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Volatile economic environment increases need for treasurers to have an active hedging strategy Back  
With the dollar taking a pounding, interest rates on an upward trajectory, and global oil reaching new highs, the summer of 2006 is a challenging time for corporate treasurers. A treasurer’s best protection in a volatile environment is to have an extensive hedging strategy in place to mitigate currency, interest rate and commodity risks, and in this issue, we examine the options for Irish corporate treasurers.
FOREX hedging
Although the introduction of the euro reduced the need for hedging currency risk, Irish corporates’ exposure to a range of currencies, particularly sterling and the dollar, means that foreign exchange hedging remains very much top of the agenda for Irish corporates.

The range of products looking to meet corporates’ needs has grown significantly over the past number of years, and from forward contracts to FX derivatives, from spot trades to currency swaps, Irish banks have got it covered.

Although some of the products available have gotten more complex, there is also a tendency to simplify them, in order to make them more attractive and usable to corporate treasurers, who may have to explain their hedging strategies to company directors who are unfamiliar with such products.
Increased price growth in oil highlights the need for treasurers to have a complete hedging strategy in place.

In this issue, Ciaran Cash, a treasury manager with Bank of Ireland Global Markets, describes how a FX linked deposit can be used. While this product does not provide an exact hedge for FOREX exposure, it does reduce the potential downside of an unfavourable exchange rate move.

Energy hedging
Volatility in the commodities market is also impacting on treasurers’ foreign exchange hedging strategies, as most commodities are priced in dollars.

The commodities market, which includes energy such as oil and gas, is currently in a state of contango – whereby the future price of the commodity is higher than the spot price. While prices are rising, the return on commodities is now flat, increasing volatility for treasurers.

As energy prices are four times more volatile than forex or interest rate movements, treasurers need to consider using similar hedging instruments to limit their exposure to energy prices. The current environment highlights this, with continuing hostilities in the Middle East making a big impact on oil prices, with a new high reached on July 17th, and no abatement of price growth on the horizon. Moreover, Paul Harris, head of energy & emissions at Bank of Ireland Global Markets, predicts that the cost of a barrel of oil will hit the $80 mark shortly.

The impact of this price growth is already having a negative impact on Irish corporates, with Fyffes for example, revealing an expected €9 million fall in profits attributable to increased shipping costs.

Traditionally in Ireland, energy purchases have come under the ambit of the procurement manager. But in Bank of Ireland’s latest Irish Business Review, it is argued that the hedging strategy should be determined by the company executives/board of directors in conjunction with the procurement manager and that users of oil and gas should look closely at the range of hedging instruments that can limit their exposure to further price rises in a variety of energy products - coal, gas, jet fuel, gasoil, heavy and light fuel oil, diesel and gasoline.
According to BOI, hedging instruments such as swaps, collars and caps operate in the same way for energy as they do for interest rates and foreign exchange and instruments can be tailored on a monthly basis to match actual consumption levels.

For example, companies wishing to protect against rises in fuel costs can enter into a number of different derivative (financial) contracts. Under a swap the company can pay a fixed fuel price and receive the average monthly index price for the specific fuel type. In this way, if fuel prices rise, the company will receive a cash benefit, which can be used to offset any increase in the physical supply contract. The advantage to the company of this structure is that they are fully protected against price rises and have a degree of certainty about the cost of their fuel for a given period. Fuel swaps can extend as far as three years.

The other main type of hedge is a fuel cap for which a premium is payable. In return for this upfront fee the company establishes a cap, or ceiling for its fuel cost. If the monthly average index of the fuel type exceeds the cap rate, the company is compensated. Caps are available for up to three years.

Interest rate hedging
The energy sector is not the only sector which is experiencing an uncertain time. Since the European Central Bank raised interest rates for the first time at the end of 2005, it appears that the historically benign interest rate environment in the Euro zone has come to an end, and rates are now on an upward trajectory. As such, treasurers need to work on their interest rate hedging strategy, as this new environment will highlight any weaknesses in a corporate’s treasury policy.

On the opposite page, Declan Fitzgerald, head of capital markets at Ulster Bank, gives advice to treasurers operating in this new interest rate environment, and he recommends that treasurers regularly review their existing debt and hedging profiles, versus their underlying requirements and keep them in line – as any rate increase has a proportionally larger effect on the total costs of doing business.

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