Hedging Intercompany Loans: A New Way to Mitigate FX Risk

Discover a new way of hedging intercompany loans. Mitigate the FX risk and achieve savings on the cost of carry.Intercompany loans are loans made from one business unit of a company to another. They are extremely useful, as they require no credit application, can be made available on short notice, and can have very long repayment terms.However, there are significant challenges when it comes to hedging loans made by headquarters to a subsidiary whose currency trades at a forward discount to that of the group.In this article, we will explore these challenges and discuss how Kantox's currency management solution can help.

Breaking down the headaches of hedging intercompany loans

Let's take the example of a European company that makes a EUR-denominated long-term loan to its subsidiary in an emerging market. Two immediate pain points or challenges come to mind:

1. Determining the exposure to currency risk
2. How to mitigate the high cost of carry

For these companies, there are many benefits to finding the best way to handle intercompany loans. Check out how Swiss companies leverage them to tackle the heavy CHF's forward premium.

Determining the exposure to currency risk

To calculate the exposure to currency risk, nothing beats a good ‘FX risk map’. The FX risk map is a simple yet powerful graphical representation of FX risk across the transaction journey.In this case, it would show when and how the exposure to currency risk is generated. The underlying currency risk does not necessarily start when the loan in EUR is made, but rather when the funds are actually deployed by the subsidiary. And, the FX rate to defend is the weighted average of all the rates that prevail at the time when conversions are done.

Shortcomings to the traditional approach

A common approach to hedging long-term intercompany loans is to take a one-year hedge that is rolled over for as long as necessary. However, this approach has several pain points:

• High cost of carry: At about 10% per annum in EUR-MXN, it implies a very high cost of hedging.
• Open FX risk: The initial hedge may not be adequately aligned with the conversions.
• Impact of mark-to-market valuations: While negative valuations trigger margin calls, positive valuations are not cashed in.

Save big, earn more: cutting the cost of carry

Here's a much more cost-effective way of hedging intercompany loans. The secret to mitigating the high cost of carry is delaying the hedging as much as possible. The best way to do this is by setting conditional orders. Let's see how.An entry is set for the amount of the conversion with a monthly value date. To this entry, conditional stop-loss orders and take-profit orders are attached at a given percentage from the weighted average exchange rate.If, for example, one of the conditional orders is hit after two weeks, a forward contract is executed with a maturity of only two weeks. As the next monthly period unfolds, the previous position is cash-settled, and a new entry, with its own conditional orders, takes hold.By delaying the execution of hedges in this manner, we achieve savings in terms of the cost carry in two ways:

1. From the shorter maturity itself: We are moving to the 'left-hand side' of the forward curve, with lower maturities.
2. From the shape of the forward curve: In convex forward curves, savings are more than proportional as we act in the 'shallow part' of the curve.

Benefits galore!

But the benefits of this new approach to hedging intercompany loans don't end there. Not only you are mitigating the high cost of carry but your FX risk remains under active management.As time goes by, FX gains and losses (on a spot basis) will tend to cancel each other as both stop-loss and take-profit orders are hit.In our work with clients and our statistical simulations, this way of hedging intercompany loans has proven very effective, as savings on forward points far outweigh increased trading costs.

FX Automation to the rescue

As you can see, there is a way to achieve significant savings on the cost of carry while keeping your firm's exposure to currency risk under active management at all times.Kantox's currency management solution can help you implement these strategies and overcome the pain points of traditional approaches to hedging intercompany loans.