Karl Schamotta, director of global product and market strategy at Cambridge Global Payments in Toronto, expects the currency markets to see continued high levels of volatility.

In addition to the impact of political events, FX markets will be responding to the prospect of a pick-up in inflation, he said.

Schamotta pointed to a number of President-elect Trump's plans, including the prospect of a tax amnesty that would allow corporations to bring a lot of money back to the U.S.

"His pledge to improve infrastructure would increase wages in a labor market that's already extremely tight, and if Trump follows through on his promise to erect trade barriers, that will raise import costs," he said. "So interest rates may need to move higher.

"That's currently boosting the U.S. dollar and creating a really wide divergence between some of the central banks," Schamotta said. "The Bank of Japan is going in one direction, the U.S. Federal Reserve is going in another direction, the European Central Bank is also looking to reduce stimulus. It's just a complex environment."

In terms of particular currencies, Schamotta said sterling is likely to move dramatically "in both directions against the U.S. dollar and the euro" as the U.K. prepares to negotiate its exit from the EU. And commodity-linked currencies "remain vulnerable" as China's rebalancing of its economy triggers volatility in other countries, he said.  

FX Challenges for Treasurers

Bibbey argued, though, that volatility in the FX markets is nothing new. "You can go back to the late '90s and look at the move in dollar-yen, and it would be as extreme as anything we've seen in recent history," he said.

Similarly, he said, the challenge faced by corporate treasury teams is an age-old one.

"For anyone that has an operation that spans multiple countries, you have significant exposure to currency fluctuations. Your challenge is: How do you mitigate or smooth the effects of these currency fluctuations as best possible, such that when you make your business plans and your projections, you're able to do it with the knowledge that you have a degree of protection?" he said.

"Now, what is the right blend, what is the right approach? It varies very much from client to client depending on multiple variables," Bibbey added. "How long do you hedge? Historically different segments have had very different profiles around this."

Giles Jewitt, a director and the head of FX options automated trading and e-risk at HSBC, said the nature of the current volatility is particularly difficult for treasurers.

"This kind of whippy market and lack of strong trends is something that makes it difficult to forecast your business going forward," he said, adding that if companies "are up on a hedge, it's tempting to take profit."  

Foreign Exchange Exposures

Getting a handle on their FX exposures can be the toughest part of hedging for companies, according to Schamotta, given that the process involves communicating with sales, operations, and other units of the company; quantifying the exposures involved; assessing their timing; and then figuring out what to hedge.

"It's certainly a complex process," he said. "But I would suggest that it's the area that is given the least focus, which is quite unfortunate. I would suspect a lot of things go wrong because the treasurer focuses on the instrument being traded as opposed to the extent of the exposure and how much should be hedged out."

Schamotta noted, for example, that he has seen companies with exposures that net out, "and yet they're hedging both."

"Every corporate that has FX risk really needs to understand their exposures," said Peter Seward, vice president of product strategy at Reval, a provider of treasury and risk solutions. "All these shocks keep re-emphasizing the fact."

Companies generally will be looking at their forecasted transactions, such as sales, dividend payments, and capital expenditures, Seward said, and he cited three aspects that companies need to consider: the timing, the variability, and the likelihood of the transaction occurring.

Those three elements are critical because they play a role in deciding how to hedge, he said.

For example, an M&A transaction will either happen or it won't. "So typically you would hedge with options, and hedge bit by bit as the event becomes more certain," Seward said.

On the other hand, sales forecasts are more uncertain as they go farther out in time, he said. "So you may want to enter into some kind of layering strategy."

Technology can help companies evaluate their exposures by tracking how an estimated exposure changes over time. If the company puts the forecast for sales in the fourth quarter of 2017 in a treasury management system or other system, and then tracks the updates to that figure every quarter, it gets a sense of how those estimates vary over time, Seward said, and can adjust its hedging accordingly.

"If I know that forecasts two years out historically change 50%, then I should only hedge 50% of a two-year forecast," he said.  

Regulatory Issues

Allan Guild, global head of regulatory change and FX options business management at HSBC, said the biggest regulatory change "is the bilateral margin requirements and the need from the first of March 2017 for all clients to effectively collateralize their derivatives portfolio and post margin to their market makers—which for our clients means sourcing that collateral."

That requirement, which stems from new rules put in place by global regulators in the wake of the financial crisis, carries with it "the associated cost of funding that collateral and making the systems and operational changes to be able to handle that process," Guild said.

And the regulatory changes will affect the overall market. "Because of all these rules in terms of margin rules and regulatory capital rules, we are seeing a reduction in liquidity in the interdealer wholesale market as the cost of trading and also of holding inventory increases," he said. "The result of that is less liquidity available in the market, which increases the cost of hedging for market makers."

The increased cost in the wholesale market will eventually increase the cost of hedging for corporate clients, he said.

On the other hand, Seward credited the new international hedge accounting standard, IFRS 9, with making it much easier for corporates to use options from the standpoint of the accounting involved.

"In the past, even though options could be used to hedge, they didn't get very good accounting treatment," Seward said.  

Advantages of Electronic Execution

Amid the FX market's ups and downs, Guild said HSBC is working to provide FX hedging solutions to its corporate clients that take into account various aspects of the exposures that companies are dealing with.

He gave the example of an import-export firm that expects to pay for an order of manufactured items in a foreign currency in six months, although there's some uncertainty about whether the manufacturer will deliver on time. Given that prospect, different companies will take different approaches, he said.

"Some will look to do an FX forward—lock in today's exchange rate, plus or minus an interest-rate differential," he said. "Others may choose to use an FX option to reflect that they may not need to make the payment, but for that they will pay a premium up front. Others may use a forward with a flexible delivery date, if they think the manufacturer will make delivery but may deliver late."

HSBC's approach is "understanding the business requirements of our clients and working with them to understand the risks they are trying to hedge and the most appropriate solution to do that," Guild said.

Bibbey noted that HSBC has realigned its corporate sales team into two groups, one for corporate treasury solutions and the other for corporate risk solutions."Whilst we recognize that our clients are sophisticated, we also appreciate that sophisticated clients need carefully crafted solutions."

He cited the "increasing electronic efficiencies" in foreign exchange trading as a plus in that regard. "It frees up time such that we can spend far more time in a far more targeted way in providing more bespoke relevant specific solutions to our client base across the board," he said.

"Historically, you would be sent lots of emails in terms of research, you would constantly be calling up to deal, the settlement process would be quite manual and quite involved," Bibbey said.

HSBC is in the process of rolling out a distribution portal, called HSBC evolve, which "provides a platform that will deliver an array of functionality that is designed to make our clients' lives easier," he said. "It's about making things easier for our clients, rather than making FX easier."

HSBC evolve, which is linked to HSBC's treasury portal, includes a suite of algorithmic strategies that helps the bank's clients achieve smarter FX execution and support their risk management strategy, and also offers post-trade analysis so they can assess the performance of their execution.

"In an environment where technology makes people's personal life easier with clear, simple, intuitive solutions, what we're trying to do is deliver what is a very complex product in a very simple form so they benefit from the same simplicity in their professional lives," Bibbey said.  

Not Hedging

Yet a recent study of U.S.-based companies by Chatham Financial, a financial risk management company, suggests that considerable numbers of sizable U.S. companies are not hedging their FX exposures.

The study, which looked at the 10-K filings of more than 1,500 U.S. public companies, found that while more than two-thirds are exposed to foreign exchange risk, just 55% of the companies with those exposures are hedging.

In fact, the Chatham data show that just 37% of the companies overall hedged FX exposures in 2015, which is down from 40% the last time it conducted the study, in 2012.

Amol Dhargalkar, a managing director at Chatham, said that while those results seem surprising, companies may become complacent and decide to stop hedging.

"It can also be very difficult for companies to begin hedging programs—to figure out what their exposures are, figure out hedge accounting, and go through all the steps of the process," he said.

The expense of hedging was one of the factors cited in the Chatham study.

Dhargalkar noted that companies that want to contain costs can use FX forwards rather than options, since options are more expensive upfront, while forwards entail no upfront cost.

"But forwards have a different kind of cost," he said. "The difference between the spot rate and the forward rate is something that is a true cost. In that scenario there really isn't much that you can do, other than figure out ways to have to hedge less."

Companies concerned about costs can use "natural hedging," in which they try to arrange receivables and payables locally so that their FX exposures are offset, Dhargalkar said.

"Another is to really evaluate the efficiency of your hedging program by looking at things like an efficient frontier type of analysis," he said. "'What am I getting for all of this spend on my program? Is there a way to get 80% of benefit from 20% of the cost?' Often there are ways."

For example, Dhargalkar said, a company that is hedging all of its currency exposures by 70% might be able to get a similar outcome at a lower cost by hedging just its top five exposures by 80%. "Instead of hedging everything a little bit, hedge a few things a lot more," he said, but he noted that this approach might require additional tools and expertise.

Cambridge Global Payments' Schamotta said that while options are more expensive than forwards, using them to put on a collar is a way to save.

"What option collars do is they effectively wrap an upper and lower bound around your exchange rate, and they don't cost anything up front," he said. Basically, a corporate concerned about the euro depreciating against the dollar would buy an option to protect against the euro depreciating and at the same time sell an option on the euro's appreciating.

"So you're selling insurance, the market pays you, and you use that amount to pay for the downside protection," Schamotta said. "Unless the markets go crazy, you may not use the collar at all. If they do go crazy, you're sacrificing upside but your downside is protected."

Reval's Seward noted that companies can eliminate the need to hedge FX exposures by striking fixed-price contracts with suppliers. For example, a U.S. company that is buying parts from Mexico and paying in pesos could switch to paying in dollars.

"Wherever that can be done, it takes the risk out of the equation," he said. "We see that a lot."  

Expense of Not Hedging

Of course, there's also the potential expense of not hedging to consider, a problem evidenced by the many U.S. companies that have cited currency volatility to explain disappointing earnings over the last couple of years.

But Dhargalkar noted some distinctions. If a public company's earnings are hurt by unhedged FX exposures, but its peers aren't hedging either, "then you say, 'The whole industry is going to report weaker-than-expected earnings; we'll be fine,'" he said. But if a company operates in an industry where some of its competitors hedge and others do not, companies that don't hedge could see damage to their stock price or investor sentiment.

He also noted the effects that FX volatility could have on a company's financial agreements. "Should they have tight financial covenants, if FX movements lead them to get close to or to breach those financial covenants, that's a pretty significant financial cost that will need to be considered by the company," Dhargalkar said.