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Hedge the Tails and Sleep at Night

Posted over 4 years ago by Charlie Robinson

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Corporate Treasurers have a wide array of decisions to make when determining how to manage their exposures to foreign exchange and interest rate exposures.  Considerations range from the practical, i.e. what tools are best suited to the exposures at hand, as well as more market-based decisions such as where is the greater balance of risk/reward in the underlying risks to which the business is exposed.   But in determining the optimal hedge ratios the Treasurer needs to take into consideration two significant factors that are often overlooked.

Corporate Treasurers have become more sophistacted in their employment of options within the hedging toolkit, and the prevalence of Target Reemption products (executing a hedge at better than prevailing forward price levels in return for taking on some extra risk in the case of an unanticipated rate movement) is a manifestation of this comfort in selling optionality as a way to fund a hedge.  But the outright outlay of option premium to purchase deeply out-of-the-money options is anathama to many  corporate treasurers – it is deemed a waste of precious cash to hedge against extreme scenarios . 

Hedge the Tails and Sleep at Night

Yet in times of extreme market stress, the ability to think clearly and trade from a position of strength is significantly underestimated.  Hedging the “Tails” – scenarios which have statistically low probability of realisation, is something that companies undertake as a natural course of their business in the purchase of catastrophic event insurance.  No manufacturer in their right mind would run the risk against total loss of a production facility due to fire, nor fail to take out product liability insurance especially if exporting to jurisdictions such as the Untied States with robust Tort frameworks.  So it is entirely logical to take the stance that financial catastrophe insurance should also be deemed a prerequisite.

Back to basics of Competitive Advantage

Going back to first principles of competitive advantage, it is not just manufacturing, labour or transportation costs which can provide a company with an advantage over a direct competitor.  The company with a better credit rating can secure financiang at more attractive rates, and one with lower inventory levels has more free cash, example of which can contribute to a freeing-up of capital for other areas of the business such as investment, R&D, or promotional pricing structures.  To have effective hedges which cover low-probability risks can provide just such a significant competitive advantage when markets are dislocated.

All in the mind?

All too often in the face of an adverse rate move, many market participants are “caught short” – they find themselves underhedged, and then struggle to make clear decisions in the midst of market turmoil.  Often choices are made not on the basis of what is appropriate but rather what is available and necessary to keep senior management quiet.  During times of market stress it is all too tempting for analysts and the press to extrapolate further market moves, panicking some firms into adding hedges at comparatively unfavourable rates.  The firm that had the tail hedges already on its books can go about its core business with more clarity: unlike unhedged competitors, it is not in fire-fighting mode and can concentrate on its core business.   The cash flow benefits of the hedges also serve not just to bolster the balance sheet of the company, but also provide that competitive advantage vis a vis the under hedged firms.

Despite a number of years with G10 Central Banks having managed to take the volatility out of FX and rates markets through massive Quantative Easing programmes, there have been dislocations elsewhere that have had large impacts on businesses in various regions – the reversal of the CNY in Q1 of this year and the devaluation of the Russian Rouble over the past couple of months but to name two (borne from very separate events).  With the divergence of G10 Central Bank policy a reality, to feel that such dislocations are localised is perhaps fanciful.