Corporates left at the sharp end of currency risk

The disjointed global economic recovery has led to high levels of currency volatility over the past 18 months; at its low point, the euro shed more than 20% of its value against the dollar and, in a single week in June, sterling rallied by nearly 4% against the euro, only to see those gains almost entirely eradicated 10 days later.

With economic conditions remaining unstable around the world, it is not uncommon to see exchange rates move by more than 1.5% in a single day - considerably more for riskier currencies. This has prompted corporates to rethink their currency hedging strategies and, in some cases, to look to hedge foreign exchange (FX) exposures for the first time.

Impact on cash flows

Ben Nicklin, head of FX structuring at Royal Bank of Scotland (RBS) in London, says the recent economic climate has affected both the size and the nature of corporate cash flows, and that reduced and less predictable cash flows have made many corporates less certain about the future.

This uncertainty has prompted some corporates to look more closely at their FX exposures and, for those already hedging, there has been a shift in the strategies used. Unprecedented volatility and uncertainty have considerably shortened the hedging horizon of corporates.

"Two or three years ago, corporates were forecasting their cash flows further into the future and were hedging these out to 18 months - even 24 months was not uncommon; but now they are less keen to do this," says Mr Nicklin.

For a corporate, the worst-case scenario is hedging its forecasted cash flows, only to find that actual cash flows are smaller than anticipated. The hedge it has in place will need to be partly unwound, typically at a cost. It is precisely this situation that a corporate seeks to avoid by reducing the hedge horizon or reducing the obligations associated with the hedge.

Shift in products

The financial crisis and subsequent exchange rate volatility have also resulted in a shift in the kind of products that corporates are using for hedging purposes. A few years ago, when exchange rates were more stable, many corporates saw no reason to hedge. Those that did hedge were often looking for some sort of pick-up: rates better than those achievable via 'vanilla' products, such as spot or forwards.

"The way they would achieve this was by using structures that involved selling optionality," says Mr Nicklin.

"Corporates effectively sold options to earn a premium, which was received via an improved exchange rate. The financial crisis has heavily impacted this strategy. Having witnessed extreme movements in the FX market, corporates are far more cautious about potential cash-flow obligations resulting from short options."

Happy to own options

Now, instead of selling optionality, FX bankers say that corporates are happy to buy and own options, despite these being expensive when compared with historical prices. However, companies are tending not to pay an upfront premium. Typically, a corporate will transact a zero-premium structure that will often contain an option-owning aspect. The structure will usually give the corporate protection in its full exposure with an obligation that is reduced, sometimes to zero.

Cheaper strategies

While an options-owning strategy is also convenient for the corporate because it consumes less of its credit line (which is now an increasingly scarce resource), options are still expensive. However, Mr Nicklin says there are a number of ways to make such strategies cheaper.

"You can put a contingency on the option to reduce its cost or be more careful with choosing the tenor of required optionality as opposed to the tenor of the actual cash flows," he says.

"Ultimately, we can cheapen an options-owning strategy by becoming more aware of the nature of the underlying exposure and the business that we are talking to.

"The better we understand the business, the more closely we can align the solution, allowing us in many cases to construct something with an options-owning component that is relatively inexpensive."

Cash-flow risk

There is a growing trend towards 'cash-flow-at-risk' (CFaR) strategies. Less well known than its close relative, value-at-risk, CFaR is a measure of the variability of future cash flows and, therefore, is well suited to corporates, which need to be able to identify impacts on earnings.

In essence, CFaR is assessed by looking at the effective rates that corporates achieve via their hedging, compared with future exchange rates that reflect their view and those of economists.

Examining the effect of FX rates after hedging helps exporters to quantify their receipts and importers to quantify their invoices. Being unhedged in the face of an adverse exchange rate move will result in an exporter receiving less base currency from its activity. Rate moves in the opposite direction will leave importers with a higher cost of foreign goods. Left unhedged, either FX move will immediately hit cash flow - this is the cash flow at risk.

A typical option-owning strategy provides protection on the full exposure, but obligation on only half, allowing the corporate to transact the other half at the prevailing rate. This means that the effective rate is not always a clear-cut number across all possible exchange rates.

Using corporate language

RBS is working to develop a way to communicate the risks and the meaning of a corporate's positions using metrics that corporates will understand. "The challenge is to present the possible outcomes in a clear and simple way expressed in terms of an effective rate. RBS has developed a tool called Xportfolio that does this," says Mr Nicklin.

"It allows a corporate to perform its own cash-flow analysis to assess effective rates achieved under possible scenarios and thus to quantify the CFaR."

Corporates typically attempt a crude form of this analysis using spreadsheets, but recent volatility has highlighted the need for more sophisticated tools.

Peter Seward, vice-president of product strategy at hedge accounting specialist Reval, which has developed a CFaR module for its risk management software, says both banks and companies have started using this more accurate risk assessor.

"Corporate FX hedgers, for example, most often hedge their forecast foreign-currency revenues or expenses - cash flows that are outside the current reporting period; say out [to] two years," he says.

"These corporates are interested in identifying the impact that currency movements will have on the value of future cash flows, profit and loss and hence earnings."

He adds: "Even though these cash flows will hit the balance sheet as receivables or payables, it is usually for a short period [30 to 90 days]. They [the cash flows] then move to the profit-and-loss statement as revenue or expense, and it is this final value - profitability - that corporates are concerned about."

Understanding CFaR

Clive Banks, head of derivatives and FX for European corporates at BNP Paribas, says that his bank has been helping companies understand CFaR for several years.

"Chief financial officers want to know what will be the impact on announced earnings," says Mr Banks. "Often they will comment on earnings before interest and taxes [EBIT] changes at constant exchange rates but, of course, exchange rates do not stay constant. We show companies what you might call CFaR by simulating stress cases on earnings per share, revenue, EBIT or whatever is the main observed measure."

Clive Banks, head of derivatives and FX for European corporates at BNP Paribas

Uncertain times

Mr Banks adds that a bigger problem than wrestling with where FX rates might be is finding a way to enable corporates to forecast their cash flows in times of economic uncertainty and budget volumes for the year ahead, based on what amounts should be hedged.

He agrees that this has led to an increased interest in options. "The increased volatility deterred outright buying of options by corporates but conversely gave great value in selling options on longer dates, where they knew a core amount of hedging would be required," he says.

Additionally, Mr Banks says the current economic climate has prompted a greater interest in the hedging of emerging market currencies. With many large corporates focusing growth and investment strategies on Asia or other developing regions, the risk surrounding exposures to non-G-10 currencies has become a more pressing issue.

Chris Leuschke, global head of FX sales at RBS, says corporates are also concerned by the impact of foreign exchange moves on their accounting statements. This kind of translation risk means that a company may suffer a reduction in value because a change in exchange rates reduces the value of its accounts or assets denominated in foreign currencies.

Mr Leuschke says that the accounting impact from currency volatility is similar to day-to-day transactional exposure, which means that relevant tools already exist to help corporates manage this kind of exposure. "The hedging tools used are very similar; it is just a different reason, translation exposure," he says.

Corporates are not typically in the business of trading foreign exchange. They want to know the impact of currency risk on profit and loss and, in turn, earnings per share. While volatility in the FX market continues, the use of CFaR as a more accurate measure of what needs to be hedged looks set to become more widespread.