From the May 2011 issue of Treasury & Risk magazine

Hedging in a Crisis

In a volatile world where currency movements are unpredictable, companies like travel arranger Tauck must react quickly.

When Japan was hit by a severe earthquake and then a devastating tsunami in March, travel arranger Tauck had nearly 1,000 customers booked for dozens of tours of Japan through the end of the year. Normally that would mean paying Japanese vendors roughly 500 million yen ($5.97 million). Normal was suddenly out of the question, and Tauck was forced to cancel its departures through May and refund customers’ deposits and prepaid fees.

Then John Cappelli, Tauck’s director of revenue management, had to deal with the yen forward contracts he had bought to hedge the company’s yen exposure.

Just a month earlier, the Norwalk, Conn., company’s spring and summer seasons of Egyptian tours had gone down the drain as a result of the unrest there.

Amid extraordinary events, currency movements are more unpredictable than ever, and treasury departments must adroitly hedge the expected and then react to the unexpected.

Not one, but a series of shocks has wreaked havoc on companies’ risk exposures, business plans and budgets, notes Gareth Sylvester, a director at San Francisco-based Klarity FX (formerly HiFX), which provides FX advisory services for corporations.

“You never know when another 9/11 attack or earthquake might hit,” Sylvester says. “The world seems to be more crisis-prone. What happens falls outside historical patterns and is neither controllable nor predictable. You have to approach risk management as a way to accommodate the unexpected.”

Cappelli did that. He contacted PNC Bank, where Tauck maintains multicurrency accounts funded largely by forward and option contracts. He paid the modest forward points to swap the yen forward contracts from spring and early summer 2011 delivery to fall 2011.

In this case, reacting wasn’t difficult, and it wasn’t expensive since the forward points were not substantial, Cappelli explains. Tauck, a Klarity client, doesn’t disclose its annual revenue, but Cappelli says it is a nine-figure amount.

Tauck’s dollar revenue is determined by the prices it quotes in its sales brochures. No matter what happens to the currency in the destination country, tourists pay the price in the brochure. Tauck pays vendors in the destination country in local currency, so it has a lot of currency exposure.

“Depending on the currency, we’re hedged 12 to 18 months prior to departures,” Cappelli explains. “We hedge a significant portion of the exposure at the time we mail the brochures. Then we add to those hedges by the end of the year prior to departure, as our sales forecasts become tighter.”

The hedging is done with a mix of forward and option contracts, with the final portion of exposures managed with options. “Options provide us more flexibility to deal with unexpected passenger fluctuations,” Cappelli says. “If a global volatility event causes a large passenger loss and the currency has weakened, the option will expire worthless. If the currency has strengthened, we sell the option at a premium. In both cases, we don’t have to take delivery of the currency.”

Flexibility is a key part of a hedging policy given the extent of the global volatility, Cappelli says, adding that hedgers need to be prepared to accommodate not only disasters and revolutions but also fluctuations in customer demand.

“South Africa was a really hot destination this year,” he notes. “Our goal was to be 75% hedged ahead of time, but when sales are really booming, what you thought was a 75% hedge could turn into a 50% hedge. You have to watch sales and recast your currency exposures.”

Egypt was a business setback but not a hedging problem because vendors there are paid in U.S. dollars, he adds.

Hedging 100% of a budgeted exposure sounds safe, but it may not be. Cappelli illustrates the dangers by citing the case of a tour company that needs to lock in its costs so that it won’t have to raise prices on a European package if the euro appreciates relative to the dollar. In that scenario, if the tour operator hasn’t hedged and its competitors have, it will either see its profit margin suffer or lose business based on price. But if the economy slumps and people travel less, or if there’s a volcanic cloud hovering over European airports that discourages travel, the tour operator might be over-hedged, and that can also be expensive, Cappelli says. “It’s hard to hedge forecasted exposure when the business can go up or down dramatically.”

Today treasury staffs are dealing not only with increased volatility but also with volatility in previously stable parts of the world, reports Wolfgang Koester, president and CEO of FiREapps, an FX risk management software company in Phoenix.

“The dollar used to correlate with the other major currencies,” Koester notes. “You could hedge the dollar against the five majors and protect most of your balance sheet. Now those correlations are weak, and companies are being surprised.” He cites divergences between the Swiss franc and the euro, and the Aussie dollar and the yen. “Some of the big pharma companies based in Switzerland have been surprised,” he says. “It’s not just about the dollar any more.”

And events in relatively tiny economies, like Libya or Portugal, now have global reverberations, he observes. “Even a small country can upset global GDP,” he says. “There used to be a plateau. Now it’s a tightrope. Everything is interwound. Food production in Egypt affects inflation in Europe. It’s scary.”

In a disjointed world, investors are paying closer attention to currency risks, putting CFOs on the spot as currency questions crop up more frequently during analyst calls. “Treasurers are under pressure to do a better job of explaining to the CFO how currency values impact the corporation so the CFO can sound smart when questioned by analysts,” Koester says. He notes that CFOs have to appear to be transparent without giving away the store, since currency positions may reveal competitive information. 

But the smarter CFOs sound, the more likely analysts will be to conclude that cash flow and earnings are predictable, which is a plus for the company’s share price, he says. FiREapps offers its client CFOs a one-page “cheat sheet” they can refer to when fielding questions about currency exposures, he adds.

Analyst calls aren’t a concern for privately held Tauck, but it has other things to worry about.

“We have our hedges in place for a fall season in Japan and we’re hoping that we can go, but the radiation problems are making that more and more unlikely,” Cappelli says. “If we have to cancel fall, we’ll have to sell our forwards again.”  


See a story from last fall about the challenges of hedging in China.

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