Published: May 01, 2005
• Increasingly, companies are pursuing continuous rolling hedge programs and shifting away from annual static, set-and-forget hedge strategies.
• We examine the historical results of three different types of hedge programs: an unhedged program, a static “set-and-forget” hedge strategy, and rolling strategies with various hedge initiation periods.
• By contrasting rolling hedge programs against “no hedge” and static hedge strategies, we find that rolling strategies result in more stable hedge results over time with lower period to period deviations.
• Moreover, we find that the longer the hedge horizon, the less volatile the effective hedge rates.
• The reduction of hedge volatility supports our qualitative assessment that hedging early (with longer tenors) and hedging often (by layering hedges) will enhance a company’s risk management results.
In years past, it was common for companies to set budget rates and execute most of the hedges for the entire year at the beginning of the fiscal calendar. Upon completion of these hedges, companies would largely consider themselves “finished” with the majority of their hedge activity. In our advisory work with multinational corporations, however, we have noted a shift in hedging practices. Increasingly, companies are refining exposures and layering in hedges throughout the year to build up coverage from exposed assets, liabilities and cash flows. And as coverage increases for the existing forecasts, new forecasts are formed, and hedges are extended forward into future periods. One aspect of the shift toward rolling strategies has been an extension of the maximum hedge horizon. This longer-tenored, layering and rolling practice has turned the exposure creation and risk management process into a continuous exercise that is sharply different from the annual, set-and-forget strategy previously mentioned.
There are several reasons why companies are changing hedge practices. Periodic revaluations of exposures and derivatives as required by FAS 133/ASC 815 accounting rules have led companies to review their hedges more often, with a refinement of hedged amounts over time leading to less hedge ineffectiveness. Another main driver is the weak business environment that has made it more difficult to determine exact exposure forecasts, especially for longer-dated exposures. Faced with uncertainties, companies have realized a need to adjust hedges and become more active in managing their risks throughout the fiscal year. Finally, Wall Street’s intense focus on the stability of earnings growth has caused treasurers to look beyond hedge performance within a particular fiscal year. Layering and extending hedges across fiscal years provides more stability in effective rates during and across fiscal years.
Qualitatively, we would say that rolling and layering hedge strategies are attractive because these strategies require companies to review exposures and refine hedge coverage across time. Doing so can help avoid timing and coverage mismatch due to exposure forecasts that are often less certain at the outset of the year. The longer horizon helps the process by anchoring hedge rates across longer time periods, adding to the reduction in hedge rate volatility.
Witnessing a change in hedge execution practices across firms and industries led us to examine the historical results of three broad types of hedge programs: an unhedged program, a static “set-and-forget” hedge strategy, and rolling strategies. With the rolling strategy, we also examine the impact of different hedge horizons. By contrasting rolling hedge programs against “no hedge” and static hedge strategies, we find that the rolling and layering hedge methodology results in more stable financial results over time with lower period to period deviations in hedge rates. With regard to hedge horizon, we find that the longer the hedge horizon, the less volatile the results. Reduced volatility, in combination with favorable economic results, supports our qualitative assessment that hedging early (with longer tenors) and hedging often (by layering hedges) will enhance a company’s risk management effort.
We study three main types of hedge programs using quarterly historical market data from 2000. In total, six hedge methodologies are tested—unhedged, a static hedge program, and four rolling programs of various tenor. They are outlined below:
• No hedge—exposures are converted at period-end spot rates
• Static hedges—hedges are initiated for the four quarters of the coming year during the final quarter of the ‘previous’ year.
• Rolling hedges—several quarters prior to the start of the budget year, hedges are executed to cover a percentage of the quarterly exposures and added in the subsequent quarters.
• Four rolling periods are examined: with initial hedges placed 4 quarters prior to the start of the year, 6 quarters prior, 8 quarters prior, and 12 quarters prior.
Details regarding how each program is executed are described in the next section. We use FX forwards as our hedge vehicle, and assume the underlying exposure is long EUR with a USD base currency and that the exposure notional is constant in every period. As we consider the various strategies, we assume that the risk management effort is focused broadly on economic outcomes.[[[PAGE]]]
To compare the programs on an “economic” basis, we calculate the all-in annual exchange rate achieved through the execution of these strategies. This annual rate is the average of exchange rates used to convert exposure at the end of each quarter.
With no hedges in place, a company would simply transact at the prevailing spot rates at the end of each quarter. The annual effective hedge rate is calculated as the simple average of these quarter-end spot rates.
The static and rolling strategies involve the execution of FX forwards prior to the start of the exposure period. The static program is depicted in Figure 1.
Figure 1. Static Hedge Program
With the static hedge strategy, the company will execute a strip of forwards on the final date of the previous year to protect the exposures for the upcoming fiscal year. In the illustration, the hedges for Q1~ Q4 of Year 1 are a strip of 3m, 6m, 9m, and 12m forwards transacted at the end of Year 0. The notional amount of each hedge is 100% of the quarterly exposures. As FAS 133/ASC 815 requires the hedge end date closely match the exposure end date, the effective hedge rate for each quarter is the hedge rate matching that exposure period.
Figure 2 displays the hedge term and timing for a 4-quarter rolling program.
Figure 2. Rolling Hedge Program—4-Quarter Hedge
For rolling strategies, hedges are layered-in every quarter, with the hedge amount per quarter determined in proportion to the rolling term. To protect the exposure in Q1 of Year 1, as an example, four forwards (12m, 9m, 6m, and 3m tenors) are executed across Year 0. The risk manager starts with a 12m forward covering 25% of the exposure notional when the exposure is 12 months in the future, and increases coverage by 25% three month later with a 9m forward. Hedge coverage is increased every quarter until it reaches 100%.
The most important element in the rolling program is that partial hedge coverage is executed on a forward basis across a set of upcoming exposure periods. Hedges are executed across time with the effective hedge rate for a particular exposure date reflecting all of the hedges executed for the particular exposure period. This periodic hedging used in the rolling programs is the principal difference between the static and rolling hedge methodologies.
For different horizons, the longest tenor determines the length and proportion of the rolling program. For example, a 4-quarter rolling hedge program would begin with the execution of a 12m forward covering 25% of the exposure 12 months in the future while a 6-quarter program would begin with the execution of an 18m forward hedge covering 1/6 of the exposure 18 months in the future.
It is important to note that while we compare the economic results for exposures in the same annual period (i.e., the four quarters within Year 1), the effective translation rates are the result of hedges of different tenors, transacted at different times.
Figure 3 compares the effective hedge rates of the six different hedge execution methodologies. As the first hedges for the 12-quarter hedge program are executed 12 quarters before the first exposure quarter, the results display effective hedge rates beginning in 2003 as the first hedges for 2003 would have been executed in 2000.[[[PAGE]]]
Figure 3. Forward Hedge Results – Average Annual Effective Hedge Rates
Summary statistics for the six hedge programs are depicted in Figure 4.
Figure 4. Forward Hedge Results – Summary Statistics
On average, the unhedged exposure had the highest average EUR/USD rate, but this is largely due to the significant run up in the EUR during the early years of the study. This increase in the EUR level meant that the longer tenor rolling strategies sold EUR in hedges that were executed before the currency move. A period that had roughly equal moves up and down in currency levels should result in average hedge rates across the strategies that are quite similar. As most firms avoid market timing, the deviation of hedge rates is a more important story than the average rate derived from an historical study.
When examining the deviation of effective hedge rates, the longer rolling strategies perform the best, with annualized standard deviations of the changes in hedge rates a fraction of the variations for the unhedged and static hedge strategies. Moving to a 4-quarter rolling hedge program from either an unhedged strategy or from a static 1-year strategy reduces the period to period variation in hedge rates by roughly half. Just as investment professionals recommend buying investments throughout the year (dollar cost averaging), rather than on a single day, the rolling hedge strategies remove a significant portion of market volatility.
Rather than waiting until the exposure date to translate exposed amounts (the unhedged strategy) or executing hedges on a given day prior to the start of the fiscal year (the static strategy), rolling strategies smooth hedge rates across time. The hedge rates achieved by the rolling strategies avoid the peaks and troughs of market levels, and reduce the variation in hedge rates across time.
In Figure 5, we graph the realized exchange rates through time. The ‘smoothing’ effect of the rolling hedges can be seen (compared with the kinks and sharp turns of the unhedged and static strategy). The graph also shows that 12-qtr rolling has even more consistent rates and less “turns” than unhedged, static or the shorter-term 4-qtr rolling hedge.
Figure 5. Forward Hedge—Effective Annual Exchange Rates
[[[PAGE]]]
In Figure 6, we chart changes in the hedge rates through time. The larger quarter-on-quarter hedge rate variations of the unhedged and static hedge strategy are evident.
Figure 6. Forward Hedge—Change in Hedge Rates
Standard deviation comparisons show that rolling programs have smaller period to period changes than an unhedged strategy and less than a static hedge strategy. Rolling strategies smooth results over time by spreading out the impact of market changes, thereby blending rates from different points throughout the hedge period. For rolling strategies, deviations decrease as hedge tenor increases due to the increasing number of periods when hedges are executed.
Through numerical exercises in this paper (albeit more simplified when compared with the actual risk management process), we show that lower volatilities on overall hedge results can be achieved through the use of a rolling-hedge program. By increasing the number of hedge execution periods, companies can reduce the variability of hedge rates and achieve more stable financial results. Moreover, the exercise calls for companies to review hedges regularly and put on partial coverage for longer-term exposures. It is our belief that frequent and systematic monitoring of exposures and hedges should help improve the overall risk management effort.
About the Author
John Bird is a Partner with Atlas Risk Advisory LLC, where he consults and conducts research for corporate treasury groups on risk management issues. John has more than 30 years of experience in risk and portfolio management, quantitative modeling, research and trading. For 14 years, he led the Portfolio and Risk Strategy group at Bank of America/BofA Merrill Lynch, the top-rated bank group providing client risk advisory and research. John consulted with more than 1,000 corporations, asset managers and other entities on risk and portfolio issues, and built a set of systematic FX models that he ran with bank and client capital. In previous positions, he managed fixed income and FX derivatives trading groups for CIBC/Wood Gundy and First Interstate Bank and worked in research and consulting positions. John holds a BA in Management Science from UCSD and an MBA in Finance from USC, and has spoken and published on many aspects of risk and portfolio management.
Disclaimer
The information contained in this publication is provided for information purposes only. The information contained herein has been obtained or derived from public sources believed to be reliable, but we do not represent that it is accurate or complete and should not be relied upon as such. Any opinions or predictions constitute our judgment as of the date of this publication and are subject to change without notice.
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