Why Hedge Performance Is Not the Right Measure of Cost

Individuals less familiar with hedging may think that the cost of a hedge is equal to the monetary gain or loss upon settlement of the derivative. This is not an accurate assessment, as it ignores the fact that hedging is ultimately meant to reduce risk and uncertainty.

Consider a company that is planning a bond transaction. In one month, the organization will issue a $1 billion, 10-year bond at 3.5 percent. The treasurer is worried that interest rates may rise over the next month, making the bond more expensive than expected, so she decides to partially hedge that risk using $500 million worth of 10-year treasury locks. If rates rise, the derivative will be an asset that offsets the increased interest rate at issuance, reducing the financial impact that market shift has on the company's new debt.

By contrast, if rates fall, the derivative will become a liability; the bond will be priced better than expected, and the derivative will look like an unnecessary cost. Suppose rates fall by 50 basis points (bps) from the time the hedge is executed until the time the bond is issued. The bond issuance will be executed at 3.0 percent, and the derivative will be a liability of roughly $2.5 million. However, that is only half the story. Amortizing the termination value of the hedge over the life of the financing results in an effective cost of debt of roughly 3.25 percent, which is still better than the original expectation of 3.5 percent.

Some executives facing such a scenario will view the hedge as costly because it ultimately was not needed. This is not the right perspective. The purpose of the hedge was to reduce risk in future outcomes, giving the company greater certainty around cost of capital planning. Think about the opposite scenario: If rates had risen 50 bps instead of falling, the hedge would have been an asset worth roughly $2.5 million, and the effective cost of debt would have been roughly 3.75 percent—higher than the original expectation because only half of the issuance was hedged. In this case, would the treasurer be happy that the hedge was an asset, even if the cost of financing was higher than anticipated?

In both scenarios, the hedge serves its purpose by reducing the potential volatility of future issuance outcomes and narrowing the band of possible issuance rates. By keeping in mind that derivatives are meant to reduce risk, companies can move away from measuring the costs of their hedging programs using gains and losses.

It's healthier for treasury groups to look at hedging costs in the same way they view insurance products. When CFOs are evaluating the importance of their insurance spend, they typically don't calculate whether the payouts from a particular policy—say, business interruption insurance or cyber insurance—were larger last year than the company's premiums paid. The goal of purchasing insurance is to reduce risk—and, within that framework, to ensure that the firm is paying the appropriate price for that protection.

The true "cost" of cyber insurance is the markup that a company pays over prevailing market rates for the protection that it seeks.  Similarly, the true cost of hedging is the markup the company pays above the market price of the derivative itself.

Challenges with Determining Derivatives' Market Price

Unlike corporate bond issuances, derivatives purchases are difficult to compare against prevailing prices because derivatives markets are fundamentally less transparent than other markets due to their over-the-counter (OTC) nature. For example, consider a company using a cross-currency swap to convert USD-denominated debt into EUR-denominated debt in order to reduce interest rate risk. Many factors impact the market price of this transaction, including size (notional), tenor, payment frequency, company credit quality, regulatory requirements, and existing credit exposure between the parties.

How, then, can a business truly evaluate the direct costs of hedging using a derivatives structure? Ultimately, the cost of a specific transaction relative to the market approximates the markup that the counterparty earns on the transaction. So, the first step to pinning down a company's hedging costs is to make sure someone on the treasury team has deep knowledge of how banks price the derivatives they sell.

Once the company has the right knowledge base, access to pricing tools and support from firms such as Bloomberg, SuperDerivatives, and Chatham Financial create a path toward transparency. Organizations can input key market data—including exchange rates, interest rates, and cross-currency basis—into the tool's model to understand their counterparties' cost of hedging.

Unfortunately, given the credit exposure on OTC derivatives transactions, it's much more difficult to understand the associated fair credit charges. There are no calculators available to compare across multiple transactions and counterparties, because the data itself is not readily available in OTC markets. Even with Dodd-Frank reporting requirements, information on executed transactions is masked so well that it's nearly impossible to see what other firms have paid for similar transactions.

Many companies introduce a competitive dynamic across counterparties to incentivize pricing efficiencies, asking multiple banks to bid on each derivatives transaction. This can be a highly effective strategy for reducing prices, compared with giving all the company's hedging business to a single counterparty. Still, even a competitive bidding process leaves some challenges for companies—namely, balancing banking relationships with the desire for transparent pricing. The prices that banks offer are affected by availability of credit relationships, consistency of credit exposures across counterparties, and even bank profit levels, all of which may remain opaque to the company purchasing the derivative.

Since no public database for prices paid relative to market prices exists for OTC derivatives, companies can compare their costs only within their own history of derivatives trades. Sometimes, individuals at companies may be able to connect with other individuals at other companies to compare notes on prices, but even then, unique circumstances such as transaction structure and market environment may reduce the practical value of such comparisons. Often, the best path for full transparency includes hiring an adviser that can leverage a database of derivatives transactions to provide information on prices paid by similar firms in similar transactions and to isolate and quantify market rates, credit charges, and profit levels. Advisers with larger client bases definitionally have access to more data (from their clients' transactions), enabling greater confidence in the comparison process.

Quantifying, and Reducing, Share of Wallet

A treasury team with a clear view of their hedging costs is prepared to find the best deals on upcoming derivatives transactions and more effectively allocate business among multiple banking relationships.

Figure 1 illustrates costs based upon different types of hedging programs and structures. For each type of hedging program, the figure shows an example index hedged in different ways, comparing across options using the sensitivity of 1 basis point (0.01 percent—commonly known as the DV01) or 1 pip (0.0001 in the EUR-USD exchange rate, for example). The bank profit on any transaction varies based upon a number of factors including the credit intensity of the derivative (how large of a liability can it become?) and the creditworthiness of the company.

Per $100 million hedged, operational foreign exchange (FX) hedging has both the lowest risk to counterparties and typically the lowest level of profitability for banks, driven by short-term balance sheet hedging programs that involve monthly hedges. Pre-issuance hedging—interest rate swaps entered into in advance of a bond offering—and standard interest rate swaps have the opportunity to incur costs to the company, as measured by profits to the bank, well into the six figures per $100 million hedged. Meanwhile, cross-currency swaps create the largest counterparty exposure for banks, and so carry the highest cost potential for corporate FX risk management teams. The cost of cross-currency swaps may rival fees paid on transactions in the debt capital markets.

For a particularly active corporate treasury team, hedging costs can easily exceed $1 million per year across these and other types of transactions. Companies should focus on quantifying the benefit of any hedging program and determining whether natural hedging can accomplish the same objective—netting currency exposures or issuing non-USD debt, for example. Ultimately, once a company identifies a need to execute a series of derivatives to mitigate risk, it needs access to tools that enable transparency in pricing across counterparties and transaction types.

Additional Cost Considerations

Quantifying the direct costs of hedging is challenging. Further complicating evaluations of risk management cost-effectiveness: An accurate estimate of hedging costs must also consider indirect costs associated with staffing, tools, and prioritization of hedging activities. The treasury team needs to understand these administrative and related costs before executing a financial risk management program. This is particularly important in high-volume operational hedging programs.

Operational FX hedging may require a company to commit to a variety of systems and personnel that can be difficult to undo once implemented. For companies with balance sheet re-measurement or mismatches in currency of revenue and expenses, FX volatility can create meaningful impacts on key profitability metrics such as gross margins, EBITDA (earnings before interest, tax, depreciation, and amortization), or net income.

Running an effective operational FX hedging program requires many steps, including gathering and analyzing exposures, determining natural offsets, trading derivatives, and then accounting for such transactions. Often, companies must do this at scale, managing hundreds if not thousands of trades simultaneously. Leveraging specialist software systems can reduce the time required to run such a program, though managing the software often becomes a full-time role for an individual.

These costs may be more transparent than the direct costs of trading derivatives, though transaction costs often exceed these back-office costs. For example, running an operational FX hedging program with a notional value of $1 billion can incur transaction costs of $500,000 alongside personnel and system costs of a similar order of magnitude.

Thus, the true cost of hedging is determined by combining easy-to-quantify systems and personnel costs with difficult-to-quantify transaction costs. More visible costs often get greater scrutiny, but transaction costs may be materially larger when considering the full spectrum of hedging strategies. Leveraging processes and tools to create transparency around these costs, and to identify ways to minimize them, can have disproportionately positive impacts on the true cost of hedging.

Amol Dhargalkar is a managing director leading the Global Corporate Sector at Chatham Financial. In this role, he serves companies focusing on interest rate, foreign currency, and commodity risk management. Dhargalkar earned his B.S. in chemical engineering and economics from Pennsylvania State University and his MBA from The Wharton School at the University of Pennsylvania, where he was a Palmer Scholar.