Deciding To Hedge
A Practitioner's Guide to Hedging Risk
A Practitioner's Guide to Hedging Risk
Deciding to Hedge
by Franois Masquelier, Chairman, ATEL
To hedge or not to hedge: that is the question
If we refer to the comments of Merton Miller,
winner of the Nobel Prize in Economics in
1990 for his pioneering work in the theory of
financial economics, we might conclude that
hedging serves no purpose: "The most valuemaximising
firms do not hedge". But can we as
treasurers accept this statement at face value?
Wouldn't that amount to the negation of our
profession? Even if we take into account the
context of his words, and even if we accept
that hedging means taking a decision and
making a choice that could lead to a possible
loss of opportunity, it strikes us as inadvisable
to adhere purely and simply to Merton Miller's
theory (with due respect to the man and his
work), as well as to his colleague Franco
Modigliani. The academic issue here is whether
hedging creates value'. In certain cases,
hedging is an obligation (contractual in the
context of credits) and, in imperfect markets,
sometimes makes it possible to continue to
borrow. Hedging also enables treasurers to
concentrate on the operational and
management sides, and can create value when
it sustains the company's activity and ensures
the continuity of its main aim and corporate
purpose.
Non-financial companies don't at all like
speculating and remaining completely
unhedged. Imagine the totality of exposure to
one or more risks, such as all of the exposure
to the USD, and apply to it a stress-testing
factor of 20%, for example. While the CFO
could live with such an impact (even if, in part,
the accounting P&L result would not be
affected by off-balance sheet underlying
commitments), there is a high likelihood that it
would not accept or tolerate such an impact,
even a potential one. Just think of the amount
recorded in OCI/EHR (Equity Hedging Reserve)
to find out what we avoid entering in our
profit and loss accounts. Thank God the IASB
invented hedge accounting, to reduce the
valuation to the correct level.
Once you have got past the question of
whether or not you are going to hedge, the
next issue is figuring out the extent to which
you are going to minimise your financial risks.
One hundred percent hedging of all balance
sheet or off-balance sheet risks strikes us as
foolish and inadvisable. Essentially, the
treasury is a function of management and this
management needs to be applied to hedge part
of its exposure and control the remainder,
often according to principles and a strategy
that have been clearly defined in the internal
hedging policy.
Figure 1
Figure 2
Hedging without applying hedge
accounting would seem to be suicidal, as it
would amount to not hedging and taking all
the impact in the accounts through the markto-
market' revaluation of the financial
instrument portfolio. Consequently, the issue is
how far should hedge accounting be applied?
Here too, the treasurer needs to define an
intelligent compromise strategy between what
is required in terms of hedge accounting and
what can, due to its size or lesser impact,
remain hedged and re-valued without
offsetting to compensate for the accounting
impact recorded. Treasurers have also a duty to
educate boards and CFOs in order to make
them sensitive to risks of inappropriate
hedging strategies.
Adaptive hedging strategy
So-called hedging strategy must always be the
subject of written rules and principles that
have been clearly transmitted to subsidiaries.
However, it needs to remain adaptable in order
to respond to changes in the markets and the
economic situation. But there is no single onesize-
fits-all' solution. Every policy is different
and specific to the company concerned. It
needs to be validated by the Audit Committee
and reviewed regularly. It should also take the
accounting aspect (IFRS) into consideration,
based on the hotly contested and unnatural
principle initiated by IAS 39 of putting the cart
before the horse'. The strategy also needs to
determine the precise type of instruments
authorised, and this must be done in
accordance with the IFRS strategy adopted in
order to always remain on the right side'.
Finally, it defines the counterparties to be used,
as this credit risk is no longer theoretical at all.
The company's hedging strategy will depend on
its general culture, its approach to and
appetite for risk, and lastly the CFO's tolerance
for the volatility of the financial result. It is
dependent on external factors (geography of
the group, currencies, long or short positions,
profile, natural or economic hedging, etc.), as
well as on internal factors as described above.
These factors will shape and define the
hedging policy. What currencies to sell in?
Should the translation risk be covered? Fixing
the debt or not? And so on.
What to do and what not to do
when it comes to hedging
Where hedging is concerned, there is a series
of pitfalls and errors that must be avoided at
all costs in order for it to be effective and
appropriate. We are going to try to list some
of these in a non-exhaustive fashion.
To be effective, a company needs to
design an appropriate hedging policy and to
know precisely what it intends to accomplish.
It is not as straightforward as it seems.
Obviously, everyone wants to protect the
business from P&L volatility. The objectives
should be aligned to the overall business
strategy and be specific as well as
quantifiable. The flexibility should not be
used to justify the reluctance of the
corporate to document a sound hedging
strategy. A formal policy is paramount even if
viewed as cumbersome and also rather
bureaucratic. Without formal rules, there are
risks of absence of discipline, transparency in
communication to stakeholders and
continuity when facing staff turnover. The
performance benchmark needs to be
measured to determine whether it is effective
or not. It also has to be aligned and adapted
to strategic objectives targeted. For these
metrics, treasurers need to use appropriate
state-of-the-art IT tools. The simulations are
also important for monitoring closely open
positions (e.g., currencies with high
differential of interest making hedging
expensive'; floating IR portfolio).
Despite the usefulness of FX and IR
forecasts issued by investment banks, it can
be dangerous to rely too much on simple
market views or predictions even from wellknown
gurus. The hedging process should
remain adaptive and gradual to weight
possible wrong assumptions. Forecasts are
more useful for short-term hedging. The
strategy needs solid foundations and
principles rather than market-changing'
views. The art is in defining the appropriate
ratio level. Another risk is to use overcomplex
instruments in order to reduce
hedging costs. Some features are designed
with knock-outs, barriers, corridors, etc. to
create so-called zero-cost' products.
Treasurers have to use powerful IT tools to
revalue these types of products, if dealt.
Furthermore, treasurers should have the
expertise to de-structure the products in
order to price them properly. The more
complex a product is, the less transparent it
is in terms of pricing. It is essential to align
the time horizon of underlying and financial
instruments. By hedging short-term, the rollover
of hedging instruments could be
expensive and create cash shortfalls.
Mismatches are not to be advised. However,
(too) long-term hedges could also be
expensive (e.g., because of interest rate
differentials).
Treasurers should always consider cash-
flow impacts, especially when hedging noncash
items (e.g., translation risks) or
uncertain future exposures. The most
complex issue is correlation between
exposures and underlying items. When
identified, it can reduce the global hedged
position, even if not fully perfectly hedged
(e.g., CAD and aluminium price, USD and
crude oil). When treasurers rely too much on
proxy hedges, it can become very dangerous.
The hedging strategy needs to be coordinated
across the group to avoid potential
inefficiencies.
Advantages of trading platforms and new technologies
These days, for reasons of efficiency,
comparability and internal controls, not
making use of trading platforms would be a
big mistake. Using this type of tool, such as
360T, MyTreasury or FXall, for example, is now
established as best practice. These tools permit
a straight-through processing (STP) approach
and the automation of trade in financial
instruments from their initial trading until their
final settlement at maturity, including the
accounting entries during the life of the
product and the ad-hoc transfer instructions.
They provide an opportunity to obtain the best
prices (real trading market prices online and
even better than the indicative pricing
displayed on Reuters), but also to obtain a
number of reports and statistics that can be
useful for internal controls and KPIs/KAIs. They
allow operational risks to be significantly
reduced, especially when supplemented by a
transaction confirmation matching service via
MT 300 or Misys CMS. Lastly, they provide a
means of putting all one's banks in open and
simultaneous competition in order to allocate
the side-business correctly.
Key factors impacting hedging
strategies
The design and the implementation of an
effective group FX risk management strategy
and policy can be a real challenge for many
corporate treasurers. The extreme volatility
level experienced on FX markets (especially
EUR/USD) over recent months has highlighted
the need for carefully considering the FX and
interest rate hedging requirements. Then, the
question is how sufficient these hedging
strategies are in meeting their risk
management objectives.
More expensive FX pricing to
come?
One of the unexpected or unsuspected
consequences of the current financial crisis
could be a significant increase of FX pricing on
longer periods. Dealers are beginning to think
more seriously about credit-adjusting the
prices quoted on FX derivatives in general. The
pressure on banks may force them to adjust
pricing up on longer period FX transactions to
include the credit risk element. It means that
leaving aside swap points and interest
differentials, the longer a forward deal, the
more expensive it will be. This evolution which
we have noticed recently seems to be
crystallising now. This is rather surprising for
some corporates although it was inevitable,
especially after such a deep credit and faith
crisis we faced. The solution to reduce the
extra cost adjustment applied to FX
transactions is to sign an agreement like CSA
type (Credit Support Annex) to collateralise
bilaterally amounts corresponding to changes
in mark-to-market valuation of portfolio of FX
transactions made with the bank. The idea, like
for margin calls, is to secure the potential
(unrealised) loss on portfolio of FX deals
revaluation. If the portfolio has a negative
change in fair value (lower value compared to
inception value), the customer would have to
secure this amount with a cash collateral
deposit. In the case of a positive change in fair
value, the deposit in cash would be made by
the bank. Both deposits are remunerated at
EONIA rate. Of course, the larger and the more
diversified the portfolio, the less collateral
would be potentially required.
It is obvious that in case of default (e.g.,
Lehman Brothers or Kaupthing Bank) the
customer can recuperate and compensate, via
the deposit, the loss incurred. The bargain
would therefore be: does it make sense to
reduce cost of hedging FX transactions by
collateralisation or not? The more FX
transactions dealt, the more the banks used for
dealing, the more collateral would possibly
have to be immobilised and locked. It could not
be considered as cash and cash equivalent
according to IAS 7 as pledged to the bank. The
return offered will not be as good as the one
potentially achieved now with money market
funds of prime quality. The CSA will imply
review by lawyers and extra legal costs, at
least for first contracts to be signed (similar to
ISDA schedules).
Fortunately, limits and margin calls will be
managed by the banks' back-offices.
Nevertheless, it will create extra administration
for treasury teams. For companies which are
cash poor, it has an additional cost, especially
when spreads are extremely high, as today.
Corporate treasurers could also decide to have
recourse to shorter FX transactions
rolled-over over time. Again, it will generate
extra administration and interim volatility at
roll-over dates. That is the price that has to be
paid for this type of solution.
The challenges of OTC
derivatives reform
The Obama Administration announced in June
2009 a sweeping reform of the financial
markets, including a brand new approach of
the OTC (over-the-counter) derivative markets
(Financial Regulatory Reform: A New
Foundation published on 17 June 2009).
Meanwhile, the European Commission has
issued a consultation document on possible
initiatives to enhance the resilience of OTC
derivatives markets (Brussels Commission
staff working paper 3/7/9 SEC 2009- 914 /
"Ensuring efficient, safe and sound derivatives
markets" COM 2009-332).
The major issue in this reform is its scope. It
does not only cover the trading of CDS and
CDOs but also plain vanilla hedging
instruments (e.g., IRS, currency swaps, etc.). We
will all be impacted by such a reform. The aim
is to apply new rules to all derivatives, no
matter what type of them is traded or priced,
regardless of whether they are standardised or
customised and it also includes the derivatives
to be invented in future. There are no
exceptions for simplifying the rules application.
Are the standard and classical' OTC products
victims of the excesses of a bunch of them
(e.g., CDS and CDOs)? In general, companies
use derivatives to reduce exposures and risks
and not to trade speculatively.
The direct impact for corporate end-users
is obviously the increase of cost of hedging
because of margining system, the increased
P&L volatility given potential ineffective
hedging strategies and unwanted
transparency on hedging strategies applied.
The OTC reform would lead to higher costs
and therefore to increased borrowing and
possibly to additional capital requirements.
The use of derivative products is essential
and legitimate for sound risk management.
They are aimed to stabilise prices and
mitigate risks. More transparency is certainly
Figure 3
a recommended and praiseworthy goal,
which can prevent future systemic risks.
However, we do not want to negatively
impact basic plain vanilla products, the use
of which could become ultimately impossible.
As always, the excesses from a limited
number of persons will penalise the whole
derivative user community. The misuse of a
couple of sophisticated and complex
instruments by traders, together with the
weakness of controls by regulators and
supervising bodies will eventually impact the
vast majority of the users. The cost of
repairing the damage to the financial system
is extremely high.
To avoid some of the impacts for
treasurers, and to avoid being
counterproductive, a few financial
professional organisations and service
providers have recommended excluding
derivatives or at least exemption from this
reform. We have noticed a real simplification
and cleaning of derivative products compared
to a couple of years ago, before IAS 39's
stringent provisions on financial instruments.
The risk is that if no exemptions are
planned corporations will decrease the use of
OTC derivatives, even basic ones. The cost of
margining and reporting would be too high
compared to benefits. Corporations would
need to arrange committed credit facilities to
meet central counterparty margin calls,
reducing accordingly their total debt
capacity. Corporations could suddenly decide
not to hedge some financial exposures any
longer. The result would be to have unhedged
risks and bigger exposures at a time where
operations are already affected by the world
economic crisis. With IAS 39, some financial
hedging decisions were driven by accounting
considerations. With the OTC derivative
regulations, hedging strategies would be
driven by cost and administrative
considerations.
We should admit that so far, corporate
treasurers are relatively immune from any
financial regulation. The idea with the OTC
derivatives regulation would be to
standardise derivative instruments (sensu
lato) and to require them to be dealt through
an exchange with settlement handled
through a clearing house or a Central
Counter Party (CCP). Interposing a CCP with
rules on margining and collateral is designed
to reduce counterparty risk (which seems to
be an important and useful objective). It also
aims to promote fungibility of products and
full transparency of markets, to increase legal
certainty and to reduce legal risks.
Eventually, it enhances operational efficiency
by enabling electronic confirmation services
and more standardised collateral
management processes.
However, after recent bail-outs we could
reasonably accept that the default of large
multinational banks is rather limited
(although not excluded). Furthermore, it
remains a delivery risk (which is at the end of
the day smaller than a pure credit risk). It
should facilitate offsetting and netting down
of operations or, if necessary, wind-down. If
derivatives (including FX forward and plain
vanilla IRS) are quasi burned' because of the
administrative burden and costs they would
create, the risk management by non-financial
corporations would become extremely
difficult. The risk would be to avoid hedging
to minimise related costs.
All treasurers would support all regulation
measures dedicated to improve controls on
financial counterparties and dealers. A better
way to reduce risk in the banking sector is
certainly not the transfer of constraints and
costs to corporations and users. The last
thing one would wish is to make hedging
impossible, too complicated or expensive for
normal business exposures.
As usual with such proposed reforms, it
impacts several activities and professions,
including blue-chip companies, which may
suffer for crimes they did not commit. In the
modern economy, the banks provide the fuel
and corporations are the engines. The risk is
to try to purify the fuel while altering the
engine.
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