| Using FX hedging to add to the bottom line |
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| In the current economic environment, with fundamental uncertainty creating volatile foreign exchange markets, corporates face increasingly uncertain variables that effect bottom line financial performances, writes Bryan Conway. By identifying these pitfalls (in advance, where possible) and being proactive in creating a suitable risk management profile, corporates can not only prevent unpleasant surprises to the bottom line, but they can turn these into opportunities for organisations, he adds. |
Companies face many risks when conducting their business. Among these many risks is business and financial risk: business risks are associated with engaging in their chosen activity of business while financial risks are the risks faced by holding assets or liabilities, or generating cash flows whose value fluctuate as financial markets move.
Foreign exchange risk falls into the category of a financial risk to a business as it can affect the receivables (income) and payables (expenditures) of a firm due to changes of exchange rates where revenue is generated or costs occur across international boundaries. | | Bryan Conway |
An estimated €1.5 trillion worth of business is traded on the global foreign exchange market on a daily basis, with a mere 15 per cent of this volume been driven by corporate demand. This would indicate that foreign exchange rates are being driven primarily by speculation. Like any other commodity, good or service, the price of foreign exchange is determined by the law of supply and demand. Prices are influenced by the demand and the ability of the market to meet that demand. Many factors will influence currency markets and the supply and/or demand for currencies. Among these are geo-political events such as political unrest, election results, conflicts or wars and fundamental shifts in economic policies that determine interest rates, inflation, unemployment and GDP. From a market perspective rates can be driven by flows out of one currency into another and a technical aspect that records price movements with the view that history repeats itself. The one certainty is that the foreign exchange market will move, most often in ways we least expect it!
Financial risk management can be defined as the process of gathering information on potential risks to an organisation with the view to making informed decisions to manage that risk. By identifying the risks to the organisation, management can establish the probability of an event occurring and the magnitude of effects if the event does occur to the financial state of that organisation. By pre-empting these factors an organisation can identify potential solutions that would protect themselves from such adverse movements leaving them to concentrate on their chosen activity of business.
Foreign exchange markets have become more volatile
As an example of what foreign exchange risks exist within organisations, we look at how EUR/USD has traded during the past two years. We can see how a firm with exposure of $100 million against EUR would have fared if they had not hedged their foreign exchange exposure and instead simply purchased USD at spot. The EUR/USD has traded a range of 1.1650 to 1.3600. This represents a 17 per cent fluctuation in the value of the USD with the potential to impact positively or negatively to the tune of EUR 12m in revenue terms.
Risk management
The majority of corporates hedge forward using fixed forward contracts, others elect not to hedge and instead transact currency at spot. Forwards put an obligation on the corporate to buy/sell a predetermined amount at a predetermined rate in the future, which provides full cover on the exposure but is limited in flexibility to benefit from any favourable moves or ability to change nominal/ timing. Spot trades give complete flexibility to participate in favourable moves and ability to choose nominal to hedge at various levels and dates, but provides no protection whatsoever against adverse moves in rates. This leaves corporates facing the trade off between the flexibility of spot and the security of forwards.
By turning to the foreign exchange options market, corporates can hedge exposures using a simple vanilla option that offers the ideal solution i.e. complete hedging of an exposure with total participation. It can often be a very expensive product, a cost that corporates are generally unwilling to deduct from their bottom line.
Recognising the dilemma posed by the desire for both participation and protection at zero cost, Barclays have developed a range of structured solutions that seek to better balance the three P’s of premium, protection and participation. Our structuring capabilities enable Barclays to create tailor made solutions for individual corporates by engaging in a trade off between some of the hedging variables in order to create a very attractive solution which will offer the desired level of protection with improved levels of participation.
The Efficient Zero Premium Frontier joining both the forward and spot approaches. Structured solutions enable exporters to position themselves anywhere along this line, thereby obtaining a solution that better meets their requirement for both protection and participation. In essence, a solution that not only protects margin but also provides them with the opportunity to enhance profitability.
While corporates are looking to extract the maximum capability from structured products the closer the structure approaches the top right hand corner the greater the premium paid. This requires structures to participate in a combination of buying and selling options to deliver a solution that meets the participation and hedging requirements but within cost parameters that restrains corporate treasuries.
This puts the corporate in a position where they can now start with the zero premium constraint and it is now possible for exporters to obtain solutions that offer a more dynamic balance of protection and participation.
Given the pressures on businesses to deliver ever increasing returns to shareholders, finding the most optimal hedging solution is an important role for any finance manager. Adoption of a measured approach to foreign exchange risk management that ensures that margins are protected and that does not limit the opportunity for margin improvement can help achieve this goal.
As one of the leaders in structuring foreign exchange, Barclays has seen some common elements in what corporates are factoring into their decision making process when looking at tailoring option structures:
• Companies are increasingly becoming more proactive and implementing dynamic hedging strategies using the foreign exchange options market
• The dynamic profile goes out to 12 months and often beyond as opposed to a more short dated focus as was the case in the past.
• Many corporates are using a portfolio approach to improve their foreign exchange hedging performance
• An important objective is to successfully exploit market opportunities that offer perceived value, and therefore…
• Minimise the number of times that they deal at ‘bad’ rates
• To achieve this, many have opted (in addition to the traditional hedging instruments) to use hedge structures that provide protection against negative market rate movements and…
• Offer the ability to benefit from favourable rate movements
In the current economic environment with fundamental uncertainty creating volatile foreign exchange markets that are being exaggerated by increased trading volumes, corporates face increasingly uncertain variables that effect bottom line financial performances. By identifying these pitfalls (in advance, where possible) and being proactive in creating a suitable risk management profile, corporates can not only prevent unpleasant surprises to the bottom line but they can turn these into opportunities for organisations.
Any foreign exchange hedging strategy that you consider should protect you from the possibility of rates moving adversely and offer the ability to benefit from favourable market improvement. |
Bryan Conway is a senior dealer with Barclays Capital.
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