Between the Delloite 2016 Global FX Survey and the FIREapps Q4 2015 Currency Impact Report, it appears that treasurers and CFO's have resigned themselves to accepting emerging markets currency risks. A deeper dive into the surveys reveals that the FX exposures to hedge (if known because its too expensive to track) can't necessarily be trusted (can't verify hedging numbers), and the high volatility price of EM currency pairs makes it difficult. My advice to those with responsibility for hedging currency exposures is to budget for currency exposure reporting software for 2017, put in place a hedging policy and procedure document that is board approved, and ensure that zero cost collars are utilized to hedge EM exposures.
I'm not advocating FIREapps as the company of choice for FX reporting software, but I am providing their name as a potential solution to being in the unenviable position of not having any software to assist their currency-hedging program. In my experience, too little is often done to ensure that corporate FX risks are quantified and understood by those outside of treasury, like sales for example. FIREapps refers to this as 'currency awareness' and they measure company's levels of sophistication by the degree to which they measure and report their exposures such as EPS impact.
What I like best about using reporting software is that KPI's can be set and monitored for increasing hedging efficiencies over time, thus allowing organizations to understand where they were, where they are now, and where they are headed. This is important to the CFO or treasurer when articulating the hedging results are reviewed and analyzed for effectiveness, which are key factors to better understanding currency risks of the business.
While the bean counters are subjecting your 2017 software request to the rigors of their trade, you must, must, must have a FX Hedging Policy and Procedure manual in place prior to starting the physical hedging process. Apart from possible regulatory requirements, policies and procedures makes good business sense. While I've written many of these policy and procedures, no two are alike because every organization is different. From the exposures, to the people, to the risks, to the frequency, each policy has its own traits.
To ensure success, each firm should engage key stakeholders in a series of meetings that outline fully the implications of such a policy. Depending on the size of the organization, this can be an unwieldy number of people. If your global organization is involved and geographies are vast, the process can be quite time consuming as well. Here I've found that an outside consultant (myself) can create efficiencies between departments and insist on deadlines, aging reports, and milestones.
Once all stakeholders are in place, the factors that have to be completed and agreed are to include (but not exclusively):
Finally, and most importantly with respect to emerging market currency pair hedging, the FX product (hedging strategy) that I endorse for simplicity, cost, and flexibility, is the zero-cost collar or more commonly referred to as a risk reversal. The risk reversal being a simultaneous purchase of a currency call (right but not the obligation to buy a currency) and sale of a currency put (right but not the obligation to sell a currency).
Although a derivative strategy by definition, the risk reversal is a relatively straightforward product that can, and should, be easily explained by the CFO or treasurer to the board of directors or other authorized approving committee. I can't stress enough how the policy and procedures documents all things that the program entails so as to eliminate the 'I didn't know about that' statements about the use of derivatives for example. Incidentally, if an organization does not approve risk reversals there are other hedging strategies that may be more acceptable and I'd be happy to discuss those alternatives.
While strictly not a 100% hedge due to the out-of-the-money nature of the zero-cost strike prices, the hedging strategy offers a range (due to strike prices) of hedging, in a potential zero cost environment. While this strategy is not a 100% hedge, it is very attractive due to the cost being minimal to nothing. At times, if a specific hedging level is desired, a cost may be incurred rather than solving for the zero cost strikes.
If we look at and example of the Brazilian Real (currency code: BRL), we would usually recommend that clients consider a 3-month expiration. With a spot price of 3.50 real's to the dollar, the zero-cost strategy has an upside strike price (protects against a weakening real) of 3.84 which the clients buys, and simultaneously the client sells a downside strike price (provides partial upside to the client if the real strengthens) of 3.42. The zero-cost collar then hedges the client above 3.84 (right not the obligation to sell reals at 3.84) and below 3.42 the client does not benefit and will have to buy reals at 3.42, until the option expires.
The name of the strategy is derived from the visual that is presented when one thinks about the topside and bottom side strikes prices that are around the present spot price. These strike prices are around the spot and create a collar around the spot price. Traders usually refer to these strategies as risk reversals because of the resulting change in portfolio risk profile that buying an out-of-the-money and selling and out-of-the-money strike for the same expiration date. The traders resulting risk is reversed, and thus the nomenclature 'risk reversal'.
Hedging requirements differ between institutions for many reasons and I recommend that risks are measured, understood, and hedged appropriate to an approved policy. If you believe that a currency discussion would be beneficial to your organization, please book a complimentary initial consultation at email@example.com.
Keith Underwood is a respected 25-year veteran of the Global Foreign Exchange market where he earned a reputation as a formidable FX derivatives portfolio manager and business architect. He is an expert in market practice and in the institutional structure and widespread trading strategies commonly employed by traders. Background Experience - Mr. Underwood has managed spot, forward, option, and NDF traders globally. In the course of building customer franchise businesses for US investment banks and European commercial banks, his endeavors carried him to every major trading center in the world. He spent 17 years in the London FX market and eight years in New York. He is a dual citizen of the US and the United Kingdom.
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