|
|
Thursday, 25th April 2024 |
| Foreign exchange hedging |
Back |
| An overview of foreign exchange hedging by Des Leavy and Rachel Killeen. |
Many consider structured products to be something new and as such to be treated with a certain amount of caution, however it is worth remembering they were first used in the 17th century. It was not until after World War II that they were established as a widely used foreign exchange hedging tool in the US and globally thereafter with the most rapid development over the past decade. Structured products continue to evolve as a hedging tool allowing corporate clients to more accurately express their view or to ensure their risk profile is consistent with their underlying business.
Today, risk management is a critical consideration for corporate treasurers and this article seeks to place foreign exchange hedging in context - from definition to implementation.
Spot and outright forward contracts
Beginning at the very basis of foreign exchange trading, a spot foreign exchange transaction settles two working days after the trade is agreed. An outright forward contract fixes a rate of exchange to buy or sell currency in the future. Both can be useful depending on the situation, however, while an outright forward provides certainty of the exchange rate, it does not allow the company to benefit from favourable exchange rate movements as the rate is already fixed.
Corporate treasurers increasingly see their role evolve toward strategic risk management many with a direct reporting line to the board and ultimately to shareholders. Setting a risk management profile for the company is an integral part of corporate governance and it’s approval the remit of the board.
In managing foreign exchange risk, clearly the treasurer’s mind turns toward the company’s unique situation - the contracts, currencies, timing, market conditions and the particular products that they bring to market. Balancing these and numerous other variables particular to each company, in a way that will achieve a risk profile consistent with the requirements of the company, requires careful consideration and not a one size fits all approach.
This is where structured hedging products are extremely useful. These flexible products range from plain vanilla currency options right up to a whole range of advanced first, second and third generation structures.
Why should you hedge?
The dangers of leaving currency positions unhedged are easily appreciated. With an unhedged position the company is fully exposed to adverse currency fluctuations while also having the ability to benefit fully from favourable movements, effectively treasurers take a ‘hard view’ that the exchange rate will move in their favour. View not realised - disaster impending.
There is a myriad of foreign exchange hedging instruments designed to manage the downside and preserve or maximise the upside - and many at zero cost. Corporate treasurers can protect the underlying business at a known ‘worst case rate’ while also gaining benefit from favourable currency movements within agreed parameters. Importantly, these products are structured to match the risk profile of the company, ensuring that projected gains don’t turn to detrimental losses with the passage of time.
In its simplest form, a currency option gives the buyer of the option the right but not the obligation to exchange one currency for another at a predetermined rate at a future date, thereby giving protection against any adverse movements in rates. This gives the buyer benefit from any improvement in the exchange rate. If you are uncertain of the amount and timing of your exposure, currency options are useful. By buying the right, but not the obligation to deal under pre-agreed conditions, the ‘plain vanilla’ option works much as an insurance policy with the premium giving protection against the adverse exchange rate movement. Should the rate remain favourable there is no need to utilise the policy, meaning the downside risk is eliminated and the upside has potential gain.
Structured hedging products can be designed to give full protection at a rate chosen by the corporate treasurer while also benefiting from favourable currency movements, all tailored toward a level of risk management consistent with the profile of the company. Most of these currency hedging products, such as Forward Plus, Late Limit Forward Plus, Knock In and Knock Out Cylinders and so on are structured at zero cost to the company.
Looking at more advanced structures the product names become less relevant as they are tailored more to the company’s needs than to a predefined product parameter. They allow account to be taken of many factors including irregular cashflows; multiple currency exposures hedged in a single transaction; deferred cost solutions; reduced use of credit lines. They also take into consideration elements such as risk parameters, budget rates and market views.
The role of the corporate treasurer
It is impossible to eradicate risk entirely but one of the roles of the corporate treasurer is to ensure that currency exposures are managed within a policy that is appropriate to the underlying business. As margins have become tighter the pressure on corporate treasurers to protect their companies from adverse currency movements has increased. As outlined above, there are many ways to manage foreign exchange exposure and the methodology needs to match the company’s risk appetite. Can you afford not to explore the alternatives? |
Des Leavy is deputy head of large corporates and Rachel Killeen is marketing manager at Ulster Bank Financial Markets.
|
| Article appeared in the October 2002 issue.
|
|
|
