Avoid the cliff and protect your cash flows! Welcome to CurrencyCast. My name is Agustin Mackinlay, I am the Senior Financial Writer at Kantox and your host. In this week’s episode we present one of the most important and interesting FX hedging programs: layered hedging. 

Why is this an important topic? Because layered hedging programs allow CFOs and treasurers to handle the related problems of FX markets volatility, shifting interest rate differentials and helps reduce cash flow variability.

Now let’s see how that’s done!

Pricing characteristics and exposure

The goal of a layered hedging program is to smooth out the hedge rate over time to lower the variability of company cash flows.

It is best suited for firms that need or desire to keep steady prices not only for one individual campaign/budget period, but for a set of campaign/budget periods linked together. Things to consider:

1. prices are usually not FX-driven: the FX rate plays no role in pricing;
2. the impact of the ‘cliff’ —a sharp adverse fluctuation in currency rates between periods—, cannot be passed on to customers at the onset of a new period
3. the exposure to hedge is a rolling cash flow forecast for a set of periods linked together.

Unlike other cash flow hedging programs where prices are either frequently updated or updated at the onset of a new budget period, pricing does not act as a hedging mechanism in layered hedging programs.

But that puts cash flows at risk. So a solution must be found elsewhere. Let us see how that is done.

Smoothing the hedge rate over time

The secret of achieving a smooth hedge rate over time is to create commonality between trade dates for a given value date. Take, for example, a 12-month layered hedging program. The value date of October is hedged in 12 different months, from October in the previous year down to September.

Next, the value date of November is hedged in the same manner, starting in November of the previous year down to October. And so on and so forth. Note that the two value dates —October and November— share eleven out of twelve trade dates with the same spot rate. That’s the concept of the mechanically created commonality that lies at the heart of layered hedging programs.  

Additional points about layered hedging

We can make three additional points about layered hedging programs:

• Configurations. Depending on risk managers’ secondary objectives, there are many possible configurations of a layered hedging program. Some of these configurations regard:
  1. The degree to which the hedge rate is smoothed, for example by adjusting the programs’ length.
  2. The optimisation of forward points. For example, hedge execution can be delayed if forward points are ‘unfavourable’.
  3. The distance between the average hedge rate and the spot rate.

• Constraints. Each treasury team may face its own set of constraints. Examples include:
  1. The degree of forecast accuracy.
  2. Possible limitations imposed by liquidity providers who might not let a firm trade forward contracts that expire, say, more than two years out. 

• Automation. Needless to say, a manually executed layered hedging program can be pretty demanding, especially if many currency pairs are involved. We’ve seen companies running such programs with the help of enormous spreadsheets. But this only creates two different operational risks:
  1. Spreadsheet risk, including data input errors, copy & paste errors, formatting and formula errors.
  2. Key person risk, as only a handful of individuals understand the formulas that underpin the ‘monster’ spreadsheets.

Conclusion

Layered hedging programs are a powerful tool to face the trifecta of problems created by a highly volatile scenario: currency risk —including the risk of a cliff, as we saw recently with the GBP-USD exchange rate—, shifting interest rate differentials and less-than-stellar cash flow visibility.

In fact, a layered hedging program is created from scratch to deal with the problem of forecasting accuracy.

Why? Because instead of ‘protecting’ an FX rate, layered hedging programs build the hedge rate in advance. And because hedges are applied in layers, in a progressive manner, you do not need a 100% accurate forecast at all.

That’s a pretty powerful advantage in a scenario of pandemics, inflation and war!