Hedging Strategies for a Perfect Storm

Published: October 19, 2022

Turbulent times call for strong financial risk mitigation. Amol Dhargalkar, Managing Partner and Chairman, Chatham Financial, tells TMI that hedging strategies should now become the centre of attention.

Against a backdrop of rising inflation and interest rates, tightening monetary policy, and currencies such as sterling weakening significantly against the dollar, corporate commodity, FX and interest rate hedging strategies should now be subject to intense scrutiny, advises Dhargalkar. The position he takes on this call to action is clear. A perfect storm of fiscal and monetary events is driving markets into dark times, and companies that are not seeking to protect their financial positions could pay a heavy price.

Costs are rising, not least as many of the world’s trades are executed in USD, which has again proven to be the financial refuge of choice. With UK inflation reaching new multidecade highs, sterling being mauled on the markets, and the euro having briefly fallen below the dollar for the first time ever, many businesses see sky-rocketing energy prices as a source of intense pain.

The impact of higher energy bills, especially for manufacturing companies, will be visible in the third-quarter earnings season, with operating margins expected to be hit by higher production costs. With the increasing sterling overnight index average (SONIA) forward curves rate expected to rise above 4% from February 2023 and remain until Feb 2024, hedging strategies should certainly be high on the agenda of every corporate.

Of course, treasurers will be fully aware of the difficulties posed by the volatile economic environment, but not all have been in a position to respond effectively at a strategic, policy and operational level. In many cases, Dhargalkar believes that treasury teams have navigated the volatile economic environment incredibly well by having clear policies and processes, a well-staffed department , scenario planning, and robust data. But for those lacking any one of those items, the combination of rapidly moving markets and gaps within their existing teams or capabilities has caused difficult moments.

“A common challenge we’ve seen is companies considering ending hedging programmes in the face of a strong dollar or higher interest rates,” says Dhargalkar. “This is the exact time when a hedging programme shows its value. A major mistake firms have made is ending programmes believing that ‘things will get better, then we’ll start hedging again’, without recognising that things can actually get worse far before they improve.”

Points of practice

Each firm must take its own objectives and exposure profiles into account when developing a hedging programme. However, while an individual approach is always necessary, Dhargalkar notes that there are some common areas of best practice.

These include:

• Developing clearly articulated policies and strategies and ensuring these are understood at the C-suite and board level
• Streamlining processes through technology to enable team members to focus more on strategy rather than repetitive button clicks
• Ensuring access to data to better facilitate analytical approaches to measuring risk.

The current considerations when addressing specific revisions for interest rate, commodity and FX hedging strategies will naturally differ by asset class. “Markets have generally moved by more than two standard deviations from what standard statistical models would have predicted a year ago,” comments Dhargalkar.

With this in mind, for interest rate risk, he suggests evaluating tail risk scenarios and evaluating company capital structure for sources of risk, including future financing costs. On currency risks, he says now is a good time to evaluate the effectiveness of any existing programmes, including reviewing which exposures are hedged to what degree, how long the hedging programmes run, and their impact on reported financial results.

For treasury teams spending significant time operating their programmes, Dhargalkar urges consideration of investment in technology to help streamline the entire process. “Commodity hedging is particularly challenging, as it requires a multidisciplinary approach, bringing together areas such as business units, procurement, accounting, tax, and treasury,” he explains. “Often, these are the hardest programmes to start because of supply chain contracts and limitations in financial markets to hedge certain types of commodity risks.”

Move now

With significant concern developing in the markets over a global recession, and central banks becoming hawkish, firms that have a strong grasp of events are already spending time on scenario analysis, and understanding the impact of large (more than three standard deviations) moves in rates, FX, and commodity markets on their business, says Dhargalkar.

“That being said, it’s impossible to future-proof a hedging programme because not only can markets change but also company strategies and exposures can change,” he continues. Indeed, Covid-19 and other factors have led many companies to reconsider their manufacturing locations, for example. As a result, their exposure footprints can change quickly. Similarly, he sees commodity markets continuing to bring more into the financial hedging realm, creating opportunities that didn’t exist 12 to 24 months ago.

As the already perfect storm of economic uncertainty continues to be fuelled by new and often unforeseen drivers, it’s clear that hedging strategies should be high on the treasury agenda. As Dhargalkar warns, “‘set it and forget it’ is a great slogan, but it’s not one that can reasonably be applied by corporate treasury professionals”.