Today at the monthly San Francisco Treasury Management Association luncheon JoAnne Tillemans, of Avalon International Strategies discussed how recent market gyrations have impacted FX hedging strategies. She shared some war stories and offered guidance to a mixed audience of cash management bankers and corporate treasurers. There was a fair amount of discussion among what is often a rather reticent audience, so the topic really resonated.
What I learned:
There are three primary types of exposure that companies look to manage. The type of exposure that is most linked to payments is Transaction Exposure.
- Economic Exposure – Protect against anticipated transactions denominated in a foreign currency but have not yet been entered into a company’s financials. This type of exposure is typically hedged via option and forward contracts to offset revenue and costs of goods sold (operating margins) risk due to foreign currency exposure. FAS 133 accounting rules govern cash flow hedges.
- Transaction Exposure – Occurs when a specific payment commitment is recorded in the books (as incoming A/R or outgoing A/P) at one value (at an a presumed exchange rate), but the payment does not occur until some time later at another exchange rate. This impacts Other Income/Expense lines. There are two parts to the hedges: remeasurement and conversion risk. Forwards are typically used to hedge this type of exposure. FAS 52 guidelines per remeasurement of Non-functional Monetary Assets/Liabilities is the governing accounting rule. Intercompany loans and transactions fall under this type of exposure if the entity uses the local currency as its functional currency.
- Translation Exposure – Arises from the translation of local currency balance sheet to USD for consolidation at the corporate level. FAS 52 applies here. All items are translated at current ME rate; equity at historical rates. In the case of local-currency functional entities, this exposure is usually not hedged unless a company feels that the foreign subsidiary will be liquidated.
A few observations and suggestions from JoAnne:
- Counterparty risk has become a source of great concern to corporations management of their hedging portfolios. Until recently, counterparty risk was a minor component of hedging strategies. Now counterparty risk is everything – will the person that you are buying futures from be able to honor their commitment? Credit ratings are irrelevant, and even the largest, most-fabled Wall Street brand names are questionable. Corporation’s are spreading their trades out amoungst more banking counterparties and monitoring the length of their hedging horizons. Some corporation’s are shortening the duration of their hedges.
- Purchased Option hedging is much more expensive than it used to be. Volatility is a primary factor in determining pricing and what used to be relatively un-risky currencies are now demonstrating extreme intra-day fluctuation (although less so than last fall). The impact of higher premium costs for purchased options is leading some corporations to move to utilizing more risky strategies such as forwards or range forwards to hedging their economic risk. Depending on the position that needs to be hedged, some companies are postponing hedging with the hope that volatilities will stabilize.
- There has been considerable trading focus with regards to down-ward pressure on European currencies (Euro, Sterling) and it seems that Asian currencies, such as the India Ruppee, which are dependent on world economies for their growth have not yet corrected downward.
- Inter-company politics are taking a toll as business units argue over pricing between themselves, and are reluctant to take on the cost of hedging (preferring that the corporate entity cover hedging). Many of the corporate treasurers in the audience chuckled and observed that, of course, when hedging results in profits the business units clamor for their share!
- Operational solutions are becoming popular as alternatives to hedging. Companies are endeavoring to line up their costs and revenues in the same currencies and are renegotiating their third party contracts to take advantage of recent market moves.
Joanne characterized the last 5 months as "non-stop triage" and observed that "I feel like I trained my whole life for this." But if anyone can handle the stress it’s Joanne. She started her career with Salomon Brothers in the mid-eighties (with Michael Lewis, their experience was immortalized in his book Liar’s Poker) and experienced the FX fallout of the Asian financial crisis first hand. Having left the trading floor behind her she’s enjoyed a calmer (at least until recently) second career advising Silicon Valley companies on their FX strategies.