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In our previous blogs in this series, we saw that firms that require continuity in pricing are best suited for layered FX hedging programs. We also clarified some of the most common misconceptions and/or suboptimal practices that hinder the effectiveness of these programs (you can read them 👉 here and 👉 here). 

This third blog tackles the nuts and bolts of FX layered hedging programs according to best practices in currency risk management. In particular, we pay special attention to:

1. The concept of commonality

2. How to achieve a smooth hedge rate 

3. How to optimise forward points

4. How to tackle forecast accuracy

5. How to add precision to your program

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Commonality: the concept at the heart of layered hedging

To reduce the variability in performance in the face of adverse currency fluctuations, treasury teams at firms that desire to keep steady prices need to create a commonality between hedge rates. But what does that mean? And how can this be achieved? 

Let us see how commonality between hedge rates is created. In the example below, value date refers to the time the forecasted revenues and/or expenditures are set to materialise, while trade date is the date chosen by the treasury team to execute the hedges:

- Value dates. There are four value dates (VDs) corresponding to the quarters of the year: VD1, VD2, VD3 and VD4, each forecasted at USD 100 million.

- Trade dates. Each VD is hedged at different trade dates: 25% eight quarters before, 25% four quarters before, 25% two quarters before and 25% one quarter before.

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What the example shows is that each value date mechanically shares three out of four exchange rates with the following quarter’s rate: a 75% commonality. Therefore, the average hedge rates will display little variability over time. 

This is precisely how the treasury team mechanically creates the commonality needed to achieve a smooth average hedge rate over time.  

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How to achieve a smooth hedge rate over time

Treasury teams can configure the degree of ‘smoothness’ of the FX hedge rate by adjusting the length of the program. The example below displays different linear FX layered hedging programs.

This means that layers representing the same percentage are used (for example 8.3% = 100%/12) each month. We can see how the length of the program impacts the degree of smoothing: 

- Program 1. Each monthly WAHR (Weighted Average Hedge rate) shares 11/12 FX rates with the following month’s rate (91.7% commonality).

- Program 2. Each monthly WAHR (Weighted Average Hedge rate) shares 17/18 FX rates with the following month’s rate (94.4% commonality).

- Program 3. Each monthly WAHR (Weighted Average Hedge rate) shares 23/24 FX rates with the following month’s rate (97.2% commonality).

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As the chart shows, the longer the program, the more the commonality between hedge rates—and the higher the degree of FX hedge rate ‘smoothing’. Is there an ideal degree of ‘smoothing’? Not really. It is up to each finance team to decide on it, based on:

The competitive landscape faced by the company and the constraints faced by the finance team in terms of:

• ‍Forecasting accuracy concerning duration, granularity and reliability
• The possibility of trading in long-maturity FX forward contracts

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How layered hedging helps optimise forward points

Forward points management can be an important secondary objective of a layered FX hedging program. Treasurers can adapt the configuration of their program to the degree of forward premium/discount of their functional currency. 

When selling in a forward discount currency, or when buying in a forward premium currency, forward points are said to be unfavourable. Conversely, when selling in a forward premium currency, or when buying in a forward discount currency, forward points are favourable. 

These forward discount/premium largely reflect the interplay between spot exchange rates and the interest rate differentials between currencies (see our report Forward Points Optimisation. How to profit from interest rate differentials between currencies). 

Netflix, for example, sells in both BRL and CHF. In the first case, it needs to reduce the cost of hedging from unfavourable forward points, as BRL trades at a forward discount to USD. In the second case, it can capture extra margin thanks to the Swiss franc’s forward premium.

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Unfavourable forward points

As we have see, layered hedging is a valuable tool for treasurers managing unfavourable forward points. By placing conditional orders at various price levels, treasurers can gradually capture profits as the market moves in their favor. This helps to reduce the overall cost of hedging and potentially obtain a better exchange rate.

To automate this process, treasurers can use conditional stop-loss and take-profit orders, allowing them to manage risk and capture profits without constant monitoring.

An example of how this strategy could be applied is a Swiss exporter selling in USD and Asian currencies. By using layered hedging, the exporter can potentially mitigate the impact of unfavourable forward points and improve their overall financial performance.

Favourable forward points

Layered hedging can also be used to capitalise on favourable forward points. By extending the length of the layered hedging program, treasurers can potentially capture larger financial gains as the market moves in their favor. This can help to increase profit margins and improve overall financial performance.

To automate this process, treasurers can use API connectivity to ensure timely and complete collection of exposure data. An example of how this strategy could be applied is a Mexican food producer selling to US supermarket chains.

By using layered hedging, the producer can potentially benefit from favorable forward points and enhance their profitability.

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How to tackle the problem of forecast accuracy

Treasurers may feel reluctant to implement layered hedging programs because the finance team entertains doubts about the degree of forecasting accuracy in terms of duration, granularity and reliability. As a result, they end up implementing the wrong FX program.

Combinations of programs allow treasurers to work around these constraints. For each currency pair, layered hedging can be implemented in combination with a micro-hedging program for firm commitments: 

• ‍Initial hedging is based on forecasts. As firm orders take some time to accumulate, hedging is at first carried out according to the layering schedule chosen by the treasury team. ‍
• Accumulated firm orders take over. As soon as accumulated orders surpass pre-determined hedge ratios, hedging is automatically done on the back of firm commitments.

To see this at work, look at the chart below. The orange area shows hedged positions of a given value date. As the corresponding sales or purchase orders are received, their accumulated amount is initially below the hedge ratio set by the layered program.

To avoid over-hedging, they are not hedged. However, as soon as their level surpasses the indicated hedge ratio, the program is automatically ‘switched’, executing hedges only on the basis of firm exposures. This setup reduces the need for extremely accurate forecasts.

Here’s another way to put it: the emphasis on forecasting accuracy results from the mental process of linking the degree of accuracy to the passing of time. But this is not entirely correct. It is much more relevant to consider how and when an uncertain exposure turns into a more certain exposure:

Forecast ⇒ Firm Orders ⇒ Balance Sheet items

This information sits in the systems of the company: ERP, TMS, and others. As hedging based on firm commitments takes over from hedging based on predictions, this data can be leveraged by the finance team to reduce the need for super-accurate forecasts. All that is required is to connect the systems to a software solution that automates the entire process.  

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Adding precision to your layered FX hedging program

Typically, layered FX hedging programs are ‘time-driven’ programs. The schedule of hedges is known in advance and has to be executed according to a predetermined calendar of trades. But ‘market-driven’ elements can be introduced to reduce costs and/or to profit from favourable moves in currency markets.

One example is the automatic monitoring of FX markets for individual layers, using conditional orders to reduce the financial impact of unfavourable forward points.

We can go one step further. Technology makes it possible for finance teams to finetune their layered hedging program to take advantage of favourable moves in exchange rates: 

• Maturity flexibility. If the spot FX rate moves in a favourable direction, the finance team can increase the length of the layered hedging program.

• Hedge ratio flexibility. If the spot FX rate is more favourable in the current period than in the previous period, the hedge ratio can be increased for nearer-term exposures. 

This is accomplished by applying different ‘partitions’ to the hedging program, allowing the software solution to monitor FX Markets 24/7 to automatically increase hedge duration or hedge ratios whenever currency markets move in a favourable direction.

FX automation, anyone?

In our concluding blog of the series, we will discuss the need for Currency Management Automation solutions to help treasurers handle the complex array of tasks required by best practices in layered FX hedging.

Already, we’ve covered a lot of ground discussing the pricing parameters of companies that need layered hedging programs, the pitfalls associated with manual execution, and the key ingredients of a well-crafted solution. Stay tuned.

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