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Is your company run by narcissistic managers? Chances are that they are engaging in selective hedging that may put the future of your company at risk. Welcome to CurrencyCast! My name is Agustin Mackinlay, I’m the Senior Financial Writer at Kantox and your host. In this episode, we explore some of the links between the quality of corporate governance and foreign exchange hedging.
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Empirical studies overwhelmingly show that firms with weak corporate governance standards, that is to say, with a low percentage of independent directors, tend to engage in speculative unsystematic hedging, otherwise known as selective hedging, a well-known recipe for disaster. We'll see how all of this can be measured, and we’ll propose four ways to improve the quality of corporate governance in the area of foreign exchange risk management.
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Selective hedging is when a company hedges the underlying exposure, but does so in an opportunistic manner, in accordance with the manager's views on currency markets. It is widespread among companies. The two key defining features of selective hedging are: A) beating the market, selective hedging relies on the notion that managers can beat FX markets by using their intuition and by adjusting the size and timing of their position in FX derivatives instruments. And B) excessive volatility of hedge ratios,
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selective hedging translates into hedge ratios, that is, the proportion of the exposure that is hedged that display excessive volatility, in comparison to what is required by fundamentals.
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Empirical studies show that firms that engage in selective hedging tend to have a weak corporate governance structure. But what is meant by that? A good proxy for the quality of corporate governance is the percentage of independent directors within the Board of Directors. An independent director is a member of the Board of Directors who has no material relationship to the company and is not part of the executive team.
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Here are two possible reasons why companies with weak corporate governance structures may be reluctant to hedge the firm's currency exposure. A) When managers think that currency markets will move in favour of the firm's current position or B) when they are reluctant to hedge in the face of unfavourable interest rate differentials between currencies. Ultimately, managers at weakly governed firms have more discretion over the firm's foreign exchange hedging policy because they are less subject to control.
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Therefore, they are less likely to be penalized whenever they incorporate their own personal views into the firm's ethics hedging policy. Strongly governed firms, on the other hand, will always hedge the firm's currency exposure, whatever the personal views of its managers regarding the path of exchange rates in the future. Related to the quality of corporate governance, is the problem of narcissistic managers.
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Managers classified as narcissistic are more prone to engage in risk-taking, extravagant and even fraudulent behaviour. Believe it or not, these things can be measured. Quite obviously, researchers do not have access to the medical records that would show a formal diagnosis of narcissism. But they have other tools at their disposal. Let me show you an example. Using natural language processing, researchers have computed the proportion of first-person singular pronouns -I, me, mine, myself- to the total of first-person pronouns
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-I, me, mine, myself, us, our, ours, ourselves- in thousands of documents released by companies in the oil and gas sector in the United States. Regression analysis was then used to assess those metrics against the variability of hedge ratios, a sure sign of selective hedging. The results are clear-cut. Narcissistic managers tend to engage in selective hedging, much more so than non-narcissistic managers.
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Empirical studies show that the quality of corporate governance has a major impact on the way managers use foreign exchange derivatives markets. Managers at strongly governed firms will use foreign exchange derivatives in a way that maximizes the value of the firm. Managers at weekly governed firms will use foreign exchange markets in a way that is consistent with their egoistic ambitions.
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So here's a list of four simple yet powerful steps to improve the quality of corporate governance in the context of foreign exchange hedging. Number one, set controls at each phase of the FX workflow, the pre-trade phase, the trade phase, and the post-trade phase. Number two, when facing unfavourable forward points, rather than leaving exposures on the hedge, consider using automated conditional orders to delay the execution of hedges and will allow you to reduce the cost of carry while still keeping all exposures under active management throughout.
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Number three, consider moving away from time-based FX hedging programs to automated market-driven programs that will allow you to easily scale to any desired currency pair, thus avoiding again, having exposures that are left unhedged. And finally, number four, consider increasing the degree of FX centralisation that will allow you to avoid silos within the organization, and it also will allow you to curb the use of foreign exchange derivatives as subsidiaries that may have weaker corporate governance structures.
