What Type of Company Should Apply Layered Hedging

In late 2023, the finance team at streaming giant Netflix made a startling announcement: faced with profit margin pressure from the strong U.S. dollar, the company told shareholders that the treasury team would start “layering in [FX] hedges”. Why was this decision taken?

The first thing to note is the increasing weight of FX in terms of Netflix’s business. By late 2023, the company’s non-US dollar revenue had grown to 60% of total companywide revenue. Clearly, this proportion was “likely to increase over time”. That’s the first point.

Now consider the firm’s pricing strategy. 

The Los Gatos firm is not shy about bumping up pricing in its 10 largest markets —especially in the standard and premium segments. The basic segment displays a different pattern. There, Netflix keeps prices as steady as possible, for as long as possible [see]. For example, no price changes were seen in Germany and South Korea between 2016 and 2022.

And that’s precisely where layered FX hedging comes into play.

In this post, the first in a series devoted to layered hedging, we start by answering a simple, yet often disregarded question: What type of company should apply layered hedging programs? 

We will also learn about:

• The differences in pricing parameters between companies that apply static FX hedging programs and those that need layered hedging. 

• The notion of the ‘cliff’, both in terms of FX markets and the impact of sharp currency moves on companies' profit margins. 

• The type of cash flow exposure that needs to be collected and managed in layered hedging programs.

Characteristics of companies that need layered hedging

First things first: keep steady prices

At Kantox, we are keen to emphasise the importance of the pricing characteristics of each firm. This is the key to understanding what type of FX hedging programs companies need to apply as they seek to protect themselves from fluctuations in currency markets.

• Pricing parameter 1: catalogue-based pricing. We exclude from the analysis companies that can pass onto their customers the impact of large adverse FX market fluctuations—for example, firms with catalogue-based pricing, where prices are periodically adjusted. In this particular case, static budget hedging is the right approach as we explained in recent blogs.  

• Pricing parameter 2: continuity in pricing. FX layered hedging programs are best suited for companies that need or desire continuity in pricing, period after period. Companies in this category include:
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  1. ‍FX-driven firms. Firms that use an FX rate in pricing while facing a competitive landscape may need to keep prices as steady as possible. Example: a South Korean exporter of commodity-type chemicals.
  2. Non FX-driven firms. For commercial reasons, some companies desire to display the same prices to their customers, period after period. Example: Netflix has recently announced a layered FX hedging program.

It goes without saying that, in the face of adverse fluctuations in currency markets, keeping prices steady is not possible without accepting a corresponding degree of profit margin erosion. This is where the ‘cliff’ enters the picture. 

Mind the cliff

The concept of the ‘cliff’ is used to assess the effectiveness of layered hedging programs. In its simplest form, the cliff denotes a sharp move in currency markets. Such episodes occur frequently in currency markets.

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At the level of a company, we define the ‘cliff’ as a measure of how much profit margins are impacted if selling prices are not changed in the face of adverse FX fluctuations. As we will see in coming blogs, a key objective of layered hedging programs is to reduce the average cliff between hedge rates.

For now, it is sufficient to stress the following point: the only way for companies to keep prices as steady as possible in the face of adverse moves in currency markets is to apply FX hedging programs that reduce or remove such FX-induced ‘margin cliffs’.

Studies on pricing parameters and currency ‘cliffs’

There is no shortage of studies regarding firms’ pricing parameters and the impact of currency fluctuations. Central banks are keen to study such episodes as they frame monetary policy. Here are some examples: 

• ‍Sweden. The Sveriges riksbank finds little in the way of price changes in the event of a USD-SEK ‘cliff’. Sustained USD appreciation reflects 'flight-to-safety' episodes that signal less economic dynamism ahead. As a consequence, "firms choose to not pass on the increased costs, as demand is low."‍
• Switzerland. Firms in a tight financial position refrain from decreasing prices to maintain profits—even at the expense of future market share. Here, time is the striking element. The large pass-through elasticity rate of 41% only materialises about a year after the FX shock [see].‍
• United Kingdom. Following the GBP-USD 'cliff' after Brexit, UK exports have been partly dollarised. USD-invoicing surged from 1/3 to nearly 55%, while the share of non-EU exports invoiced in GBP declined from 55% in 2015 to 35% in 2022 [see].

Type of exposure

Before discussing what many companies get wrong as they implement layered hedging programs —and how Currency Management Automation can come to their rescue—, we need to say something about the type of exposure that is relevant in layered hedging.

Layered hedging programs are cash flow hedging programs. The exposure is in the shape of rolling forecasts for budgeted, FX-denominated revenues and expenditures over a number of campaign or budget periods linked together. This rules out purely transactional hedging where the exposure is in the form of firm sales/purchase orders or invoices.

Note however, that layered hedging programs can be effectively combined with micro-hedging programs for firm orders or invoices.

Why do we stress the importance of several campaign or budget periods? Because, unlike in static hedging programs for businesses that keep prices fixed for only one period, firms that apply layered hedging take a longer-term approach as they seek to keep prices steady for as long as possible. 

This ‘timing’ aspect of the exposure is also relevant as treasury teams consider possible constraints to their layered hedging programs. For example, their banking partners may not allow them to trade FX forward contracts beyond a certain maturity.

Wrapping up

In coming blogs we will discuss layered hedging programs in more detail. In particular, we will endeavour to show what many companies get wrong, partly as a result of a confusion between layered hedging and simple rolling hedging programs.

We will then dig deeper into the concept of commonality between hedge rates that lies at the core of layered hedging programs. Finally we will show how automation is the way forward for firms that deal with many currency pairs. 

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