FX Hedging: Reactionary or Insulating?

A common question for corporates that actively hedge currency risk is whether underlying market trends should influence their risk mitigation strategies. This becomes especially relevant during times of prolonged strengthening or weakening in major operating currencies, when risk managers may be facing persistent unfavorable volatility in financial statements and the C-suite may be weighing changes to the strategic direction of the business if those foreign exchange (FX) trends continue.

Consider the recent strength of the U.S. dollar (USD), which has been especially impactful for corporates whose revenues are primarily foreign and expenses are mostly USD, or vice versa. While high inflation numbers last spring created a brief weakening trend, the prospect of a rising interest rate environment in the United States subsequently pushed the dollar index to its highest levels in 18 months. Corporates whose foreign revenues depreciated against the dollar may be concerned about margin erosion, particularly if Fed rate hikes push the dollar even higher. (See Figure 1.)

But should a trend like this cause treasury practitioners to re-evaluate their hedging strategies?

In answering this question, the first thing to do is to determine how the market trend relates to the company’s unique exposure profile. Even during periods of broad-scale USD strength, there may be more nuanced trends playing out between specific currencies. For example, the Canadian dollar (CAD) strengthened against the USD last year, bolstered in part by rising oil prices that make Canada’s crude exports more valuable, and by increased demand for the Canadian currency. Organizations that have primarily USD expenses and primarily CAD revenues may not be particularly concerned about broad dollar strength. It’s important to understand these types of nuances, paying special attention to the currencies with the most material impact on the company’s financials.

If, during a deep dive into the prevailing currency trends, treasury determines that those trends have actually led to unfavorable results, the company should reconsider the structure of its hedging program. If it is hedging a high percentage of exposures far into the future, the organization may have already reduced its overall risk by a material amount. It’s still useful to assess the program’s realized FX outcomes against an unhedged scenario, with the goal of quantifying the effectiveness of the program and ensuring that stakeholder expectations are realistic.

Alternatively, if the organization’s hedging ratios are low—particularly for more distant tenors, where the band of potential outcomes is wide—financial risk managers may have some obvious levers to pull in adjusting the program. For example, a company might be in a position to change the nature of its exposures through sourcing or pricing decisions, or managers could adjust their hedging ratios or products.

The Theory

Different treasury organizations have differing theoretical viewpoints about whether hedging programs should ever be reactionary.

Some corporates take an opportunistic view of risk mitigation and are eager to tailor their strategies to reflect current market trends. Perhaps the objective for these treasuries is not to completely fix FX-related outcomes, but instead to manipulate the band of outcomes in a way that is conducive to the broader objectives of their business. Such corporates often explore options products or rely on portfolio effects and correlations for natural offsets, with a goal of preserving greater upside in outcomes. It’s important to keep in mind that the upside comes at price, whether in the form of premium payments on options products or a greater tolerance for unhedged risk.

The counterargument to this, of course, is that an overly opportunistic approach runs counter to many companies’ ultimate purpose of hedging, which is to achieve certainty regardless of underlying market trends. From this perspective, hedging does not seek out best-case scenarios. Instead, it aims to make financial outcomes dependent only on the success or failure of the core business. Treasury groups with this viewpoint usually take a programmatic approach to risk mitigation, emphasizing rules-based FX policies that limit the amount of subjectivity driving decision-making over time. They also tend to favor forward contracts and higher hedge ratios, to mitigate as much risk as possible, even at the expense of upside.

Regardless of which camp treasury professionals reside in, hedging does not provide a permanent solution for grappling with long-term market shifts, which may ultimately require changes to the core business. Instead, hedging offers a smoothing effect through volatile times, which can give treasury professionals time to think about long-term strategy and risk.

Figure 2 illustrates the smoothing effect that a USD-functional company would have brought to its financial statements from early 2018 through mid-2021 if it maintained a rolling 12 months of hedge coverage on euro exposures, at either an 80 percent or 40 percent hedge ratio. In periods of rapid euro appreciation or depreciation, the hedges would have provided a buffer against short-term fluctuations and led to more range-bound results.

Most companies considering whether to adjust their hedging policy to reflect market trends land somewhere between these two perspectives. They may employ a policy-driven approach, which reduces subjectivity around hedging decisions, but even the most programmatic approach must be revisited as the company’s exposure profile evolves over time or competitive dynamics change in certain geographies. To the extent that underlying market trends impact business decisions around forecasting, cash needs, and risk tolerance, those changes will inevitably trickle down to hedging decisions as well.

Other Catalysts for Revisiting a Company’s Hedging Approach

Even among corporates that believe hedging policy should be independent of market trends, a variety of business and organizational changes can make it necessary to review the hedging program. Chatham Financial frequently works with companies that are planning or have recently undergone some form of merger or acquisition. The M&A activity may cause material changes to their exposure profile or introduce questions about hedging priorities, such as “Will strategies be formed at the consolidated level or by business unit?” and “Will the incentive structures we have in place encourage our new business units to effectively manage FX risk?” The appropriate hedging strategy is often driven less by market forces and more by stakeholder preferences for where volatility should be eliminated (i.e., at the subsidiary or parent level).

If the company’s objective is to minimize volatility in consolidated financials, a centralized hedging program is often the simplest and most effective choice. A decentralized program, by contrast, is ideal for mitigating subsidiary risk (and satisfying incentive structures). However, in some cases, decentralized hedging overlooks or even increases key exposures for the parent organization.

For example, consider a USD-functional parent company in which a euro-functional subsidiary has significant British pound (GBP) revenues. The EUR-functional subsidiary may elect to enter into ‘Sell GBP, Buy EUR’ forwards to mitigate currency risk within its own financials. Those hedges will reduce volatility in subsidiary-level financials, but they may actually increase the USD parent’s exposure to the euro, since they inadvertently introduce a long-EUR position. Whether the hedges are right for the company overall largely depends on internal priorities. To make that decision, financial risk managers require a nuanced understanding of both subsidiary-level and parent-level exposure profiles.

Cost management initiatives also lead many corporates to re-examine their hedging programs in terms of risk mitigation per dollar spent. In these cases, it’s important to think about the incremental impact of each currency hedged, and to target only those currencies that provide a material reduction. The article “Understanding the Cost of Hedging” by my colleague Amol Dhargalkar provides more detail on how to quantify hedging costs. Corporates that fail to assess risk in this way often underestimate the impact of portfolio effects, which may lead them to hedge more currencies than needed, creating an operational burden.

During the pandemic, forecast uncertainty has been another factor that has commonly forced companies to revisit their hedging strategies. In 2020, demand in certain industries plummeted, requiring revisions to revenue forecasts. More recently, supply-chain issues have created forecast uncertainty for companies struggling to keep up with surging demand as they face longer-than-usual wait times from suppliers.

Regardless of the cause, forecast uncertainty usually introduces constraints on which currencies should be hedged and at what percentages. If the impacts are large enough, the uncertainty may require a broader review of the company’s cash flow hedging strategy. That said, flexibility can be introduced into hedging programs, in many cases, to better absorb changes in exposure timing or periodic uncertainty on exposure magnitude.

Responding to Stakeholder Input

Putting underlying market trends and business changes aside, treasury practitioners often need to review or adapt their hedging programs to satisfy the evolving demands of the organization’s key stakeholders. Perhaps a new CFO has more aggressive risk mitigation objectives, or different functions—such as accounting and treasury—have conflicting goals for financial risk mitigation. In either case, treasury professionals should keep in mind a few essential factors for navigating the competing priorities of hedging.

First, a robust hedging policy can help to formally align stakeholders around a shared hedging strategy and prevent second-guessing of the strategy during market swings. Second, quantitative insight into total unhedged risk, on the one hand—at both the business unit and the corporate level—and into the effectiveness of the organization’s existing risk mitigation efforts, on the other hand, can be extremely helpful in defending the efficacy of a program during periods of high volatility. It’s incumbent on treasury teams to provide this data to management and other stakeholders.

Reporting on hedging program performance can be challenging, especially for companies with complex exposure profiles, but doing so is crucial. Stakeholders need to be consistently apprised of program performance through various market performance cycles. A treasury function that understands and quantifies how exchange rates are impacting the company’s underlying exposures is well-equipped to illustrate the corresponding activity in its hedge portfolio and demonstrate the effectiveness of its currency risk management activities.

Amanda Breslin leads Chatham Financial’s Corporate Treasury Advisory team, where she partners with clients on strategy, analysis, and execution of interest rate, foreign exchange, and commodities risk management. Breslin has advised corporate clients on challenges ranging from standing up a new risk management program, to navigating complexities of cross-border M&A risk profiles, to driving operational efficiencies in high-volume programs.