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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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Correlation Trading

In the world of financial trading, asset correlation establishes how and when the prices of different financial instruments move in relation to each other. With regards to currencies and forex trading, correlation is the behavior that certain currency pairs exhibit where they either move in one direction or in different directions, simultaneously:

A currency pair is considered to be positively correlated with another if their values move in the same direction at the same time. A good example of positively correlated currency pairs is the GBPUSD and the EURUSD. When the GBPUSD trades up, so does the EURUSD.

A negative correlation between currencies occurs when there are two or more currency pairs that trade in opposing directions simultaneously. A good example of this phenomenon is the USDCHF and EURUSD. When the USDCHF falls, the EURUSD often trades up, and vice versa.

Types of Correlation

 

There are three recognizable forms of asset correlation: positive, negative and no correlation. If two assets’ prices move up or down in the same direction simultaneously, they show a positive correlation, which could be either strong or weak.

However, if an asset tends to move down when another rises, then the correlation is negative. The level of correlation is measured as a percentage figure, from -100% to 100%, also known as a correlation coefficient and it is established by analyzing the historical performance of the assets.

For instance, if two assets have a correlation of 50%, it means that, historically, when one of the assets’ value was rising or falling, there was a corresponding rise or fall in the same direction in the value of the correlated asset, about 50% of the time.

Conversely, a -70% correlation means that analysis of historical market data shows the assets moving in opposite directions at least 70% of the time. A zero correlation means that the asset prices are completely uncorrelated. This means that the movement of the price of one asset has no noticeable effect on the price action of the other asset.

It is also essential to understand that the fact that correlations exist on average over a period of time, does not necessarily mean they exist all the time. Currency pairs or assets that may be highly correlated one year, could diverge and show a negative correlation the following year.

If you decide to try out a correlation trading strategy, you need to be aware of times when the correlation between assets is strong or weak, and when the relationship is shifting.

Correlated Assets and Asset Classes

 

It is common to find correlations between the most heavily traded currency pairs and commodities in the world.

For instance, the Canadian dollar (CAD) is correlated to the price of oil since Canada is a major oil exporter, while the Japanese yen (JPY) is negatively correlated to the price of oil as it imports all of its oil. In the same way, the Australian dollar (AUD) and the New Zealand (NZD) have a high correlation to the prices of gold and oil.

Airline stocks and oil prices.

Stock Markets and gold offen, but not always.

Large-cap mutual funds generally have a high positive correlation to the Standard & Poor’s (S&P) 500 Index.

Correlation-Based Trading Strategy

 

While positive and negative asset correlations have a significant effect on the market, it is vital for traders to time correlation-based trades properly. This is because there are times when the relationship breaks down – such times could be very costly if a trader fails to quickly understand what is going on.

The concept of correlation is a vital part of technical analysis for investors who are looking to diversify their portfolios. During periods of high market uncertainty, a common strategy is to re-balance a portfolio by replacing a few assets that have a positive correlation with some other assets with a negative correlation to each other.

In this case, the asset price movements cancel each other out, reducing the traders risk, but also lowering their returns. Once the market becomes more stable, the trader can start to close their offset positions.

An example of negatively correlated assets that are used in this type of trading strategy is a stock and a Put Option on the same stock, which would gain in value as the price of the security drops.

Why Is Asset Correlation Important to Investors?

 

In the world of investment and finance, asset correlation is studied closely since asset allocation is aimed at combining assets that have a low or negative correlation in order to lessen portfolio volatility. Having a combination of assets with a low correlation reduces the portfolio’s volatility. This gives a trader or portfolio manager room to invest aggressively.

What it means is if a trader is ready to accept a certain amount of volatility, then they can put their money into high return/risk investments. This combination of low/negatively correlated assets in order to lower volatility to acceptable levels is known as portfolio optimisation.

 

Risk Management Tips for Correlation-Based Strategies

 

Sound risk management is essential when making investment decisions in order to lower the adverse effects if you suffer a loss. By using the modern portfolio theory, it is possible for you to reduce your overall risk within your portfolio of assets, and possibly even boost your returns overall, by investing in positively correlated assets.

This strategy will allow you to capture and mitigate for small divergences as the asset pair stays highly correlated overall. As the divergence of the asset prices continues and the correlation begins to weaken, you need to carefully examine the relationship to find out if the correlation is deteriorating. If so, you should exit the trade or take on a different trading approach in reaction to the change in the market.

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What is Currency Hedging

Understanding Currency Hedging

When the Canadian dollar fluctuates against foreign currencies, all Canadians are impacted one way or another. For instance, if you are buying a television from the U.S. and the Canadian dollar moves higher relative to the U.S. dollar, it will take fewer Canadian dollars to buy that television. If the Canadian dollar declines, then it will cost you more Canadian dollars to buy that same TV. This principle applies to any financial transaction or investment where foreign currency valuations are involved, including exchange traded funds (ETFs).

The change in value of a foreign currency relative to the Canadian dollar (referred to as currency risk or exchange rate risk) is an important factor to consider before investing in an ETF that invests in non-Canadian assets. For example, if the underlying investments of the ETF are bought in U.S. dollars (i.e., U.S. companies listed on a U.S. stock exchange), the appreciation or depreciation of the U.S. dollar against the Canadian dollar has the potential to either add or detract from the investment return.

Essentially, there are two options available to an investor: 1) be exposed to currency fluctuations (i.e., stay unhedged); or 2) be currency hedged. The objective of currency hedging is to reduce or eliminate the effects of foreign exchange movements over the life of the investment, such that a Canadian investor receives a return solely based on the change in value of the underlying assets, without the effect of changes in currency values.

Return on Foreign Assets  +/- Change in Foreign Exchange Rate = Total Return on Investment

Currency Hedging removes this part of the equation, Change in Foreign Exchange Rate

To reduce or eliminate the impact of changes in foreign exchange rates, ETFs that invest in non-Canadian assets are currency hedged.

How currency hedging works

To initiate the currency hedge, the ETF enters into an agreement with one or more investment dealers to sell the foreign currency forward (“forward agreement”). If the foreign currency drops in value relative to the Canadian dollar, the ETF will realize a gain in the value of the forward agreement, offsetting the foreign exchange loss. Alternately, if the foreign currency appreciates in value relative to the Canadian dollar, the ETF would realize a loss in the value of the forward agreement, offsetting the foreign exchange gain. In either case, the impact of the change in foreign exchange rate is eliminated.

Exchange rates vary over time

Historic closing rate highs and lows, from 1950 to present USD to CAD CAD to USD
January 18, 2002 $1.6125 $0.6202
November 06, 2007 $0.9215 $1.0852

Source: Bank of Canada

The Canadian dollar, in percentage terms, increased in value relative to the U.S. dollar by 75% from its low in 2002 to its highest point in 2007. An ETF whose investment mandate is currency hedged would avoid the negative effect of this dramatic change in relative value of the two currencies, while an ETF that remained unhedged would have been impacted negatively to the extent its investments were denominated in U.S. dollars.

Although the illustration above shows an extreme example of a change in exchange rates, the table below shows the year-over-year volatility of the Canadian-U.S. dollar exchange rate over time, which can also be significant over shorter periods of time. ETFs that employ a currency hedging strategy seek to eliminate all (or substantially reduce) the effects of foreign exchange rate changes.

Example: in December 2003, one U.S. dollar was equivalent to C$1.31 (or one Canadian dollar was equivalent to US$0.76). In December 2007, however, one U.S. dollar was equivalent to slightly more than C$1.00 (or C$1.00 was equivalent to almost US$1.00).

Date USD to CAD CAD to USD
2003 $1.3124 $0.7619
2004 $1.2176 $0.8213
2005 $1.1613 $0.8611
2006 $1.1528 $0.8674
2007 $1.0031 $0.9969
2008 $1.2344 $0.8101
2009 $1.0560 $0.9469
2010 $1.0079 $0.9921
2011 $1.0241 $0.9765
2012 $0.9898 $1.0103
2013 $1.0637 $0.9401

Source: Bank of Canada, as at year-end

Should an investor currency hedge?

It’s important for investors to consider their appetite for currency exposure prior to investing in an ETF with a foreign investment mandate, rather than after they’ve owned it and have found themselves wondering why their experience is different than what they had expected (given the performance of the market). Some argue that over the long-term, currency fluctuations balance out, so there’s no need to hedge. Those who support currency hedging argue that most investors don’t hold an investment long enough to mitigate the effects of currency volatility.

Key considerations

Hedged Unhedged
Short-term Time horizon Long-term
Concentrated Portfolio diversification Well diversified by currency
No opinion View on exchange rates Educated opinion
Not active Activity Active

Investors have choice

Investors can choose to take on foreign currency risk or not. Remaining unhedged may be appropriate for some but not for others. For individuals buying foreign stocks, employing a currency hedging strategy may be complex and cost-prohibitive. However, ETF investors looking to avoid the impact of currency fluctuations will benefit from ETFs that conveniently employ institutional hedging techniques on a cost-effective basis.

To learn more about currency hedging and investment products that can help you meet your currency hedging needs, please contact your investment advisor.