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Rolling Hedges and Short Hedges

Mitigate Foreign Exchange Rate Risk

 

Foreign Exchange (FX) hedging can be a useful tool when seeking to mitigate foreign exchange rate risk. Notably, for businesses that have a predictable cash flow from a foreign country in a foreign currency, rolling hedges may be useful in protecting that business’s cash flow from swings in foreign exchange rates.

While businesses can use FX hedging to insulate from foreign currency conversion loss due to an unexpected shift in a foreign exchange rate, FX hedging can also prevent that business from realizing a gain in foreign currency conversion should the foreign exchange rate experience a favorable shift.

While an unexpected bump in cash flow from a favorable foreign exchange rate shift is a welcome surprise to most (if not all) businesses, some businesses are willing to forgo this potential upside or gain if it means guaranteeing, through FX hedging, that they will not experience an unexpected shortfall in their cash flow due to a detrimental foreign exchange rate shift.

 

 

What is a Rolling Hedge in Regards to FX Hedging

 

A rolling hedge is a strategy through which businesses maintain a number of FX hedges through futures and options, with varying expiration dates, in order to have a certain percentage (or all) of their expected cash flow from foreign markets hedged against foreign exchange rate fluctuations. It can help to visualize a rolling hedge as a conveyer belt of hedge positions: as one executed FX hedge position (through the use of futures contracts, or put or call options, or a combination) expires, there is already another FX hedge position right behind it to take its place, and another one behind that one, and so on and so on.

These FX hedge positions do not have to be identical: they can be for varying amounts, varying strike prices, etc. Thus, the rolling FX hedge position can be tailored to a business’s cash flow and foreign exchange needs.

 

Businesses can utilize a rolling hedge to manage their global cash flows, as well as an FX hedging tool, on a continuous basis. Instead of simply reviewing their foreign exchange exposure and setting up an FX hedge once a year, businesses can dynamically manage their FX hedging on a quarterly, monthly, or even weekly basis. One important side benefit of utilizing a rolling hedge is that it forces a business to earnestly look at its international cash flows, as well as its foreign exchange exposure, on a regular basis. It is important to note that unlike most futures contracts for commodities, such as wheat, metals, pork, oil, etc., which generally are not closed out for delivery but are instead rolled over into other future contracts or closed out for cash, foreign currency futures contracts are, quite often, exercised for delivery upon expiration, meaning the fund is bought out before a new contract is purchased.

 

 

What is a Short Hedge in Regards to FX Hedging.

 

 

A short hedge, in regards to FX hedging, is a strategy that seeks to mitigate an FX risk (a currency risk) which has already been taken. The reason it is referred to as a short hedge is because a security (in this case, a foreign currency derivative contract, such as a forward contract or a call or put option), is shorted. By shorting this derivative contract, the trader (or business) is able to hedge (protect or mitigate themselves from risk of loss) against their long investment in the underlying asset (the foreign currency).

If the short hedge is executed properly, then losses resulting from the long position in the underlying foreign currency will be offset from the gains in the short derivative position. Conversely, if the foreign currency gains in value, which would result in a gain to the trader or business, those expected gains will be offset by the losses resulting from the short derivative position.

 

 

Example

 

For example, let us say that today, Euros are trading at US$1.00 per Euro. The currency trader expects to receive a payment in the form of EUR1,000 on June 1st (meaning, the trader is now “long” in Euros, since Euros will be received). Worried that the value of the Euro may drop between now and June 1st, the trader enters into a short hedge, by promising to sell 1,000 Euros via a forward contract, expiring on June 1st, at US$0.90 per Euro. If the price of the Euro on June 1st is US$1.10, the currency trader will still net US$1.00 per Euro, because while EUR1,000 is being received as payment, worth US$1.10 per Euro (so, US$1,100) the trader is short because of the forward contract, promising to sell to the other party in the forward contract EUR1,000, at a price of US$0.90 (so, US$900).

 

 

By selling those 1,000 Euros below market value, the trader is incurring a loss of US$200 (because those 1,000 Euros are now worth US$1,100 on the open market). But, the currency trader received an extra US$100 by receiving the payment of 1,000 Euros on June 1st, because those 1,000 Euros are worth US$1,100. The net effect is a wash, and the original payment of 1,000 Euros is still effectively worth US$1,000. In this manner, the trader, or business, can execute an FX hedge against currency fluctuations, to ensure that the expected cash flow of 1,000 Euros will equal the expected currency exchange of US$1,000, and not suddenly more or less.

 

While giving up the potential gain, the business guarantees no potential loss, so that cash flow and budgeting can be accurately forecast, without fear of an unexpected cash flow shortfall which could hinder paying suppliers, lenders, employees, or other obligations.

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Dynamic Hedging

Why Is Asset Correlation Important to Investors?

 

Corporate FX challenges

The effort vastly improved the company’s planning and execution functions, they knew that in order to succeed in this era of technology their accounting systems needed to be much more robust than what they are. They turned to WP consulting to improve their accounting systems.

 

When it comes to currency management, most businesses experience similar pain points:

 

FX volatility, causing a negative impact on the business
· Lack of visibility over FX exposure and unreliable forecasting
· Flawed manual processes to identify and capture FX exposure
· Inefficient treasury or financial risk management systems
· Immature or informal hedging practices
· Inability to analyse exposures and measure hedging results.

Micro-hedge your foreign currency transactions

Dynamic Hedging is the fully automated solution that eliminates FX risk and makes it easier to buy and sell in local currencies. With profit margins safeguarded, your business is more competitive and primed to increase market share.

Companies with manual hedging processes are more vulnerable to FX risk. Micro-hedging addresses this shortcoming by hedging each transaction (e.g. a receivable or payable), as it occurs.

Using straight-through processing (STP) to speed up processing time, Dynamic Hedging streamlines the workload, no matter how many transactions are being processed, or how small the amount. Currently, larger Currency Hedger clients hedge more than 20,000 micro-transactions a year while others manage their risk in 115 currency pairs.

Boost Efficiency

 

Automate processes to boost efficiency

 

Standardize your FX management procedures

Automate micro-trade executions according to market movements

Save time and reduce human error by eliminating manual processes

Liberate your finance team from low-value administrative tasks.

 

 

Secure Margins

 

Take full control of your FX exposure

 

Capture FX exposure data in real-time

Hedge risk safely and efficiently in all your currency pairs

Monitor currency volatility 24/6

Hedge micro-transactions based on your company needs.

 

Secure margins and protect your b- line

 

Effortlessly add new currency pairs when expanding into new international markets

Retain and drive profits with safeguarded margins

Minimise FX gains and losses

Reduce P&L volatility with our Hedge Accounting solution.

 

Streamline reporting with CH

 

Use built-in analytics to streamline reporting for your CEO and the board

Oversee your FX exposure with our data-rich analytics dashboard

Gain a better visual representation of when settlements will occur to improve cash management.

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Correct Way to Hedge

Deciding how and what to hedge requires a company-wide look at the total costs and benefits.

  Hedging is hot. Shifts in supply-and-demand dynamics and global financial turmoil have created unprecedented volatility in commodity prices in recent years. Meanwhile, executives at companies that buy, sell, or produce commodities have faced equally dramatic swings in profitability. Many have stepped up their use of hedging to attempt to manage this volatility and, in some instances, to avoid situations that could put a company’s survival in jeopardy. When done well, the financial, strategic, and operational benefits of hedging can go beyond merely avoiding financial distress by opening up options to preserve and create value as well. But done poorly, hedging in commodities often overwhelms the logic behind it and can actually destroy more value than was originally at risk. Perhaps individual business units hedge opposite sides of the same risk, or managers expend too much effort hedging risks that are immaterial to a company’s health. Managers can also underestimate the full costs of hedging or overlook natural hedges in deference to costly financial ones. No question, hedging can entail complex calculations and difficult trade-offs. But in our experience, keeping in mind a few simple pointers can help nip problems early and make hedging strategies more effective.

Hedge Net Economic Exposure

 
Too many hedging programs target the nominal risks of “siloed” businesses rather than a company’s net economic exposure—aggregated risk across the broad enterprise that also includes the indirect risks. This siloed approach is a problem, especially in large multibusiness organizations: managers of business units or divisions focus on their own risks without considering risks and hedging activities elsewhere in the company. At a large international industrial company, for example, one business unit decided to hedge its foreign-exchange exposure from the sale of $700 million in goods to Brazil, inadvertently increasing the company’s net exposure to fluctuations in foreign currency. The unit’s managers hadn’t known that a second business unit was at the same time sourcing about $500 million of goods from Brazil, so instead of the company’s natural $200 million exposure, it ended up with a net exposure of $500 million—a significant risk for this company. Elsewhere, the purchasing manager of a large chemical company used the financial markets to hedge its direct natural-gas costs—which amounted to more than $1 billion, or half of its input costs for the year. However, the company’s sales contracts were structured so that natural-gas prices were treated as a pass-through (for example, with an index-based pricing mechanism). The company’s natural position had little exposure to gas price movements, since price fluctuations were adjusted, or hedged, in its sales contracts. By adding a financial hedge to its input costs, the company was significantly increasing its exposure to natural-gas prices—essentially locking in an input price for gas with a floating sales price. If the oversight had gone unnoticed, a 20 percent decrease in gas prices would have wiped out all of the company’s projected earnings.
Keep in mind that net economic exposure includes indirect risks, which in some cases account for the bulk of a company’s total risk exposure.2 Companies can be exposed to indirect risks through both business practices (such as contracting terms with customers) and market factors (for instance, changes in the competitive environment). When a snowmobile manufacturer in Canada hedged the foreign-exchange exposure of its supply costs, denominated in Canadian dollars, for example, the hedge successfully protected it from cost increases when the Canadian dollar rose against the US dollar. However, the costs for the company’s US competitors were in depreciating US dollars. The snowmobile maker’s net economic exposure to a rising Canadian dollar therefore came not just from higher manufacturing costs but also from lower sales as Canadian customers rushed to buy cheaper snowmobiles from competitors in the United States. In some cases, a company’s net economic exposure can be lower than its apparent nominal exposure. An oil refinery, for example, faces a large nominal exposure to crude-oil costs, which make up about 85 percent of the cost of its output, such as gasoline and diesel. Yet the company’s true economic exposure is much lower, since the refineries across the industry largely face the same crude price exposure (with some minor differences for configuration) and they typically pass changes in crude oil prices through to customers. So in practice, each refinery’s true economic exposure is a small fraction of its nominal exposure because of the industry structure and competitive environment. To identify a company’s true economic exposure, start by determining the natural offsets across businesses to ensure that hedging activities don’t actually increase it. Typically, the critical task of identifying and aggregating exposure to risk on a company-wide basis involves compiling a global risk “book” (similar to those used by financial and other trading institutions) to see the big picture—the different elements of risk—on a consistent basis.

Solution

 
Many risk managers underestimate the true cost of hedging, typically focusing only on the direct transactional costs, such as bid–ask spreads and broker fees. These components are often only a small portion of total hedge costs (Exhibit 1), leaving out indirect ones, which can be the largest portion of the total. As a result, the cost of many hedging programs far exceeds their benefit.
Direct costs account for only a fraction of the total cost of hedging.
 

Indirect Costs

Two kinds of indirect costs are worth discussing: the opportunity cost of holding margin capital and lost upside. First, when a company enters into some financial-hedging arrangements, it often must hold additional capital on its balance sheet against potential future obligations. This requirement ties up significant capital that might have been better applied to other projects, creating an opportunity cost that managers often overlook. A natural-gas producer that hedges its entire annual production output, valued at $3 billion in sales, for example, would be required to hold or post capital of around $1 billion, since gas prices can fluctuate up to 30 to 35 percent in a given year. At a 6 percent interest rate, the cost of holding or posting margin capital translates to $60 million per year. Another indirect cost is lost upside. When the probability that prices will move favorably (rise, for example) is higher than the probability that they’ll move unfavorably (fall, for example), hedging to lock in current prices can cost more in forgone upside than the value of the downside protection. This cost depends on an organization’s view of commodity price floors and ceilings. A large independent natural-gas producer, for example, was evaluating a hedge for its production during the coming two years. The price of natural gas in the futures markets was $5.50 per million British thermal units (BTUs). The company’s fundamental perspective was that gas prices in the next two years would stay within a range of $5.00 to $8.00 per million BTUs. By hedging production at $5.50 per million BTUs, the company protected itself from only a $0.50 decline in prices and gave up a potential upside of $2.50 if prices rose to $8.00.

Hedge only what matters

Companies should hedge only exposures that pose a material risk to their financial health or threaten their strategic plans. Yet too often we find that companies (under pressure from the capital markets) or individual business units (under pressure from management to provide earnings certainty) adopt hedging programs that create little or no value for shareholders. An integrated aluminum company, for example, hedged its exposure to crude oil and natural gas for years, even though they had a very limited impact on its overall margins. Yet it did not hedge its exposure to aluminum, which drove more than 75 percent of margin volatility. Large conglomerates are particularly susceptible to this problem when individual business units hedge to protect their performance against risks that are immaterial at a portfolio level. Hedging these smaller exposures affects a company’s risk profile only marginally—and isn’t worth the management time and focus they require. To determine whether exposure to a given risk is material, it is important to understand whether a company’s cash flows are adequate for its cash needs. Most managers base their assessments of cash flows on scenarios without considering how likely those scenarios are. This approach would help managers evaluate a company’s financial resilience if those scenarios came to pass, but it doesn’t determine how material certain risks are to the financial health of the company or how susceptible it is to financial distress. That assessment would require managers to develop a profile of probable cash flows—a profile that reflects a company-wide calculation of risk exposures and sources of cash. Managers should then compare the company’s cash needs (starting with the least discretionary and moving to the most discretionary) with the cash flow profile to quantify the likelihood of a cash shortfall. They should also be sure to conduct this analysis at the portfolio level to account for the diversification of risks across different business lines.

Companies should develop a profile of probable cash flows—a profile that reflects a company-wide calculation of risk exposures and sources of cash.

A high probability of a cash shortfall given nondiscretionary cash requirements, such as debt obligations or maintenance capital expenditures, indicates a high risk of financial distress. Companies in this position should take aggressive steps, including hedging, to mitigate risk. If, on the other hand, a company finds that it can finance its strategic plans with a high degree of certainty even without hedging, it should avoid (or unwind) an expensive hedging program.

Look beyond financial hedges

  An effective risk-management program often includes a combination of financial hedges and nonfinancial levers to alleviate risk. Yet few companies fully explore alternatives to financial hedging, which include commercial or operational tactics that can reduce risks more effectively and inexpensively. Among them: contracting decisions that pass risk through to a counterparty; strategic moves, such as vertical integration; and operational changes, such as revising product specifications, shutting down manufacturing facilities when input costs peak, or holding additional cash reserves. Companies should test the effectiveness of different risk mitigation strategies by quantitatively comparing the total cost of each approach with the benefits.
The complexity of day-to-day hedging in commodities can easily overwhelm its logic and value. To avoid such problems, a broad strategic perspective and a commonsense analysis are often good places to start.
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Hedging Strategies

Currency Exchange Hedging Strategies

It is essential when creating bespoke currency hedging strategies for your corporation that it is based upon market research and analysis, ensuring it fits your business needs. Correct implementation, monitoring and refining of the strategy is essential. Smart Currency Options Ltd., authorised and regulated by the Financial Conduct Authority (FCA), has developed a four step process.

 
 
 

1. Understanding the Risk

Foreign Exchange (FX) exposure is experienced by all importers and exporters of goods and services as they are permanently exposed to:
• Transactional Risks
• Translational Risks
• Economic Risks
There have been numerous high profile companies that have seen their entire profits eliminated by adverse currency fluctuations. Neglecting to account for volatile currency markets can lead to disastrous consequences. Understanding the factors that can affect the markets combined with proper analysis of your company’s exposure levels, are the first stages in establishing a bespoke treasury management strategy.

 

2. Developing the Strategy

Determining your company’s risk appetite
You will need to assess the risk appetite of your organisation. A good currency specialist can look at the different economic and business factors and their effects on your company’s currency exposure and help you assess how much risk your business can feasibly afford. Smart Currency Business will help develop this strategy with you, looking at your company’s exposure levels and creating different solutions to reduce this risk, through the appropriate currency tools and strategies.

Choosing the right tools and products as part of your strategy
There is a wide range of solutions and products that can be factored into your corporation’s hedging strategy. These include:

  • Spot Contract: Buying or selling currency on the spot. A spot contract involves purchasing or selling currency at live market rates for immediate transfers.
  • Forward Contract: Securing a currency rate for future use. A Forward Contract allows you to reserve an exchange rate determined on the day of the transaction for future use.
  • Currency Option Contracts: a bespoke hedging solution that can give the policyholder the right, but not the obligation, to buy or sell underlying currency at an agreed rate of exchange on maturity of the option.

These bespoke solutions are likely to form part of your treasury management solution. These can range from straightforward options (called ‘vanilla’ options), like a ‘call’ option for a buyer, to more sophisticated types, like a ‘collar’. If the market moves in a corporation’s favour, it can transact at a spot rate. However, if exchange rates are unfavourable, the company can purchase currency at a rate that was previously agreed upon. A basic vanilla option gives you the right, but not the obligation, to purchase the underlying currency at an agreed price on the maturity of the option. Flexibility can be added to your strategy through combining it with different types of option products as well as spot and forward agreements to generate fluid hedging strategies covering the best and worst case within your comfort zone of risk.

3. Executing the Strategy

The hedging strategy you decide upon will be based on where the markets are at that moment in time, where the markets are forecast to be, and the micro exposure of your business from the various risk factors previously discussed. In light of the different risks that your company is exposed to, you will need to assess the tactical options available to mitigate your exposure to these risks. A robust currency hedging strategy often involves a combination of the different products and solutions available, based on the specific business needs and currency requirements of that company. This provides several levels of protection against currency risk.

By carefully considering all inherent and extenuating factors, Smart Currency Business consultants can help you develop hedging strategies to your specific requirements, lending our guidance to help you build your own bespoke currency strategy. Effective and efficient implementation of this strategy will help to minimise risk when protecting a company’s profits from losses of funds and unexpected expenditure caused by currency volatility.

4. Reviewing and balancing the currency strategy

Monitoring and refining the hedging strategy is an important part of protecting your business from unexpected currency risk. Smart Currency Business will review the risks that your company is exposed to and will continually assess the performance of your hedging strategy against those risks, making adjustments where needed to take into account market movements and changing economic and business factors.

A hedging strategy is not a one-size-fits-all approach; it is a bespoke solution, created according to your specific business risks and requirements. Your strategy will need to be reviewed regularly to ensure it remains effective, according to your company’s needs. As your business and the markets in which it operates evolve, so will your exposure to risk, and therefore your hedging strategy will need to evolve accordingly; an aspect that many companies neglect! At Smart Currency Business, we work continuously with you to assess the market and business dynamics, refining your company’s strategy to help achieve the best possible results.