Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
The Power of Delay: How to Optimise Your FX Hedging with Conditional Orders
In our previous blogs, we discussed the pricing parameters that should guide a company’s choice of FX hedging program, and we highlighted the most common mistakes treasury teams make as they hedge company budgets.
This third blog describes best practices in terms of FX hedging programs, including:
(a) Combinations of programs. The combination of static hedging and micro-hedging programs is the most powerful tool when hedging the budget.
(b) Nowcasting the FX exposure. Treasury teams can adjust forecasts in real time, effectively ‘nowcasting’ the firm’s exposure to currency risk.
(c) The power of delay. Using conditional orders to delay hedge execution provides a number of financial and business benefits.
Combinations of hedging programs
To understand what combinations of hedging programs can help you achieve as you protect your company’s budget from currency risk, it is best to take a step-by-step approach and start with the simplest of all programs. We’ll then add more and more elements.
A big hedge at the start: serious drawbacks
The simplest approach is to take a big initial hedge. At the onset of the period, the finance team hedges the full amount of the forecasted exposure. As we saw in the previous blog, care should be taken to use a slightly worse FX rate for pricing purposes—a markup.
Thanks to the markup, the hedge rate is better than the pricing rate. This simple and widely used setup suffers from two serious drawbacks: (a) it relies on super-accurate cash flow forecasts, an unrealistic assumption; (b) it is not well-suited for situations of unfavourable forward points.
Using conditional orders: nowcasting the exposure
To tackle these drawbacks, conditional stop-loss (SL) and take-profit (TP) orders are used. While stop-loss orders protect a worst-case scenario rate that is used for pricing purposes, take-profit orders allow the finance team to take advantage of favourable moves in currency markets.
The illustration below shows the power of conditional orders. As a take-profit level is hit (see the green dotted line below), a portion of the forecasted exposure is automatically hedged. That portion is determined by the treasury team in accordance with its own tolerance for risk, its degree of forecast accuracy, and the situation of the business in terms of forward points.
Note that there is a ‘nowcasting’ effect at play. This is because the program automatically adjusts the remaining exposure as soon as hedges are executed. The passing of time not only reduces the cost of hedging in the event of unfavourable forward points—it also creates flexibility to fine-tune forecasted revenues and expenditures.
This flexibility is all the more valuable to the finance team as forecast accuracy is especially relevant in regard to the latter part of a budget period, when visibility is relatively scarce.
Combinations of programs: adding precision
An even more robust approach must now be considered. It combines the static FX hedging program outlined above and micro-hedging for incoming firm sales/purchase orders. With this combination, the finance team achieves extreme precision in currency hedging.
The source of this precision is easy to explain. Hedging is not only executed on the back of forecasted exposures—it is also applied to firm sales/purchase orders, a type of exposure that has a higher degree of certainty. To see how this setup works in practice, consider the illustration below, where a hypothetical combination of programs is at work.
Initially, incoming firm orders are hedged, no matter the number of pieces of exposure and their size. As a take-profit level is hit for 50% of the forecasted exposure (the green dotted line), a large hedge is executed. Firm orders are still automatically tracked —but not hedged— as they continue to accumulate.
The exposure is actively managed throughout. As soon as accumulated orders go beyond the hedge ratio set with the initial SL/TP orders, they are once again hedged. And if stop-loss orders are hit, as shown in our example by the red dotted line in the middle part of the diagram, the solution reverts to tracking firm commitments without hedging them, since all the forecasted exposure is by now protected.
And it is not over. In our illustration, accumulated firm orders grow beyond the total budgeted exposure, as realised revenues/expenditures surpass budgeted estimations. But there is no risk of ending up under-hedged, since the program has once again —and automatically— reverted to hedging them.
And voilà. This is how the treasury team avoids ending up under or over-hedged while systematically protecting the campaign/budget rate. And if that wasn’t enough, it can take advantage of the benefits of delayed hedge execution.
The power of delay
As the campaign/budget rate is systematically protected, the use of conditional orders and the initial markup allow the finance team to benefit from delaying hedge execution. These benefits comprise:
- Flexibility. The passing of time gives the treasury team more time to adjust and update its forecasts
- Forward points optimisation. The cost of hedging is reduced in the event of unfavourable forward points.
- Netting opportunities. Exposure netting opportunities can be uncovered, further reducing costs.
- Collateral management. There is less need to immediately set aside cash for collateral purposes.
- Profiting from favourable market conditions. If FX markets move in a favourable way, better hedge rates can be locked in.
Case study: Italian petrochemical company with USD exposure
An Italian petrochemical firm that resets its prices at the onset of each annual budget has exposure to USD on the contracting side. We proposed a static hedging program combined with a micro-hedging program for firm orders.
As the company defines its pricing at the onset of the budget period, it sets a markup to arrive at a worst-case-scenario FX rate (WCS). For example, if the spot EUR-USD rate is 1.1000 and the markup is set at 2.75%, then conditional stop loss (SL) orders are set at three levels from the spot reference rate: 1.75%, 2.75% and 3.75%.
The average of the S/L orders thus matches the 1.06975 WCS rate to protect. In addition, a micro-hedging program for USD-denominated purchase orders is added, with hedges being executed on the back of firm commitments. During each period of the backtest period (2019-2023), the budget rate is outperformed.
This is because firm commitments are hedged at a rate that is by definition better than the SL orders. Outperformance reached 11.82% in 2021, generating gains of €1.98 vs. the budget rate on a €260m annual exposure. The lowest outperformance (0.87%) occurs in 2022 as stop-loss orders are hit in the second semester of that year.
As the micro-hedging program is executed, the residual exposure is automatically adjusted, which diminishes the finance team’s concerns about the degree of forecasting accuracy.
