How to get FX hedging costs under control

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Businesses may be taking on exposures to FX risk unnecessarily because they think hedging costs are too expensive. Understanding these costs is the springboard to a robust hedging strategy that avoids too much damage when an unexpected devaluation hits.

Steve Skillman, managing director, corporate foreign exchange, RBS
Many businesses have a tipping point in terms of hedging costs. If costs are low, hedges are actively placed to protect margins and establish cash flow certainty. If costs are high, hedges may not be placed or coverage may be significantly reduced. While a well-defined policy will mitigate this dilemma, the cost of hedging now rivals forecast confidence as the number one factor determining a company’s approach to reducing FX risk. The challenge is to find your tipping point and meet the age-old challenge – let’s reduce FX risk but not spend too much doing it. First things first though – how do we define ‘hedge cost’? There are many different approaches among US multinationals. Some look at the value-at-risk – how they measure the risk of a loss on a certain portfolio of non-functional currency cash flows. Others track options pricing. And still others focus on forward points and the offset from the spot rate of the hedge contract.

There are arguments to be made for all these approaches but, for the purposes of this article, we’ll focus on forward points associated with currency hedging. The benefits of this method include that it avoids the complexity and data intensive approach involved with currency options and aligns with the most common hedging instrument – the FX forward contract. This is particularly relevant given the current global economic backdrop. As talk of Federal Open Market Committee tapering increased, the US yield curve has steepened dramatically. Meanwhile, rates in most emerging markets have increased even more significantly. For example, our electronic trading platform RBSMarketplace shows that, since January 2013, the annualised cost of hedging the US dollar against the Indian rupee (INR) has increased from 5.4 per cent to 8.9 per cent, and for the Brazilian real (BRL) from 5.1 per cent to 8.7 per cent. It’s important for risk managers to examine this change in interest rates. That is to say, once the hedge cost has been defined it must be quantified. One additional variable to consider is volatility. The more volatile markets are, the greater the risk is to the business and the stronger the desire is to hedge. If markets didn’t move, arguably you wouldn’t need to hedge at all. The dilemma is: as volatility increases the desire to hedge increases, but so does the cost of hedging. Options become more expensive and rate differentials are wider. During the financial crisis, companies started questioning whether the cost of placing a derivative contract was worth it. Those conversations continue today. Once defined and quantified, hedge costs need to be minimised in a manner consistent with a company’s overall risk management policy and philosophy. Given that most multinationals do not speculate in currency markets, the objective becomes protecting the business plan at the lowest possible cost. This process invariably involves data analysis, back testing and scenario analysis to enhance the decision-making process and determine which instrument most effectively reduces hedging costs but still provides protection against a devaluation. In high-cost currencies like the rupee or the real, a random-walk model of future FX rates implies the likelihood of generating a hedge loss may be as high as 75 per cent, which begs the question: why would a company place a hedge contract when it is almost certain to lose money? There are two reasons. First, the company may have a ‘hedge at all costs’ approach toward risk management. Second, the hedge program may be ingrained and not actively reviewed on a regular basis. Active comparison of hedge costs across forward contracts and purchased options can yield powerful results. Numerous RBS studies, including ‘Monte Carlo’ simulations – multiple trial runs using different variables – and back testing have been conducted over periods examining as much as 10 years of data. They yielded results in a variety of currency pairs showing that at-the-money forward options can reduce expected hedging costs by as much as 40 per cent. This area certainly requires a great deal of thought and should be communicated up the chain within the treasury department and the company’s business units. Everyone involved should know exactly how and when currency risk will be managed. This takes time to get absolutely right and commitment to make sure it happens. And even when it does happen, there will always be times when you wish you had hedged differently depending on market movements. There’s no such thing as nirvana when it comes to currency risk management. But businesses that see this through will have built firm foundations on which they can better protect their margins at a cost that is well understood and proactively managed.
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