Hedging the currency risk generated by a global business’s anticipated future cash flows can be a bewildering task. Uncertainties inherent in revenue and cost projections, as well as the complexity of the foreign exchange (FX) market and related derivatives, all may contribute to concerns about the efficacy of hedging activities. Yet a well-constructed cash flow hedging program is worth the investment of time and effort.
A corporation’s valuation is based on the size and stability of its future cash flows, so if it can reduce its earnings volatility, it will increase its valuation and access to capital.
For global businesses, FX hedging of cash flows is key to avoiding sharp swings in earnings, and companies that do a poor job of managing FX risk may suffer significant volatility as a direct result. Even among the largest corporations, it is not uncommon to hear a CEO or CFO blame a quarterly earnings miss on movement in the currency markets.
First, Developing an Accurate Forecast
Companies can’t hedge a risk until they know just what is at risk, so accurate forecasting is at the heart of any cash flow hedging operation. But what should an organization forecast? That varies from company to company because the appropriate hedging strategy will, necessarily, depend on how and where the company is incurring FX risk. For example, third-party foreign-currency transactions may be the basis for cash flow hedging in a company with U.S. dollar (USD)-functional subsidiaries, while USD-based intercompany transactions may be the hedged item in a company with local-currency–functional subsidiaries. Many companies have mixed environments, in which subsidiaries operate in local currencies but exposures are consolidated regionally in shared service centers or in-house banks. It is important that the corporate treasury team have a solid understanding of where FX exposures are originating in the organization.
The forecasting process should consolidate revenue and expense forecasts from all the company’s entities in which net revenues incur FX risk. It should also take into account intercompany arrangements, accruals, and the timing of significant tax bookings that involve foreign currencies.
A wide array of internal factors can undermine the accuracy of global cash forecasts. The numbers may originate from conflicted or biased sources. Some entities might consistently provide projections that are overly optimistic or that are off in their timing, while other groups might routinely provide forecasts that are overly conservative. Product lines might be introduced or cancelled. Cash forecasting is a broad, complex topic, but one best practice is practically universal: To manage the uncertainty, the FX team needs to regularly compare the forecasts of foreign subsidiaries with those entities’ actuals, and to document which groups’ forecasts are consistently skewed.
Turning Forecasts into Effective Hedges
Historically, it has been common practice for companies to set FX budget rates and execute most of their hedges for the entire year at the beginning of the fiscal calendar—a “fire and forget” approach. Such a program is simple to execute, but it can be problematic.
Entering a year’s worth of hedges at one time means all the transactions will be based on a single, potentially anomalous spot rate. Hedges established only at the beginning of the year can’t respond to changes in forecasts, and periodic revaluations of exposures and derivatives as required by FAS 133/ASC 815 could expose some hedge ineffectiveness as the year progresses.
One effective strategy that can help resolve these issues is the “layering” of hedges. This strategy creates a hedge for the exposures generated in one time period by combining instruments purchased over multiple prior periods. For example, in a four-quarter time horizon, a company might protect its Q1/2014 net-revenue forecast against currency risk by hedging 25 percent of the exposure at the end of Q1/2013, 25 percent at the end of Q2/2013, 25 percent at the end of Q3/2013, and 25 percent at the end of Q4/2013. The average FX rate across the four contracts becomes the company’s forward rate for the Q1/2014 hedge. This approach smoothes out rates compared with purchasing a single hedging instrument at one point in time, and so it also smoothes out the net hedge results.
Figure 1 shows the effect of hedge layering on cash flow volatility for a British pound (GBP)-functional entity with a need to purchase US$10 million per month. The graph presents the cost of these monthly USD-GBP exchanges in three scenarios: first, without hedging; second, with hedges averaged over the preceding six-month period; and third, with hedges averaged over the preceding 12 months. The effective exchange rate is substantially more stable under either layered hedging regime than without hedges. In this example (based on GBP-USD exchange rates in 2012 to 2013), six-month hedge layering results in a 36 percent reduction in the standard deviation (i.e., volatility) of costs over course of the year, and 12-month hedge layering reduces the standard deviation by 70 percent.
Adjusting for Time-Horizon Uncertainties
Hedging forecast net revenues a year or more in advance involves significant uncertainty. Thus, doing so requires the treasury team to decide whether to set contracts equal to the forecast, which would put the company at risk of over-hedging its actual exposure, or to set contracts less than the forecast, which obviously creates its own risk. There are several solutions.
The simplest is to hedge exposures for less-distant time periods at or near 100 percent and to systematically reduce the hedge ratio for forecast periods that are further in the future. For example, at the start of the year, a company may hedge Q1 revenue at 100 percent of forecast, Q2 revenue at 90 percent, Q3 revenue at 80 percent, and so on. Then, as the year progresses and Q2, Q3, and Q4 approach, the company may augment those hedges to match its hedge policy. One downside to this method is that it results in an average hedge ratio significantly below 100 percent of net revenue, which leaves the company exposed to some FX risk.
A second approach is to complement forward contracts with options. Unlike forwards, options convey the right to exercise but not the obligation to do so. A company may use options to hedge the fraction of its forecast in which it has the least confidence. Figure 2 illustrates a simple linear progression that assumes the most-distant periods are the most uncertain.
A more robust, but computationally intensive, method is to use a mean variance approach. This approach constructs an efficient hedging frontier composed of the expected return and variance of each hedging vehicle (forward fraction, option hedge fraction, and leaving the position open).1 An extension of this approach is to determine the correlation between all currency pairs that create FX risk for the company, and to utilize this information to determine an efficient portfolio of hedges.
A third approach is to utilize participating forwards. Participating forwards are constructed from two options. The first is a long (purchased) option with a notional equal to the net revenue exposure. The second option is short (sold) and has a smaller notional. The second option reduces the cost of the strategy compared with a single long option, but it also reduces the upside participation proportionately. If the short notional is smaller than the uncertainty in the exposure, a participating forward reduces the risk that a company will over-hedge, and to some degree it enables the company to participate in any favorable spot movements.
Regardless of the approach a company chooses to hedge its cash flow risks, the treasury team needs to evaluate the success of the program on a regular basis. Instead of looking at the hedges in isolation, they need to consider the results of the program in combination with the valuations of the corresponding cash flow exposures. Hedges will never perfectly offset FX fluctuations, and it’s important for treasury to identify and report on sources of variance—including forward points, trades in which the spot rate differs from the accounting rate, booking errors, and the effects of hedging less than 100 percent of exposures.
Integrating Cash Flow and Balance Sheet Programs
Cash flow hedging programs commonly run independently of the company’s balance sheet FX hedging, but integrating the two programs can reduce both treasury workload and trading costs, and can increase effectiveness. Before a balance sheet exposure can be hedged, it must be forecast. Two methods are commonly used for balance sheet forecasting: Companies either look for trends in previous periods’ balance sheet actuals, then forecast future-period FX risks expecting those trends to continue, or they assume that the current balance sheet snapshot is an adequate proxy for the future-period balance sheet exposure. Both approaches can lead to inaccurate forecasts, ineffective hedges, and excessive trading costs.
Incorporating cash flow data (net revenues) is a best practice when creating a forward-looking balance sheet forecast. Cash flows drive the balance sheet during the month, and because most companies dedicate significant resources to forecasting cash flow exposures (revenues, expenses, etc.), those forecasts are generally more reliable than balance sheet projections. Treasury can estimate the upcoming period’s balance sheet fairly accurately utilizing the prior period’s close, net revenue forecasts for the current and next period, and any local-currency cash deliveries in the current period.
Once the team has an estimate of the upcoming period’s net monetary assets (NMA), they can purchase hedging contracts to effectively offset the currency risks. If the team ensures that all their cash flow and balance sheet hedges expire on the same day each period, they can easily re-designate maturing cash flow hedges into the current period’s balance sheet hedges. Thus, the upcoming period’s NMA will always be hedged with a combination of maturing balance sheet contracts and maturing cash flow contracts.
Balancing Risks and Costs
There are many ways to reduce costs in an FX hedging program, some of them quite straightforward. The first place to start is to reduce the number of trades the company undertakes by identifying natural hedges and netting exposures across entities or portfolios. A good second step is to include FX considerations in negotiations with significant customers or suppliers. Currency risk-sharing clauses can be an acceptable means of reducing exposures before a company turns to derivatives.
For residual exposures that the organization can’t eliminate through netting or customer/supplier negotiations, the treasury team may simply follow a preset corporate FX policy for hedge ratios. If policy allows it, however, treasury can further manage FX trading costs by considering both the hedging cost (forward points) and the value at risk (VaR) for each currency pair. Companies often leave emerging-market currencies unhedged because forward points are often considerably higher for these currencies than for G-7 currencies. However, because emerging-market currencies are typically more volatile, exposures in these currencies tend to have a higher VaR. To optimize hedge effectiveness while minimizing hedging costs, companies need to consider both factors. Studies have shown that using fixed hedge ratios across all currency pairs is not an optimal solution.
One way to calculate the individual merit of hedging each exposure is to divide VaR by cost for each currency pair. This approach generates an ordered list of prospective hedges, from most to least cost-effective. It enables the treasury team to execute the hedges in the order on the list, until the company’s total VaR exposure is below a preset threshold2. This is simple to calculate and execute, but it ignores the very real correlations between currency pairs.
A more effective approach is to use modern portfolio theory (MPT) to identify the hedge ratio for each exposure that reduces VaR to an acceptable level while minimizing costs incurred. MPT is commonly used to calculate a portfolio balance that maximizes expected return for a given level of risk. Calculating the individual variance-covariance for each currency pair—substituting minimum hedge cost for maximum profit and hedge ratios for portfolio share in the MPT equation—helps a company build a portfolio of hedges that minimizes total cost for any selected level of risk (VaR).
Companies can also find cost savings when they actually execute their FX hedges using over-the-counter (OTC) derivatives. Banks make a large portion of their FX-trading profits off of clients with limited market knowledge. In fact, although FX derivatives constitute only 9 percent of derivative volume, they provide 59 percent of banks’ derivative-related profit. Caveat emptor. Before entering trades, the treasury team must know where the market is, via Bloomberg or another streaming spot source, or they should specify that trades be made at fixing rates such as the WM-Reuters Fix. Another trick to improve pricing transparency is to trade on the days that the FX futures markets mature, typically the third Wednesday of the month. This works because the forward and future rates for a given currency pair must converge at expiry, or there would be an opportunity for arbitrage.
There are a lot of factors to consider in creating an effective and methodical cash flow hedging program, but doing so is well worth the effort. Cash flow hedging contributes to effective and holistic risk management companywide. By reducing earnings volatility, it may improve a company’s valuation and, thus, its access to capital. And saving senior management from the embarrassing earnings calls that may result from FX volatility is priceless.
1. Yun-Yeong Kim, “Optimal FX Risk Hedging: A Mean Variance Portfolio Approach” in Theoretical Economic Letters, February 2013.
2. U.S. Patent 8,266,022: “Risk-Cost Analysis of Currency Exposure Reduction for Currency Exposure Management
Paul Stafford is managing director of Currency Risk Management, LLC. He graduated from the University of California, Berkeley with a bachelor’s degree in engineering and continued engineering studies at Stanford University. After working at NASA and Hewlett-Packard, Stafford turned his analytics abilities to the foreign exchange markets and derivatives.