As correlations break down and hard currencies stumble, corporates have been forced to reassess their approach to foreign exchange risk. More favourable accounting treatment of options could help them achieve their longer term strategies. Danielle Myles explores why.

Pascale Moreau embedded

With foreign exchange (FX) volatility indices hitting a four-year high in May, currency risks have soared up the agenda of treasurers and chief financial officers. Since the first quarter of 2015, many companies have reported significant currency impacts on their results, including the likes of Coca-Cola, McDonald’s and Procter & Gamble, while smaller importers have also been hit.

A combination of macroeconomic shifts over the past two years – including China devaluing the renminbi, the speed of Brazil’s downward spiral and the oil rout – has created a perfect storm of FX risks. But what has really shaken up risk managers is the plight of hard currencies.

“Corporates were accustomed to volatility in the emerging markets, but they have been really puzzled by the fact that some G10 currencies could be volatile – as has been the case for euro-dollar and Swiss francs after being unpegged,” says Pascale Moreau, deputy global head of rates, credit and currencies sales at Société Générale Corporate and Investment Banking (SG CIB). “All the principles that they had in mind have disappeared because of these violent moves.”

Revising hedging

The swings have even rattled ex-traders with 40-plus years’ experience in currencies, commodities and equities. “In all those years, and I’ve lived through some pretty dramatic events, these are some of the most volatile markets we have seen,” says one.  

As a result, a growing number of companies are looking to revise their hedging arrangements. Over the past 18 months, Antoine Jacquemin, global co-head of SG CIB’s market risk advisory group, has received more calls than ever from clients asking the bank to review or discuss their risk management policy at board level. This requires a detailed analysis of which risks should be hedged, which are too expensive or complicated to hedge, and which can be offset across the group’s operations.

“Our first answer is not coming up with a product. Instead, it is to understand the exposure which, when it’s a multinational corporation operating in 50-plus countries with exposures to many currency pairs, is not easy,” Mr Jacquemin says.

That process can involve assessing subsidiaries’ exposures, the possibility of netting across business lines and geographies, and the extent to which the client’s competitors are foreign firms facing the same FX challenges or local businesses. Pricing elasticity and leeway to create more natural hedges can also be considered, while the risks are evaluated within the context of the corporate’s objectives, various financial ratios and cashflow stability.

“There are many non-currency-specific factors to analyse before being able to create a relevant policy and ultimately a relevant product. If you want to be thoughtful and interesting to your clients, it’s quite a long journey to end up with the right product,” says Mr Jacquemin.

Broader approach

The move towards tackling FX exposures in a more holistic way reflects the larger trend of treasurers taking a broader approach to risk management. “Enterprise-wide and integrated hedging makes total sense when done in a strategic way over the long term. Then you avoid the pitfalls such as correlations breaking down in the short term,” says Jean-Marc Servat, chair of the European Association of Corporate Treasurers.

Craig Martin, executive director of the Corporate Treasurers Council at the Association for Financial Professionals, says that the next generation of hedging is approaching. A broader spectrum of players is focused on managing multiple currencies and exploring cross-asset solutions. Stephen Baseby, associate policy and technical director at the Association of Corporate Treasurers, concurs. “For example, procurement may lead to commodity risk as well as FX risk – so they are beginning to think a bit more about those exposures. It really started with energy, when they realised they had a large exposure to energy and gas, so there’s a growing realisation about how procurement contracts can be managed,” he says.

In hedging further into the future and across multiple currencies, treasurers must pay greater attention to rate risk. While those with established hedging programmes are well attuned to the synergies between rates and FX, central banks’ unconventional monetary policies have created new considerations for cash-rich corporates. “For clients with a significant amount of cash on their balance sheet, there is definite value in taking into account the rate/currency issues arising from that cash on hand,” says Mr Jacquemin. “There’s been a need for clients to find a suitable solution on the deposit side, especially at a time when in Europe, for instance, short-term rates are turning negative.” SG CIB’s cross-asset desk covers FX, rates and deposits, and has been innovating ways for these clients to optimise deposits.

Correlation breakdowns

At a more granular level, derivatives houses and corporates are focused on the breakdown of the historic correlation between the dollar and emerging currencies. A common way to manage emerging market exposures is to hedge the dollar, given the security of a more active secondary market and a lower cost of carry. But with Latin American currencies losing up to 40% against the dollar over the past two years and the Bank of China edging towards free floating the yuan, some have been caught off guard. “Some clients were accustomed to thinking in terms of correlations, and they were managing their risks to take into account that and liquidity. But with the volatility last year, there has been a change in paradigm, and many are asking us to revisit their hedging policies,” says Ms Moreau.

Yuri Polyakov, head of financial risk advisory at Lloyds, says while the bank has no firm evidence that people have changed the degree to which they hedge emerging markets through the dollar, it has seen more treasurers rely less on correlations-based hedging, as this does not always deliver the required certainty.

With the proxy dollar solution no longer working, and insurance on emerging currencies often being prohibitively expensive, banks are rethinking how to structure trades more efficiently. While the products continue to be vanilla – partly because they must be validated by the client’s board – SG CIB’s engineering team has been looking at how to hedge high-yielding currencies while avoiding the full forward premium. One product gaining traction embeds an FX future into the hedge – be it a forward or cross-currency swap – so that the nominal exchanged is hedged to cover the most likely of exchange rates. “It’s a cheapener, and it’s being used quite frequently at the moment. It’s a good way to be hedged on a certain level of FX and not pay too much carry,” says Ms Moreau.

Year-to-May 31, percentage performance vs US dollar

While this has proved popular for cash flow risks, sophisticated clients looking to hedge balance sheet risks are using a tactic whereby on a rolling basis, they switch from an option-based strategy to forwards – depending on the movement of the spot price. So while they are hedged, they only pay the full carry in certain circumstances.

IFRS 9 and option strategies

Hedging decisions tend to be driven by efficiency, simplicity, cost and hedge accounting. The latter has led corporates to favour the simplest of products, usually forwards, as their accounts are protected from the full force of the instrument’s mark-to-market volatility. “In the past, corporates were doing many more derivatives but they have been really penalised from an accounting perspective under [international accounting standard] IAS39. It can be tough to even do some options, which is a real pity,” says Ms Moreau. Unfortunately this has coincided with increasingly stringent documentation requirements to obtain hedge accounting.

But when IFRS 9 replaces IAS39 in 2018, it is hoped this will change. To qualify under today’s standards, there is a bright line ‘effectiveness test’ whereby over the life of the hedge its value must be between 80% and 125% of the hedged exposure. If at any time that is not the case, the accounting treatment will be terminated for the entire hedge. However, under the incoming accounting guidelines, only the portion that falls outside that 80% to 125% bracket is ineligible. Market participants agree it is a win for option strategies.

“Corporates’ revenues aren’t fixed and aren’t predictable, they need flexibility on their hedging instruments so options are more appropriate than doing a pure fixed vanilla forward. With IFRS 9, we expect it will be easier for them to do options, and a lot of them will contemplate using them to hedge their FX exposure,” says Ms Moreau. “So after about 10 years of being used very little by corporates, option products could pick up.”

While IFRS 9 is still a few years away, risk management advisers are already urging clients to consider a broader mix of instruments such as risk reversals and other collar strategies. “People realise more and more that using simple forwards may not be the best solution for everything,” says Mr Polyakov. “There’s a growing realisation that at times the pain or additional work associated with using options can be warranted, given the protection and flexibility you get.”

Euro-dollar turmoil

Option strategies are primed for today’s volatile markets, where corporates are determined to avoid giving away any upside. “It’s a contentious time for corporate treasurers because you don’t want to over-hedge in FX and lose the opportunity to benefit, particularly in very competitive markets,” says Mr Baseby. “We saw sterling drop towards 1.40 against the dollar and now heading back up towards 1.50 and for corporates at the sharp end, if they get that wrong it can make their businesses less competitive.”

But of all the G10 currency pairs, the euro’s drop against the dollar (some analysts still believe it could hit parity) has created the biggest penalties, and for a wide range of players. Its steep decline last year paralysed small European importers, which did not know whether to quickly implement hedges or wait for the euro to recover. Instead, some banks encouraged them to use a strategy whereby they incrementally take on small portions of a hedge, giving them the flexibility to manage their level of protection.

“They were completely shocked by the one-way move of the euro but they weren’t ready to fully hedge,” says Ms Moreau. “So they started using products such as accumulators, where each day you accumulate a certain portion of the hedge, and at a better level than if it were a straightforward hedge.”

For multinational corporations the bigger issue is translation exposure, which has caused significant discrepancies between the currency-induced hits to euro- and dollar-functional companies’ earnings reports. While Europe-headquartered companies may have suffered from emerging market troubles, the weaker euro benefited their US sales. But the strong dollar means US companies’ sales have taken a hit in Europe as well as emerging markets whose currencies no longer track the dollar.

Rethinking their hedges

For truly global companies, to a certain extent FX risk is an unavoidable cost of doing business. Yet they are reconsidering their strategies. “Even the largest, most sophisticated hedgers – whether in Europe or the US – all of them that I talk to over this period of time have been re-examining their hedging strategies,” says Mr Martin.

For the latter this has been stymied by FAS133, pursuant to which the hedging of net income is not eligible for hedge accounting. An AFP study, however, has identified five ways to sidestep this issue: hedging forecasted intercompany transactions; hedging non-functional currency expenses; building effective sourcing relationships to help identify the right exposures to hedge; setting up a centralised re-billing entity; and in some cases hedging the sale of available-for-sale securities.

For all the talk of Brexit risks, there are mixed reports from bankers regarding the extent to which companies have hedged their FX exposures on account of the UK’s referendum on its membership of the EU on June 23. “The UK corporates are really concerned by that, but there is so much uncertainty that they are just waiting and not touching the market. They are pretty much less active than usual,” says Ms Moreau.

Yet there have been cross-asset trades to address referendum-related risks. While hedge funds and asset managers have been most active, it is understood that corporates have also traded to hedge exposure and planned deals.

Perhaps more importantly, Brexit has fostered a greater appreciation among UK corporates of FX hedging as a way to manage long-term risk, not just the volatility of their quarterly cash flows. So irrespective of whether they were prepared for the outcome of June 23, they should be ready for the next potentially market-moving event.


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