- Dipak Khot
- Head of FX Solutions EMEA, HSBC
by Dipak Khot, Head of FX Solutions EMEA, Stephane Knauf, Global Head of FX & PM Structuring and Marc Tuehl, Global Head of FX Overlay, Global Banking and Markets, HSBC
Corporations across many industries are responding to the current extended period of market volatility and slow growth by refining their international strategy and by redirecting their focus to their core business. This is resulting in many companies contemplating disposal of non-core foreign assets that no longer fit into this strategy and instead considering reducing funding cost by repaying debt, releasing trapped cash, safeguarding consolidated earnings and optimising their balance sheets by expanding in core markets. Treasurers have an important role to play in ensuring the success of such approaches, in particular to maximise the value of these disposals by managing balance sheet translation risk. Amongst treasurers we work with, there has been a widespread view that balance sheet (net investment) risk is an accounting risk, rather than an economic risk, and therefore these risks were excluded from treasury’s hedging strategy.
However, this view is being exposed as a myth due to a direct impact it can have on the value of the asset, and is hence instrumental in creating the liquidity that treasurers need to free up to meet one or more of their key drivers mentioned earlier. Although managing this translation risk can be challenging, there is a range of realistic and potentially viable mechanisms available to do so, together with expert guidance on how best to identify, measure, monitor and manage such risks.
A changing risk perspective for treasurers
Some companies have traditionally taken a long-term view of the value of foreign assets. Such a view could be aided by the fact that mark-to-market changes of such investments are taken to the balance sheet and any depreciation or appreciation does not impact the profit-and-loss account. The common response amongst treasurers to risks that are perceived to be accounting rather than economic risks is not to hedge; however, as companies divest non-core assets, a currency mismatch is created resulting in an economic risk. The entire accumulated and ongoing currency risk is then imminently expected to impact the P&L following it being earmarked for sale. It additionally creates a liquidity risk if the currencies of disposal and its ultimate use are different. In particular for companies with stretched balance sheets, this translation risk can create equity as well as P&L volatility affecting key ratios, such as leverage and debt service coverage ratio (DSCR).
Today, however, the post-crisis economic environment, characterised by market volatility, liquidity risk, sluggish growth prospects, and the end of the commodity super-cycle, means that the disposal of non-core assets is an important means of generating liquidity for companies in many industries. Therefore, managing the associated translation risk is key to the success of an asset disposal strategy. As a result, companies can no longer take the long-term view of their international network as they did in the past, and are being forced to look at their assets with a view to increasing the return on capital, and revising their investment strategy accordingly.
Consequently, many clients are engaging with HSBC to understand how they should hedge this risk and critically, when and how much. In most cases, this engagement is driven by clients that recognise the importance of protecting the value of potential disposals, while in other situations this contact is initiated by HSBC as part of our strategic dialogue with clients.
Managing translation risk, from natural hedging to derivative instruments
A frequent problem is that treasurers seek to measure and consider hedge translation risk when they are in the final stages of a disposal, which at times can be too late: instead, they need to be doing so as soon as they earmark an asset as non-core and available for sale or perhaps to hedge opportunistically even earlier. Secondly, there is the difficulty of quantifying this risk, particularly where companies have multiple assets. Treasurers need to look across their whole portfolio of assets, identify any cross-correlation benefits that might exist and simulate the movement of FX rates on the entire portfolio to measure the risks. In effect, the objective is to balance the cost of hedging against an acceptable risk the company is willing to assume and manage the company’s liquidity requirement in the event of disposal. Correlation across currencies can sometimes help reduce the portfolio risk and additionally companies can also fund these assets in their local currencies or synthetically (via cross-currency swaps) creating a degree of natural hedge. However this is not as straightforward due to challenges in raising debt or entering derivatives in certain markets/currencies. Using derivative instruments ultimately results in paying the effective yield of the hedged currency. For example, a UK company hedging translation risk in RUB (Russian ruble) will pay the effective RUB yield. Therefore this will increase the cost of funding compared to say a CHF funding. To a certain extent this increased cost of funding will provide a natural hedge to the EBITDA generated by the Russian business. In reverse cases (low yielders), the opportunity to generate a foreign currency yield can be a motivator for using derivative hedging, particularly in cases where favourable forward points can be used to boost earnings.[[[PAGE]]]
There is a range of options available when using derivative instruments, but hedging strategies do not need to be complex. The more difficult issue is to determine the appropriate level of hedging. If a company has a high balance sheet exposure to RUB, a treasurer may start hedging using derivatives, but will pay a high RUB carry. Spot to spot movement should achieve hedge accounting and offset movements in OCI providing hedge at equity level but will create P&L volatility for the forward/swap points and also create liquidity/settlement risk, as it is a cash instrument hedging a non-cash risk.
Is dynamic hedging the way forward?
Non-core assets for disposal can sometimes be illiquid and the date at which the risk will materialise uncertain depending on market conditions and investor appetite. Therefore, there is inevitably a mismatch between the time that the risk will be realised and the tenor of the hedging instrument. When the asset is in an emerging market currency, there is the added problem of lack of market liquidity and availability of hedging instruments over particular tenors.
With this range of complexities and uncertainties, let alone the potential cost of hedging, it is no wonder that treasurers are put off. Despite this, these risks still need to be hedged, with a balance struck between the cost of hedging and the level of acceptable risk. Analysis on certain high carry currencies has suggested that a strategy of paying premium works better than paying the carry in the long run. The other alternative is a strategy that dynamically chooses the timing and the notional to be hedged based on a simple rule approach ignoring the element of emotions that are generally attached to hedging such exposures. By hedging dynamically, treasurers might not pay the full carry by gradually hedging as currency starts depreciating or conversely might not pay any carry at all when the currency continues to move in their favour. This approach is aimed at providing an outcome that can mimic (depending on future currency movements) protection when required along with participation in benefit from favourable moves.
Figure 1 illustrates evolution of the indexed value of an RUB asset in EUR terms from 2006 through to 2015, and highlights the difference in value based on specified approaches to hedging. As this shows, although the fully hedged (blue line) asset was successful in reducing the impact of currency volatility, it neither allowed the company to benefit from upside (especially) between the end of 2009-2015 nor was the cheapest strategy to employ. On the other hand, the dynamic hedging strategy not only closely mirrored a 100% hedging strategy during periods of currency depreciation insulating the company against fall in value but was also able to take advantage of positive FX movements.
Conclusion
Translation risk hedging may appear complex in theory, but the instruments used to achieve an effective hedging strategy are often relatively straightforward. Key steps to a successful risk management strategy are to identify and quantify risks, decide on a hedging strategy and, lastly, continuously monitor the risk.
Increasingly, treasurers have technology available to help them quantify and model potential risks, but equally, it is important to leverage the skills, experience and solutions available from partner banks such as HSBC. By doing so, treasurers could achieve the following:
- Greater visibility and control in mitigating risks and managing key ratios
- Enhancing the management of liquidity
- Optimising the cost of funding
Thereby, making more informed decisions on how to protect the value of assets as well as optimise an asset disposal strategy.
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