00:00:11:02 - 00:00:41:08
Unknown
Can you optimise the impact of interest rate differentials between currencies in your FX layered hedging program? Do you always need to stick to the 20-40-60-80-100% schedule for the hedge ratio? Welcome to CurrencyCast! My name is Agustin Mackinlay, I’m the Senior Financial Writer at Kantox and your host. In this episode, we challenged some of the prevailing views around FX layered hedging programs.
00:00:41:10 - 00:01:05:15
Unknown
As we discussed, a) several ways to help companies protect themselves against the impact of unfavourable forward points and take advantage of situations of favourable forward points, and b) an out-of-the-box analogy that helps us understand the flexibility of currency management, automation solutions.
00:01:05:15 - 00:01:33:18
Unknown
As we have discussed in previous episodes of CurrencyCast, the main objective of a layered hedging program is to achieve a smooth hedge rate over time. Is best suited for companies that desire or need to keep prices as steady as possible. And not just during an individual campaign or budget period, but during a set of campaign or budget periods linked together over time.
00:01:33:20 - 00:01:49:04
Unknown
This is sometimes known as continuity in pricing. In the event of a cliff in the exchange rate, the company can keep prices steady without hurting budget and profit margins, as hedging had started well in advance.
00:01:49:04 - 00:02:10:04
Unknown
In layered FX hedging, the exposure is in the shape of a rolling forecast for budgeted expenditures and or revenues. Looking at publicly available reports, we can see that layered hedging is applied by the likes of Netflix, Rémi Cointreau, Rolls-Royce, EasyJet and Jaguar, among many other companies.
00:02:10:04 - 00:02:40:22
Unknown
Looking at most layered hedging programs. Note the prevalence of the 20-40-60-80-100% scheduled for the hedge ratio. The Treasury team starts by hedging 20% of their forecasted exposure at a given value date, adding successive layers of 20% until the final hedge ratio desired, that is to say 80% or 100%, is achieved. But is it not an outdated approach?
00:02:41:00 - 00:02:51:06
Unknown
Can we not use currency management automation to provide for more adequate responses, especially when it comes to forward points optimisation?
00:02:51:06 - 00:03:18:16
Unknown
Forward points reflect the difference between forward and spot exchange rates, mainly due to differences in interest rates between currencies. They are said to be unfavourable when selling and hedging in a currency that trades at a forward discount to the company's functional currency. And there is also when buying and hedging in a currency that trades at a forward premium to the company's currency.
00:03:18:16 - 00:03:56:17
Unknown
To take an example. Short-term interest rates are about 15% in Brazilian reals and 2% in euros. Comparing one year forwards to spot exchange rates, that means that the Brazilian real is about 10% weaker in forward terms. That means that you leave a lot of money on the table. Inversely, forward points are said to be favourable when selling and hedging in a currency that trades at a forward premium to the company's functional currency, and/or when buying in a currency that trades at a forward discount.
00:03:56:17 - 00:04:25:08
Unknown
Now, let us see how companies can use currency management automation solutions to reduce hedging costs when facing unfavourable forward points, or profit from situations of favourable forward points. And there are four criteria. Number one, the length of the program. Number two, the granularity of the program. Number three, the progressiveness of the program. And number four, exposure monitoring.
00:04:25:08 - 00:04:54:10
Unknown
Now, let us start with a case of unfavourable forward points. It is pretty common. You can find it, for example, in European companies with US dollar-denominated sales, or in the case of both North American and European companies selling into emerging markets. The first criterion is pretty straightforward: reduce the length of the layered hedging program, as that would result in hedges with a lower maturity.
00:04:54:12 - 00:05:09:09
Unknown
Now let's consider the second criterion, namely the granularity of the hedging program. And let's compare a program with a quarterly granularity to a layered hedging program that involves monthly granularity.
00:05:09:09 - 00:05:17:22
Unknown
For a given value date, in both cases, the first rate, that is when we are the farthest away from the value that, has the longest maturity.
00:05:18:04 - 00:05:40:19
Unknown
Know that the first rate covers 25% of the exposure. In the case of a call of quarterly granularity, but only about 8% when in programs with monthly granularity. Why about 8%? Because 100% divided by 12 equals 8.23%. And that's how you reduce hedging costs.
00:05:40:19 - 00:06:08:21
Unknown
Granted, the frequency of ethics rating changes. All in all, companies must assess trading frequency. The benefits of automation and reduce hedging costs ideally with simulation tools. Note that all of this fits very well with a recent report by McKinsey consultants about the strategic importance of budgeting. Budgeting should be aligned with a business, and it should be as granular as possible.
00:06:08:23 - 00:06:14:02
Unknown
We see that every day at play in foreign exchange layered hedging programs.
00:06:14:02 - 00:06:43:20
Unknown
We can make a rather similar argument with the so-called progressiveness of a layered hedging program. Instead, here we wouldn't consider a linear hedging program in which the same percentage of the exposure is hedged at each execution point. Instead, an aggressive program front-loads hedging by starting with a relatively high hedge ratio and reducing the increases as the value date approaches.
00:06:43:20 - 00:07:03:08
Unknown
Conversely, defensive layered FX hedging program starts with a relatively low hedge ratio and increases hedging over time in the event of unfavourable forward points. A defensive approach makes sense as the impact of long-maturity hedges is reduced.
00:07:03:08 - 00:07:31:08
Unknown
Currency management automation offers yet another solution, namely actively monitoring the exposure. As you may have noticed, all of the layered hedging programs discussed so far are executed with time-based criteria. In other words, the Treasury team can conceivably go on holiday safe in the knowledge that the program will be executed according to the schedule, whatever happens in currency markets.
00:07:31:08 - 00:07:59:15
Unknown
By actively monitoring the exposure. That is, by setting condition of stop loss and take profit orders around the exchange rate. We introduce a market-based element into the layered hedging program. To the extent that currency markets trade inside the corridor set by stop loss and take profit orders. Hence, execution is delayed. And that's another way to achieve savings in terms of forward points.
00:07:59:15 - 00:08:27:15
Unknown
As you can infer from what has been discussed so far, there is no need to go into the details of the case involving favourable forward points, because they are the mirror image of the previous case. Examples here would involve European companies contracting US dollars, or Mexican food producers selling to supermarket chains in supermarket chains in the United States or in Canada.
00:08:27:15 - 00:08:49:02
Unknown
Here, it would make sense not to increase the granularity of your hedging program. It would make sense to increase the length of the program and to go for an aggressive, rather than a defensive layer hedging program. And finally, it wouldn't make sense to monitor the exposure.
00:08:49:02 - 00:09:22:01
Unknown
At this point, I would like to propose an analogy with biology. How do plants maximise their exposure to sunlight? The process is called phototropism. It involves photo sensors within the plant that capture the sunlight, and that causes a hormone called auxin to change the shape of the cells, and that makes the stem bend towards the sunlight. It’s in a way, an automated process.
00:09:22:01 - 00:09:56:08
Unknown
Why do I mention this analogy? It's a way to allow us to think outside the box. Now, there's nothing wrong about thinking inside the box. May be a way to find creative solutions with existing resources. But the fact is, technology increases the amount of resources available to treasury teams. The inside-the-box 20-40-60-80 to 100% schedule for the hedge ratio may or may not make sense for your company.
00:09:56:10 - 00:10:23:23
Unknown
But surely the flexibility that outside-the-box solutions in terms of the granularity of your program, the length of the program, the progressiveness of the layered hedging program, and the possibility of monitoring market surely increases the number of potential solutions available. And remember, there is lots of money at stake.
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