Smart corporates beef up FX hedging
FX volatility highlights the need for corporates to stick to long-term hedging programmes, so that they can protect profits and their credit ratings. Some firms are also positioning themselves for opportunistic trades and upgrading their treasury and FX management systems.
Volatility in foreign exchange is predicted to continue this year, propelled by factors including divergent US and European central bank policies, fluctuating oil prices and one-off sudden central bank action such as the Swiss National Bank removing its euro/Swiss franc cap. Euro/dollar, the world's most widely traded currency pair, has moved almost 20% from 1.37 a year ago to approximately 1.13 today.
FX strategists at Bank of America Merrill Lynch believe FX volatility is likely to head higher this year and might act as a "drag on global trade", according to a research note published earlier this month.
The sharp appreciation of the US dollar is being felt by US large-cap corporates. Luxury jeweller Tiffany warned last month that it expected "significant headwinds" this year from the stronger dollar, which hurt its sales from tourists in the US as well as translated income from stores outside the US over the Christmas period.
Political risk is feeding into high levels of volatility and is increasingly on corporates' radar, but should not dictate hedging policies, warns James Lockyer, development director at the UK's Association of Corporate Treasurers. “We are increasingly advising corporates to be aware of political risk in all its forms, through things like political unrest, threats of war and so forth,” he says. “Sanctions, which are increasingly pervasive, are applicable from the date it is stamped on paper. [But] we would say your overall hedging policy should be independent of volatility – low volatility can give you a false sense of confidence." Bird's-eye view of FX
Rated companies must implement sound hedging strategies to meet the strict criteria of credit rating agencies and avoid a downgrade, advises Jean-Michel Carayon, senior vice-president in the corporate finance group at Moody's. Russian railcar company Brunswick Rail, for example, was downgraded a notch in December in the light of dramatic depreciation of the rouble.
Carayon says: "There may be cases where we identify relatively high levels of operating risk linked to hedging or the absence of hedging. Part of our monitoring is to discuss hedging policy and the impact on corporates."
Companies are adapting to the new environment by upgrading their treasury management systems to ensure real-time visibility of their cash balance across different countries, currency by currency, and counterparty exposures, says Tony Carfang, partner at consulting firm Treasury Strategies.
Once that is in place, a company needs to centralize its management of these risks.
"Unfortunately for most companies, many subsidiaries act independently and will put in place hedging strategies with only a view of that subsidiary's risk and exposure," says Carfang. “The problem with that is that there could be offsetting exposure that provide the perfect hedge elsewhere in the company. Our clients are working very quickly to centralize management of their FX exposures."
Companies that already have this visibility and a sound, long-term hedging policy are able to take a more opportunistic view of heightened volatility, by taking a punt on moving exchange rates to generate profit.
Ben Birgbauer, treasurer at Jaguar Land Rover, says that the car manufacturer's philosophy is to have a consistent five-year hedging policy, regardless of the currency levels. A certain percentage is hedged a year out, and the high and low of the percentage range decreases every year all the way to five years. This banding allows flexibility to make tactical trades, where appropriate.
"The hedging range allows limited discretion for how much to hedge within the policy, so, for example, we may hedge at the higher end of the policy range when rates have moved relatively favourably," Birgbauer says.
But corporates have to remain mindful of the cost of these trades, which has increased recently. The double whammy of increasing demand for hedging in the wake of volatility and additional regulatory demands has pushed up the price of locking in exchange rates using derivatives, say market participants.
Banks' bid-ask spread – the difference between what they pay to buy a currency and what they pay to sell it – increasingly includes credit charges for counterparty risk in their forward pricing. The amount of capital banks have to set aside for derivatives transactions has increased under Basle III.
Birgbauer says: "I think that we have not yet seen the full effect of regulation and higher bank-capital requirements on credit charges to corporates, but in time I think we have to assume banks will pass these costs on to corporates."