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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.

by: Reval

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