay to achieve peace of mind.

"The market events of 2008 have had a pronounced impact on corporate treasurers' and chief financial officers' views on the strategic importance of getting their forex hedging strategies right. This is particularly important given the potential for margin erosion in earnings, balance-sheet volatility, impaired credit ratings and more limited access to funding," says Jim O'Neill, co-head of corporate risk advisory for Europe, the Middle East and Africa at Barclays Capital in London.

Last year was a roller-coaster 12 months for the currency markets. Having started 2008 at $1.4583, the euro reached as high as $1.5990 on April 22 before falling to $1.2452 by November 13. By December 31, it had rebounded slightly to $1.3953. Sterling also had a tumultuous year against the euro and dollar, starting 2008 at EUR1.3598 and $1.9827. The currency remained steady against the euro until October, before slipping to a low of EUR1.0209 on December 30. Sterling rose to as high as $2.0296 on March 13, but began sliding from the end of July, reaching $1.4411 on December 30.

The volatility in foreign exchange has already had an impact on corporate results. For instance, Arkansas-based supermarket chain Wal-Mart expects its fourth-quarter fiscal 2009 earnings to be negatively affected by exchange rate movements. "The rapid changes in currency exchange rates during the past few weeks are projected to negatively affect this year's fourth-quarter results by approximately six cents per share. In US dollar terms, strong operating performance in the international division may be overshadowed by these currency fluctuations," revealed Tom Schoewe, chief financial officer of Wal-Mart, in the company's third-quarter fiscal 2009 statement on November 13.

Meanwhile, in its end-of-year results, published on January 26, Illinois-based fast-food chain McDonald's said foreign currency translation had a negative impact on consolidated operating results for the fourth quarter as the dollar strengthened. It reported a currency translation loss of $484.6 million on the quarter's revenues of $5.565 billion.

Ominously, the instability in the currency markets has continued into 2009. The euro was at $1.2966 as of January 29, while sterling was trading at EUR1.1013 and $1.427 on the same date. And with volatility remaining at elevated levels, few market participants are willing to bet against further shifts in direction. One-month implied volatility on euro/dollar was at 20.13% as of January 29, while one-month implied volatility on euro/sterling and sterling/dollar was at 19.62% and 22.75%, respectively. As recently as last July, implied volatility on all three currency pairs was below 10%.

"The perception among corporates is that forex volatility is not going to fall in the short term, and this is affecting their hedging decisions going into 2009," says Scott Wacker, managing director, forex sales for Europe, the Middle East and Africa at JP Morgan in London.

Many are simply shifting hedging strategies to lock in beneficial exchange rates, or are unwinding trades put on at unfavourable levels. Others, however, are altering the composition of their hedge portfolios to achieve greater levels of protection.

While never the most adventurous of derivatives users, some of the larger, more sophisticated corporates had, until last year, been willing to contemplate more complex structures, in some cases employing a certain amount of leverage. Companies were able to reduce the cost of the hedge by incorporating a market view into the transaction - for instance, by embedding a knock-out barrier option on a particular exchange rate, at a strike the company believed was unlikely, in return for premium.

In some cases, these hedges have gone spectacularly wrong. Nowhere is this clearer than in Latin America, where a host of Mexican and Brazilian companies put on leveraged target redemption forward trades that resulted in millions of dollars in mark-to-market losses (Risk November 2008, pages 60-61; Risk January 2009, page 9). These products allow hedgers to lock in at more favourable exchange rates than they would have been able to achieve using vanilla forwards. Once a predetermined profit level has been reached, the contract knocks out. However, the notional amount the corporate has to transact each month increases once the exchange rate shifts against it and reaches a certain level - meaning the firm is locked in at an unfavourable rate and is forced to hedge more than the required notional.

Now, corporates are shunning complex trades that involve the selling of volatility, in favour of simpler products, such as forwards. Part of the motivation is that these strategies are quicker to execute, say dealers - an important factor in recent months, when currency rates have been fluctuating wildly.

"The large swings in exchange rates have made corporates take action on their hedging decisions a lot faster than they traditionally did in more stable markets. When time is of the essence, they will naturally go for simpler hedging strategies as it is easier for them to make a decision on instruments they are familiar with," says Chris Leuschke, head of currency structuring at Royal Bank of Scotland (RBS) in London.

With regulators looking closely at derivatives given the spate of writedowns at banks across the globe, some are also keen to ensure they are able to explain their hedging strategies to investors, and so are plumping for simple strategies to enhance transparency. "With the regulatory environment likely to tighten in some jurisdictions, increased transparency will give corporate boards and shareholders comfort around their company's hedging activity," says Barclays Capital's O'Neill.

Along with forwards, there is growing appetite among corporate clients for buying options, some dealers say. This represents a massive shift in attitudes - corporates have traditionally been reluctant to fork out premium upfront for protection through options. Indeed, some participants claim the increased cost of options in the current high-volatility environment continues to deter firms from using them, at least for short-dated hedges.

"Few corporates are choosing to purchase short-dated options for hedging downside risks due to the increased premium cost as a result of the high volatility," says James Davison, head of forex structuring for Europe at BNP Paribas in London. "Furthermore, in this high-volatility environment, corporates seem to be far more comfortable mitigating risk completely with instruments such as outright forwards, rather than accepting some level of risk tolerance up to the strike of a bought option."

Over the longer term, it is a slightly different proposition. Since the collapse of Lehman Brothers on September 15 last year, dealers are acutely aware they need to price counterparty credit risk into any foreign exchange quote. This can be achieved for a single stand-alone forward trade by combining the market rate with spread determined by the credit default swap level of the counterparty. With volatility in the foreign exchange market increasing and credit spreads widening significantly over the past six months, the cost of forward trades has increased markedly, particularly for longer tenors (Risk January 2009, pages 89-92). As a result, options can provide a more efficient means of protection, claim dealers.

"For longer-dated hedging, the cost for a corporate of entering into an outright forward has increased dramatically as a result of credit charges put in place to mitigate the risk of counterparty default. As a result, many banks now believe they can offer better value to their customers by selling options instead of forwards for longer-term hedging, since the risk for the bank on a sold option is limited to the premium payable by the customer two days after the trade date," adds Davison of BNP Paribas.

With some corporates breaching bank credit limits on loss-making hedges during the turmoil of 2008, managing credit usage has become a key issue. Using an option outright, or embedding an option within a forward trade to cap potential losses, means corporates do not use up credit lines if a trade goes awry.

"With the current high volatility, risks are bigger for corporates, and to do the same transactions today as they did a few years ago would cost more. It also puts constraint for credit lines on the amount of hedging a corporate can do, so they will have to be efficient with their hedges," says Frederic Jeanperrin, head of forex and interest rate derivatives sales for European corporates at Société Générale Corporate and Investment Banking in London.

Some banks are now starting to insist that any trade executed by a corporate client include some form of downside protection - for instance, a cap. Dealers say this is beneficial for both the corporate and the bank. "Credit has become much more expensive and the bank needs to think much more carefully about its use of balance sheet," says one head of forex structuring in New York. "Including some form of downside protection means the bank can be more efficient and do much more business with clients with fewer absolute credit appetite resources. It also means clients are being more efficient with their credit lines, and many are starting to realise it is a good idea for them too."

The cost of the downside protection can be offset at least partially by capping any potential upside - for instance, by selling a call option. However, some corporates are starting to accept the higher costs for hedges in the current environment.

"The response has been mixed and some clients are in denial," says the forex structurer. "But eventually this will all converge and it will simply be what clients do. They will do it because it makes sense and because it becomes market practice. It is mutually beneficial - it keeps their credit lines with banks open so they have more capacity to hedge and means we are better able to service them because we are not utilising our scarce credit resources on their foreign exchange hedging."

Others agree to a certain extent, pointing out it is in the interests of the bank that clients are not exposed to potentially sizeable losses. "Banks are actively encouraging corporates to turn to safer hedging strategies," says RBS's Leuschke. "If their clients' financial positions are weakening due to forex volatility, then banks' positions are weakening - it is in their interest to help minimise their clients' risk."

See also

• LatAm regulators demand derivatives disclosure

• Forex volatility puts focus on corporate hedging