FX: To hedge or not to hedge, that is the question

By Kyriba October 5, 2015

Recent global foreign currency fluctuations have many companies re-assessing the effectiveness of their hedging policies. A recent Wall Street Journal article quoted a study where the second quarter of 2015 resulted in an average loss of $177 million for U.S. corporations, as a result of FX fluctuations1.

To further highlight this, in Q4 2014, Apple lost $3.73 billion to currency fluctuations – a full 5% reduction in its revenue2. As volatility in currency markets persists, companies that underperform with their hedging programs or do not hedge at all face increasing shareholder scrutiny and reduced stock prices.

While some may argue hedging is a temporary solution – one can only hedge so far into the future – in times of currency volatility (such as our current environment), hedging smoothes the effects of currency movements and provides cost and revenue certainty. This aligns perfectly with the mandates of the CFO and treasurer – to meet expectations of shareholders and the investment community.

If we are to hedge effectively, it is first important for a company to understand what type of currency exposure it has. Does the company have specific incoming or outgoing cash flow streams outside of its functional currency, or does the company have operations, assets, or liabilities in other geographic locations that would be impacted by changes in the value of that currency? Sometimes the company will have both types of risk that it will want to hedge. Additionally, it is important to know the size of those exposures, and also where those exposures are. For example, the risk associated with a customer or contract based in euros will have much different risk to a contract based in Russian rubles. Lastly, when establishing a hedging policy, it will be important for the company to know its time horizon on protecting against this FX risk.

Once the size, scope, and time of exposures have been assessed, it is important for a company to document hedging policies so that it can easily measure and communicate compliance with and performance against hedging objectives.

Choice of derivative instruments is a key part of these hedging policies. Forward, swap, NDF and vanilla options are often sufficient for the types of FX risks most organizations face. Exotic options (such as average rate or barrier options) or combinations of options (e.g. butterflies or cable cars) can be effective, although often are overkill to meet corporate’s risk objectives. They also make regulatory compliance (e.g. hedge accounting) more complex, increasing organizational costs to support the hedging program. 

One area that is often overlooked is optimizing FX exposures before employing derivatives to hedge. In many organizations this can be managed by implementing a multi-lateral netting program. Netting will identify net currency exposures which can reduce the derivative trades required to hedge expected risk. Netting can also provide visibility into exposures that may not have been transparent in the initial gathering of exposure data.

Once the hedging policies have been implemented, it is critical to measure the effectiveness of the hedging program. Even if no hedging is performed, measurement is necessary to determine the following:

1)     How accurate were my exposures – did I forecast well?
2)     How effective were my hedging decisions (or non-decisions). What was the net financial benefit to the organization of our hedging decisions?

Not all companies – and not all exposures – necessarily require a hedging program, and not every hedging program will require a complex portfolio of exotic transactions. A proper evaluation, well-documented plan, and a measurable and monitored execution will ensure a successful hedging program is put in place. 

References

1Currency Volatility Costs Soar – Wall Street Journal, September 22, 2015

2Currency Swings Cost Apple More Money Than Google Makes In A Quarter – Business Insider, January 28, 2015

 

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