Avoiding the Edge of the FX Risk Cliff

While the principles and concepts of FX risk management remain constant, the environment in which treasurers operate has changed dramatically over the past decade. During the past year alone, we have seen the rise of populism driving major shifts in political direction, emphasised through the results of the Brexit referendum and US presidential election. More than ever before, the FX markets are being shaped by immediate political events rather than longer-term economic trends, which in turn influences treasurers’ risk management approach.  The year ahead looks set for just as bumpy a ride, as the priorities under Trump’s presidency take shape, Brexit negotiations commence and key European elections in Germany, France, Italy and Netherlands take place. As we travel deeper into what is arguably a new era for risk management, how should treasurers equip themselves for the challenges ahead?

The new economics

To borrow a phrase from David Bloom, HSBC’s chief FX strategist, “Politics is the new economics”. This summarises exactly the state of the markets we saw in 2016, and are set to encounter in 2017. Most of the currency shocks that we saw in 2016, both in G10 and emerging currencies, such as the Mexican peso, renminbi and sterling, can be traced to a political event or major news story. Consequently, rather than simply analysing forecast economic data and taking a view on currency direction, treasurers need to be prepared for repricing following major announcements followed by the currency trading at new levels for an indefinite period. 

While much of the 2017 focus is on events in Europe and the United States, the impact is not only felt on G10 currencies, but on emerging market currencies too. Furthermore, political and economic uncertainties in Asia, Africa and Latin America, such as Thailand, Malaysia and Korea, and low, volatile commodity prices, could have significant effects on currency values.

 

Adapting corporate hedging

In this environment, treasurers need firstly to assess carefully where their exposures are, and how material these are. This is not always easy in practice, particularly in organisations with a decentralised treasury approach, but building a central view of group-wide currency risks is essential during a prolonged period of market volatility and shocks. Having done so, treasurers can then stress test their balance sheet to gauge the potential impact of currency risks on their financial ratios. We work with clients to establish what solution works best for them, given their end goal, the different risk/reward characteristics for the wide range of alternatives and how this ties in with the company’s risk tolerance. For example, a key factor that influences hedging behaviour is whether the company is in a position to pass on the hedging cost to customers.

We have observed that within our client base many treasurers took a tactical approach to hedging in the past, and focused on the short to medium term, hedging specific short-term exposures and applying hedge accounting principles. However, when currency values crash, which can happen quickly, there may not be sufficient time to adjust the level of hedging, creating a cliff effect and therefore an earnings impact that could be material. To overcome this, we are now seeing treasurers looking to implement a more flexible approach with a longer hedging duration. By hedging over a longer period, for example, the business has more time to adjust to a new currency valuation. At HSBC, we model client solutions that have long optionality. For example, the Mexican peso (and currencies such as Malaysian ringgit and Turkish lira) was recently trading at historical lows, so for an exporter to Mexico or a Mexican company with large USD liabilities, the prospect of locking into a rate with a forward or currency swap is unattractive, and  could result in a negative mark-to-market value. Furthermore, for most EM currencies, a longer duration has a higher cost of carry. This is a particular challenge for corporations operating in low-margin industries, where hedging costs can erode already narrow margins.

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The challenge, therefore, is to extend the hedging duration whilst managing the cost of carry and avoiding a cliff effect on earnings. A potentially beneficial way of achieving this is to use long-dated structures that deliver optionality (which allows a better balance between managing exposures and managing costs), offering flexibility and the ability to participate in a strengthening currency.

Within our client base, we are already seeing corporate treasurers adjust their approach to hedging to accommodate more optionality. Treasurers of clients headquartered in emerging markets in particular are using more options, as part of structured cross-currency swap solutions, rather than straight currency swaps. G10 clients with large exposures to emerging market currencies, are taking a similar approach.

Developing a successful hedging strategy

To do this effectively requires a banking partner that has the required depth of liquidity in emerging market currencies, the right expertise and a sufficiently broad portfolio of FX hedging solutions. In addition, the treasury function itself needs the skills and technology to understand the risk-reward profile and suitability of option-based instruments, which can be more complex to analyse and value than forwards or swaps. Most large multinationals are well-equipped with the necessary pricing, transaction management and back office tools. However, some smaller corporations may need to boost their internal capabilities to make informed hedging decisions and manage and value transactions effectively. For example, the ability to mark derivative transactions to market is very important for credit risk management as the basis for calculating and managing counterparty exposure the corporation has on the hedge provider/bank.

In addition to the expertise, depth of liquidity and range of solutions that banks such as HSBC are able to offer, the bank also produces macro-economic models to provide ‘early warning’ systems by measuring risks attached to different emerging market currencies. These are based on the International Monetary Fund (IMF) models originally designed to predict currency crises, but HSBC has adapted these models to incorporate other factors that impact on currency pricing, such as event risk and commodity prices. These can be very helpful in determining when to hedge, when to accelerate and when to slow down. These models are supported by a variety of additional currency risk tools such as the bank’s Emerging Market Risk Indicators (EMRI) providing a ‘heat map’ of risk in 20 currencies, encouraging a disciplined approach to managing emerging market risk.

A new normal?

While 2016 appeared to be an extraordinary year, it could conceivably be a year that represents a ‘new normal’. Treasurers need to both anticipate and respond to changing FX risk conditions, particularly those with large exposures to emerging market currencies that are more vulnerable to market shocks and lack depth of liquidity. By adopting a flexible hedging strategy over a longer duration and with a degree of optionality, treasurers could give the business time to adapt to changing currency values, reduce the cost of carry and ultimately limit a negative impact on earnings.  

For more information, please visit www.gbm.hsbc.com/dealing-room-of-tomorrow

NB: Charts included in this article may relate to past performance or simulated past performance. Past performance is not a reliable indicator of future performance. For Professional clients and Eligible Counterparties only.