To Hedge or Not to Hedge?

The best hedging decisions rely very little on human judgment exercised in the heat of battle.

That’s why Atlas Risk Advisory CFO Scott Bilter cautions treasury leaders against making hedging decisions based on predictions of future rates—whether their own forecasts or those issued by banking partners. “You hear some people say, ‘Well, the dollar’s been striking like crazy, so maybe we should just hedge our expenses now and not our revenues because it’s a bad time to start a revenue-hedging program,’” he reports. “If you make decisions based on that dynamic—or, worse, by surveying five different banks on which way the euro and the yen are going to go—you’ve already lost the battle.”

Keep in mind that “you’re really trying to minimize the downside more than maximize the upside,” Bilter cautions. “If you take that approach, you’re more likely to end up with a better strategy.”

Bilter and other treasury experts stress that making optimal decisions about which risks to hedge requires the right mindset and evaluation criteria. Treasury leadership can help ensure that hedging decision-makers take the right approach by creating a formal framework for financial risk management. Such a framework will establish the company’s expectations for how staff should “identify risk capacity, [risk] appetite, and in what ways the organization measures and manages those risks,” notes Strategic Treasurer managing partner Craig Jeffery.

This framework should then inform the company’s hedging policy, which clarifies how long risks can be hedged as well as raw amounts and percentages that can be hedged. Jeffery says the hedging policy should act as an “envelope” to guide the types and magnitude of actions that corporate financial risk managers can take and the accompanying reporting that they must provide. Treasury and risk decision-makers should have free rein to operate within the envelope but should not stray outside it, Jeffery adds.

Companies can also establish an exception process through which treasury leaders can request permission to venture beyond the policy’s guardrails. For example, if a treasury team wanted to hedge a major transactional risk like an acquisition or divestiture, and that was not covered in the hedging policy, they might need to make their case to the internal risk committee, notes eBay senior director of cash management Dmitry Martynov.

The individual factors that financial risk managers should evaluate when deciding which risks to hedge include:

• Risk appetite and exposures.  “This is certainly lower than the organizational risk capacity but provides a border for any hedging or risk management activities,” Jeffery notes. Identifying exposures enables a treasury group to identify and calibrate the level of risk, then compare it with the company’s overall risk appetite to determine which exposures require a hedge, Jeffery adds.
• Materiality.  Financial risk managers should evaluate materiality based on dollar (or other currency) value and as a percentage of revenue or profit, Jeffery says. For risks that reach or exceed the thresholds identified in the hedging policy, financial risk managers should use financial instruments or another hedging approach.
• Availability.  Treasury groups need to find out whether an appropriate derivative, forward contract, option, or other type of hedge is available for purchase. Sometimes availability is limited. A company that wants to hedge an equity risk may not find another equity that is negatively correlated with the equity it wants to hedge.
• Hedge accounting.  Does the transaction qualify for hedge accounting? If not, the company’s reported earnings will need to reflect fluctuations in the fair value of the derivative. That may be problematic if the timing does not align with the period when the hedged risks affect earnings. “If I can get hedge accounting and align the gains and losses on my hedge with the underlying exposure, that’s the best outcome,” Martynov says. “If I can have the same geography and the same timing, that’s a big checkmark, and it will probably let us cover the risk.”

Working through these issues will help treasury teams sidestep the cognitive biases that Bilter cautions against. “The best role that a hedging policy serves is to take subjectivity out of the equation,” he asserts.

From there, treasury teams can focus on limiting the downside of currency, interest rate, and/or commodity exposures through a straightforward risk evaluation—one that Martynov distills into a straightforward decision: If a risk can be hedged in a cost-effective and accounting-friendly manner, the company should take action.

See also:

• October 2022 Special Report
• Getting Back to Natural Hedges
• 3 Quick Fixes for Hedging Efficiencies
• Beautifying the Business Case for Hedging Programs

Eric Krell’s work has appeared previously in Treasury & Risk, as well as Consulting Magazine. He is based in Austin, Texas.