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Bringing certainty to foreign exchange needs - how to align hedging with corporate needs Back  
Seamus Strappe and Brian Kelleher were asked to examine how a theoretical company could approach its FX hedging strategy over a 12-month period. In this article, they offer some practical advice for financial decision makers, and say that although the pursuit of rate certainty may not always be practical, it can happily co-exist with the various other competing agendas within a business.
When asked, most treasurers will state that the pursuit of rate certainty is a non-negotiable hedging objective. In practice though, most treasurers will probably agree that, sometimes, their hedging behaviours do not always live up to that ideal. The question therefore is whether the pursuit of rate certainty is always practical given the other motivations and agendas that can also impact on the decision process. In the context of the above brief, we propose to demonstrate that rate certainty can happily co-exist with the various other competing agendas within a business.
For most, 'rate certainty' means always knowing what your worst-case rate for a transaction will be. It can be achieved by:

• Irrevocably committing to dealing at an agreed rate
• Having the 'right' to deal at an agreed rate if you choose to exercise the 'right'
• Entering into a transaction which guarantees rate certainty but where that rate certainty could be either a 'right' or an 'obligation' depending on some conditionality to do with the future behaviour of the market.

In a given twelve month period - setting your rate certainty 'rate', deciding the amount you wish to protect at that rate and choosing whether it is a 'right' or an 'obligation' or a mix of both - will depend on a number of well-known factors. These include - the 'carry forward' (rate and amount) from the previous period's transactions, the budget rate for this financial year, your market view based on current conditions, whether your currency flows are predictable. There are also other factors. What if there is a lack of certainty about actual FX needs, what if current rates are loss-making for the business, what if the currency flows are potentially naturally off-setting? Finally, there is the issue of national/geographical accounting rules.

Some treasurers will bring an additional factor to bear. This is the 'in hindsight' or the 'if only' syndrome. Deferring the deal decision while you await 'windfall' opportunity is a typical example. Is it really ok to let emotions influence your decision process or should you be more practical?
To recap, there are a number of existing or potential factors which could combine to complicate what might seem like a straightforward hedging decision. The bottom line though is you can retain rate certainty as a key business deliverable and still give yourself flexibility to react to evolving business needs. All you need to do is identify the FX risk facing your business, evaluate the available product choice and choose the approach that suits your needs best.

Of course, you will also need to decide whether you wish to protect 100p.c. of your anticipated needs or whether you will leave a percentage of your exposure completely uncovered. It goes without saying that your FX strategy will need management support and that any position taken is appropriate to the company's needs. Looking at the hedging goals, reasonable goals would include:

• To avoid significant error i.e. exchange rate losses v budget or competitors
• To avoid inappropriate position-taking relative to the needs of the business
• Having a structure to accommodate committed and uncommitted cash-flows
• The flexibility to take advantage of opportunity should it arise
• To achieve the lowest cost structure.
The bottom line is that FX markets are unpredictable so you will also need to evaluate your policy in line with your changing needs and changing market conditions.

Sample product choices
In line with the brief, the following scenarios assume no offset opportunities, no carry-forward from the previous hedging period and no multi-year risk management. We have excluded the traditional forward contract and the standard vanilla option.

Participating forward contract: This product gives you rate certainty; gives you some flexibility to respond to competitors; it helps you manage uncommitted flows; is a substitute for a 'stop loss'; it lets you take an improved spot should the opportunity arise.

This product is not a guaranteed solution if your goal is to at least achieve budget at a time when current spot/forward rates are 'out of the money' for you; the protection rate will be worse than the 'at the money forward rate' (ATMF).

Forward extra: This product gives you rate certainty; some flexibility to respond to competitors; allows some opportunity to improve on the available forward rate; is a substitute for a 'stop loss'.
This product is not suitable for uncommitted flows; it threatens to knock you back to a potentially unattractive rate should a major sustained positive rate move occur; is not a guaranteed solution if your goal is to at least achieve budget at a time when current spot /forward rates are 'out of the money' for you; the protection rate will be worse than the ATMF.

Average rate option: This product gives you rate certainty; it works well for uncommitted exposures; it gives flexibility to respond to competitors; it delivers full flexibility to take advantage of opportunity.

This product requires payment of a cash premium up-front; depending on cost, the protection rate will be worse than the ATMF.

Putting these products into practice
The above products are basic building blocks. They morph issues like rate certainty, rate opportunity and cost into structures that can be tailored to match the specific needs of the business. As you can see, options can be bought or sold by the company and clear thought needs to be given to whether a 'right' or 'obligation' suits you best. Refinements can be added through the use of 'Windows', 'Extendability', 'Rate Enhancement', 'Knock-ins' and 'Knock-outs'.
'Windows' can be used to limit the period during which an option is live. We mention 'Extendability' and 'Rate Enhancement' for completeness. However, while these refinements improve your guaranteed rate within a structure, they typically embed additional conditional deals that confer no rate certainty for those additional deals. In other words, you get an improved rate on the initial structure but you ransom to fortune an additional deal which may not be dealt.
Lastly, the forward extra above is an example of a 'Knock-in' while a 'Knock-out' can be used to reduce the cost of an option.

In summary
All products involve some trade-off between cost, rate certainty, obligation and opportunity. Looking ahead, formulate a policy, develop a discipline suited to your needs and relegate hindsight.

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