Corp FX: Week Ahead
NWM FX: Managing heightened uncertainty in FX hedging
2020-04-21T08:29:26

Managing heightened uncertainty in FX hedging

  

In the current, unprecedented environment, corporates are facing significant volatility in exchange rates. While volatility alone is nothing new, many companies now also have to deal with much greater uncertainty about financing requirements as well as the timing and amount of both, costs and sales volumes as supply chains and customer buying patterns adjust.

Against this backdrop, reviewing your hedging strategy is vital: Do you hedge the maximum expected exposure and run the risk of being over-hedged? Do you hedge the minimum expected exposure and risk being under-hedged at the most volatile time in many years? How will the volatility impact financing covenants?

The following three steps will help you to determine whether, or how, your hedging needs adjusting.

  1. Review your Treasury policy

The majority of corporates will have a Treasury policy which sets out the objectives of the treasury function, its key targets and metrics, and the tools available to achieve these objectives. We recommend, as a first step, to review this policy and identify whether it is fit for purpose or requires amending at this moment in time. Some questions that should be considered include:

  • What are your key metrics? What are their sensitivities to market rates? How do those market rates feed through to the metric (e.g. spot, average rates)?
  • Has the nature of your exposures changed, and if yes how? Are some cash flows more easily forecast than others? Should you follow a different approach for different business types or different currency pairs (e.g. G10 vs EM)?
  • Is your de-centralised or centralised approach still the most suitable at the moment? What are the pros and cons of each?
  • Are you prepared to adopt a different product choice e.g. using premium-paid options to avoid uncovered losses on hedges if business volumes decline? How do current pricing dynamics, such as for example execution charges or bank charges for heightened credit risk on exposures, affect your decision?
  • Should you hedge shorter or further to seek minimising hedging cost or to lock in current spot levels respectively?

  

  1. Analyse key data

To determine the best approach for your company to hedging uncertain exposures have a close look at your financial data:

  • To the greatest extent possible, identify the size and timing of your exposure. Can your exposure be sub-divided, for example into an amount that is the minimum certain exposure, an amount that is e.g. 75% certain, and an amount which has less certainty?
  • Determine the sensitivity of each type of exposure so that you can focus your effort on those exposures that have the greatest risk on the given metric. Sensitivities can be derived based on market-expectations of potential movements (implied volatilities), historic movements (historic volatilities) or a given move (e.g. stress percentages). Your NWM FX contact can help if you do not have access to market data.
  • What is your risk appetite? Are you prepared to adjust it? In the current volatile environment, it may be necessary to risk-accept exposures which ordinarily would be beyond risk-appetite.
  • Analyse costs and benefits. What is the cost of hedging – both in terms of market costs (forward points/premium) and charges (credit, capital, funding and execution)? How does this fit with your re-defined risk appetite? Are you willing to pay more in order to reduce certain risks?

In addition, take into account economic versus reporting considerations. For example:

  • Cashflow exposures are purely exposed to spot rates, however, covenant and reporting metrics may be measured on a different basis: earnings before interest, taxes, depreciation, amortization (EBITDA) and profit & loss (P&L) are typically based on average rates, meaning they’re not so sensitive to rapid moves in spot.
  • For hedge accounting purposes, forecast cash flows must be ‘highly probable’ to occur. The general assumption is, that this threshold lies between a 70-90% level of confidence, although this varies in practice. This is one reason why bucketing exposures into those with different levels of confidence could help – you may achieve hedge accounting for some but not all of the buckets. Hedge designation strategies can further detail your approach:
    • ‘Layer designations’ – for example: “These forwards hedge the first $60 million of revenues in month x; these options hedge the next $20 million of revenues in month x.” If the additional $20 million of revenues fall below the highly probable threshold, at least hedge accounting remains for the first $60 million.  Having used options means that the non-hedge accounted ‘mark to market’ (MTM) on the option can only be a gain (excluding time value of course).
    • ‘Rollover strategies’ – for example: “In the event of the additional $20 million of revenues not occurring in month x, the hedge is considered to be a partial term hedge of the first $20 million of revenues in month y.”
  • When it comes to covenants it is not uncommon during times of market stress to realise that quantitative metrics are unhelpfully defined. Mostly, covenants are not intended to highlight breaches caused by short-term market dislocations. For this reason, you may prefer to redefine the calculation of metrics using average FX rates for a historic period. Of course, this will need to be discussed with the counterparty, and any relevant disclosures should explain the change and why the decision was taken.
  • Similarly, all is not lost if hedge accounting cannot be achieved. Many corporates do not apply hedge accounting even though they could choose to do so. Disclosure is your friend: Companies have a degree of freedom around the provision of additional information, both on the face of primary financial statements (such as the Balance Sheet and Income Statement) and in the notes to accounts, provided such information is useful in helping the users of accounts understand your business and risk management processes better.

  

  1. Select the most suitable products

The following are the most common products used by corporates and how they can be useful in the current market context:

  • FX Forwards – can generate either a gain or a loss. For this reason, they are best used on certain exposures to ensure that they do not generate a loss when the hedged exposure does not materialise. As they can move out of the money, you’ll be charged for the potential credit exposure your counterparty may have to you; this may be higher at present. Forward points may be volatile as countries move swiftly to change monetary policy.
  • Bought vanilla options – pay premium to exclude losses. These can therefore be helpful for managing more uncertain exposures. However, premiums may be higher than usual due to higher volatility. This will be compensated to some degree by the absence of credit charges that do exist in Forwards, as your counterparty will not be exposed to you if the options move out of the money for you.
  • Participating forward – think of this as a forward over e.g. 70% of your volume and a bought option over the remaining 30%. These are fully hedge accountable (subject to the usual criteria), and the percentages varied at your request.
  • Zero cost collars – hedge favourable and unfavourable movements beyond a certain range. These collars balance risk with cost and have been very popular in recent times due to their favourable hedge accounting treatment. The range of movements you will remain exposed to can be varied to fit your risk appetite.
  • Forward plus – much like a forward but with the option to participate in favourable moves within a range. Beyond that range you will be returned to the contracted forward rate, which will be slightly lower than the ‘at-the-money’ (ATM) forward rate.

  

We’re here to help

We’re here to help you navigate the heightened uncertainty in the current market environment. Please reach out to your usual NWM FX contact to discuss any of the concepts above.

NWM does not provide accounting advice. Final accounting treatments should be agreed with your auditors and advisors.

 

 

  

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This is Non-Independent Research, as defined by the Financial Conduct Authority. Not intended for Retail Client distribution. This material should be regarded as a marketing communication and may have been produced in conjunction with the NatWest Markets Plc trading desks that trade as principal in the instruments mentioned herein. All data is accurate as of the report date, unless otherwise specified. 

 

This communication has been prepared by NatWest Markets Plc, and should be regarded as a Marketing Communication, for which the relevant competent authority is the UK Financial Conduct Authority.

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Authors
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Matt Osborne
Vice President, UK Corporate FX Sales
London
+44 207 0850891

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