The Secrets Behind Layered Hedging Programs

When a company hedges its budget against currency (FX) risk, should it aim at achieving a smooth hedge rate over time? If so, what type of hedging program should it implement? (Spoiler: a Layered Hedging program).

These questions, addressed during a recent Kantox webinar, are increasingly relevant for companies that seek to protect their budgets from currency risk over a protracted period of time.

In FX hedging, as in many aspects of life, there is no “one size fits all” solution. The good news is that many different hedging programs —and combinations of programs— can be implemented to protect company budgets.

Continuity on pricing: the notion that underpins Layered Hedging

As Antonio Rami, Kantox Chief Growth Officer and co-founder, explained during the webinar, there is no specific hedging program for a specific company. It is always a combination of circumstances that defines the optimal program. Crucially, we need to consider the pricing dynamics of each company. Take the case of a firm that cannot use pricing as a hedging mechanism because it desires (or needs) to keep selling prices constant, period after period.

To the extent that an FX rate is systematically part of its pricing, a fundamental question arises: as the firm sets its prices for the following period, can it pass on the full impact of a sharp intra-period currency move —also known as a ‘cliff’— to its end customers? When competitive pressures make it impossible to raise selling prices on the back of an adverse ‘cliff’, the firm requires continuity on pricing, period after period.

And this creates the need for a smooth hedge rate. Why? Consider the alternatives. With a static hedging program, as soon as the initial hedge matures, the reality of the adverse ‘cliff’ would dawn on the company. Keeping its prices unchanged would force it to take a proportional hit in terms of profit margins. Alternatively, a rolling hedging program could help the company achieve a smooth rate—but only in the unlikely (and lucky) scenario of low intra-period currency volatility. 

Commonality underpins the notion of a smooth rate

The way to achieve a smooth hedge rate in a mechanical way, period after period, is to apply successive layers of hedges as time passes by. For example, an exposure is projected for the month of August next year. By hedging 1/12th of the corresponding amount in August of the current year, and by adding successive monthly layers during the following eleven months (each equalling 1/12th), the full 100% per cent of the desired hedge would be achieved in a year’s time. 

Commonality, the shared element, underpins the notion of a smooth hedge rate. In this example, successive monthly currency rates have more than 91.7% commonality (11/12). This type of program, where the proportion of the exposure that the firm desires to hedge is held constant, is called linear smoothing. The longer the period of a linear Layered Hedging program, the higher the commonality, and the smoother the hedge rate. 

Layered Hedging: a world of possibilities

Layered hedging can be adapted to reflect each firm’s specific business dynamics. For example, smoothing the hedge rate may not be the only goal of the Treasury team. Management may desire to have cash flow visibility as early as possible, or optimise forward points. Treasurers might also be willing to reduce the distance between the hedge rate and the spot rate, or the average spot rate for a given period.

In all these cases, the finance team faces a number of practical constraints regarding the nature of forecasts: are they available for more than a year? Are they ‘granular’ enough to be broken into, say, monthly figures? How reliable are they? It’s not only time that brings certainty to a forecast—rather, what matters is the type of exposure and its mutation in time from forecast (projection) to SO/PO (Sales Order/Purchase Order) to AR/AP (receivables/payables).

As François Masquelier, Honorary Chairman of the European Association of Corporate Treasurers, noted during the webinar: “Visibility is brought by business events as time passes by”. To work around those constraints, treasurers can combine a classic Layered Hedging program with programs that hedge SO/PO and even AR/AP. This is achieved by connecting the firm’s information systems to a software that automates hedging.

For more information on “The Secrets Behind Layered Hedging Programs”, check out the webinar below: