FX hedging dilemma vexes corporates as costs spiral

High volatility jacks up option prices, forcing firms to reconsider hedging activities

FX-hedging-dilemma-vexes-corporates

While consumer shopping baskets are becoming dearer, and householders struggle with soaring energy bills, inflation has also hit currency hedging.

Sharp rises in the cost of foreign exchange options and forwards have forced corporate treasurers to rethink their hedging programmes. Some have cut back their hedges. Drinks maker Coca-Cola, for example, reported in its most recent earnings report that the total notional of derivatives designated to currency cashflow hedges decreased 20% from $7.4 billion at the end of 2021 to $5.9 billion as of July 1.

“We’ve seen a reduction in FX hedging activity because option volatility has gone through the roof,” says Abhishek Sachdev, chief executive of Vedanta Hedging, an independent corporate treasury consultant in the UK.

Other firms are looking to reduce the cost of hedging by switching out of longer tenor instruments in favour of more flexible strategies.

Volatility is one of the key inputs for pricing options. As volatility climbs, so does the price of options. Interest rate differentials cropping up across the globe are also negatively impacting the balance sheet and cashflow hedges that some companies use to protect their assets and liabilities from wild FX gyrations. Moves in interest rates can affect the price of FX forwards.

This squeeze on pricing comes as companies face wider cost pressures due to supply chain disruptions and energy inflation brought on by Covid-19 and the ongoing Russia-Ukraine war.

Corporates are having to balance the growing cost of maintaining hedges against the extra risk they would face by reducing the protection.

“The benefit [of hedging] is that companies get close to zero volatility on their financials,” says Amol Dhargalkar, chairman and global head of corporates at Chatham Financial. “But the question is whether it makes sense to keep spending that much money, or whether they need to pull back on that kind of spend and whether it’s worth taking a little more risk.”

Dhargalkar says a US chemicals company contacted him after seeing its typical $1 million hedging cost increase by as much as tenfold, and stated that they were considering spending less on hedging and running some exposure risk.

However, not everyone thinks increasing FX exposure in the current environment would be a wise move.

“We do not believe currency exposures are a lesser problem due to volatility or hedging costs going up,” says a senior treasurer at a European manufacturer, adding that companies might consider using cheaper hedging instruments, particularly if future business revenues are uncertain.

For those with deeper pockets, the uncertainty may bring opportunities. Tech giant Google hedges its operating profits with a mixture of forwards, options, collars and non-deliverable forwards, explains head of FX, Garrett Wilson. The firm uses quantitative models to find FX mispricings based on rate differentials, terms of trade and energy prices, among other factors.

Forward thinking

Inflation has reached 40-year highs in some countries. The consumer price index in the US stood at 8.5% in July, down from the peak of 9.1% the previous month. The equivalent figures for the UK and eurozone were 10.1% and 8.9%, respectively.

With the Federal Reserve raising interest rates to tackle inflation, the US dollar has reached a two-decade high against a basket of currencies.

FX forwards – the hedging instruments most popular with asset managers and corporates – have seen price rises over the past few months. One measure is to look at the implied yield – effectively how much higher the forward rate is versus the spot level at the time – which is driven by a combination of interest rate differentials and demand.

One-year FX forward implied yields for EUR/USD have moved from -0.7105 at the end of 2021 when exchange rates were stable, to +1.3521 as of August 30, according to Bloomberg data.

Similarly, one-year forward points on EUR/USD have also increased from +126 to +293 as of July 13. This forward premium reflects the growing difference in interest rates between the two jurisdictions. For a corporate hedging against a rise in EUR/USD out to 12 months, locking in a rate would be a lot more costly.

 
 

These shifts mean companies are revisiting their hedges in a bid to find favourable risk/return trade-offs. Some corporates are looking to reduce the duration of their hedges to control their exposure, or even cut the money spent on buying protection.

“There are real differences between what’s happening in the US, what’s happening in UK and what’s happening in Europe,” says Vedanta’s Sachdev. “We’ve seen a reduction in the term of hedging because people don’t want to get hit by the FX forward points too much. We’re seeing people hedging sometimes even as little as just three months at a time.”

Those shortened hedge durations are a stark difference from earlier in the year when dollar strength had corporates locking in protection at least until late 2023. But Sachdev says corporates are now looking to build in more flexibility into the way they hedge so they can deal with uncertainties and future costs as they arise in the different parts of the business.

Because of this, flexible forwards are coming into vogue. Also known as an open forward, these types of contracts give their owners the right to access a portion of the hedged amount at a predetermined price ahead of settlement date. Residual amounts are automatically settled on the maturity date.

These strategies are beneficial for companies that want to hedge against exchange rate movements but are unsure over the timing of future payment flows. Take the example of a US corporate that knows it has to pay invoices from a European supplier at some point next year. The corporate can buy a 12-month EUR/USD flexible forward contract which allows it to make drawdowns to pay the euros as necessary during that period.

Naturally, gaining the benefit of flexible drawdowns isn’t without risks. On top of paying a little more to act at one’s own discretion, forward transactions could result in losses. If the predetermined price is worse than the spot rate when the contract is executed, the transaction will be executed at a less favourable price. Additionally, the structure may have a negative mark-to-market value over its term and may incur additional costs to close out the position before its maturity.

Optional extras

Another technique that is finding favour among corporates is to “layer on” outright forwards, as Sarah Boyce, associate director at the Association of Corporate Treasurers, describes. Simply put, a company buys an outright forward for delivery for a set period of time and keeps buying additional contracts in the following months until the desired period is covered.

“The thing about outrights is that they are straightforward,” Boyce says. “They are not cheaper, but the pricing is embedded in them so they’re easier to use than an option. You’re spreading the cost over the period.”

She adds: “Most large corporates will not have a huge option book, particularly in markets like this, because why would you? They’re expensive to have. There are other ways of doing it.”

Hedge programmes are also dependent on the type of company and the jurisdiction in which it operates.

A US company that has expenses payable in euros would welcome a strengthening of the dollar versus the euro. On the other hand, US companies with euro revenues would suffer given a similar move in the exchange rate.

For multinational companies, pricing wrinkles across currency pairs may offer upside. Google’s Wilson believes the USD/JPY spot rate is around 10% too high at current levels. He says a beneficial trade would be to switch from forwards to collars, “allowing us to remain hedged but take advantage of that move if we are correct”, Wilson says. A collar protects the holder against downside moves, while offering limited upside benefits.

But the rising costs of hedging must be set against runaway inflation and supply chain disruption for many companies. Currency costs may have risen by 5% or 10%, “but if your energy bill has gone up by 300% or 400%, that’s a bigger issue for you than your currency costs” Vedanta’s Sachdev points out.

Editing by Alex Krohn

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