How to Optimise Forward Points with Flexible Layered Hedging

Speaker A: Welcome to currencycast. Can you optimize the impact of interest rate differentials between currencies in your FX layered hedging program? Do you always need to stick to the 2040, 60, 81 Ahundred percent schedule? 4 the hedge ratio welcome to CurrencyCast. My name is Austin McKinlay, I'm the senior Financial Writer at Cantox and your host. In this episode we challenge some of the prevailing views around FX layered hedging programs as we discuss a a number of ways to help companies protect themselves against the impact of unfavorable forward points and take advantage of situations of favorable forward points and b an out of the box analogy that helps us understand the flexibility of currency management automation solutions. As we have discussed in previous episodes of CurrencyCast, the main objective of an UH FX layered hedging program is to achieve a smooth hedge rate over time. This is best suited for companies that desire or need to keep prices as steady as possible and uh, not just during an individual campaign or budget period, but during a set of campaign or budget periods linked together over time. This is sometimes known as continuity in pricing. In the event of a cliff in the exchange rate, the company can keep prices steady without hurting budget and profit margins as hedging had started well in advance. In layered FX hedging, the exposure is in the shape of a rolling forecast for budgeted expenditures and or revenues. Looking at publicly available reports, we can see that layered hedging is applied by the likes of Netflix, Remy Cointreau, Rolls Royce, EasyJet and Jaguar, among many other companies. Looking at most layered FX hedging programs, note the prevalence of the 20, 40, 60, 80, 100% schedule for the hedge ratio. The treasury team starts by hedging 20% of their forecasted exposure at a ah given value date, adding successive layers of 20% until the final hedge ratio desired. That is to say 80% or 100% is achieved. But is it not an outdated approach? Can we not use currency management automation to provide for more adequate responses, especially when it comes to forward points optimization? Forward points reflect the difference between forward and spot exchange rates, mainly due to differences in interest rates between currencies. They are said to be unfavorable when selling and hedging in a currency that trades at a forward discount to the company's functional currency. And there's uh also when buying and hedging in a currency that trades at a forward premium to the company's currency. To take an example, short term interest rates are about 15% in Brazilian reals and 2% in euros comparing one year forwards to spot exchange rates, that means that the Brazilian real is about 10% weaker in forward terms. That means that you leave a lot of money on the table. Inversely, forward points are said to be favorable when selling and hedging in a currency that trades at a forward premium to the company's functional currency and or when buying in a currency that trades at a forward discount. Now let us see how companies can use currency management automation solutions. Uh, reduce hedging costs when facing unfavorable forward points or profit from situations of favorable forward points. There are four 1 the length of the program, 2 the granularity of the program, 3 the progressiveness of the program uh, and 4 exposure monitoring. Now let us start with the case of unfavorable forward points. It is pretty common. You can find it for example in European companies with US dollar denominated sales, or in the case of both North American and European companies selling into emerging markets. The first criterion is pretty straightforward. Reduce the length or the layered hedging program as uh, that would result in hedges with a lower maturity. Now let's consider the second criteria, namely the granularity of the hedging program. Let's compare a program with uh, quarterly granularity with a uh, layered hedging program that involves monthly granularity for a given value date. In both cases, the first rate, that is when we are the first farthest away from the value date, has the longest maturity. Note that the first rate covers 25% of the exposure in the case of quarterly granularity, but only about 8% uh in programs with monthly granularity. Why about 8%? Because 100% divided by 12 equals 8.33% and that's how uh, you reduce hedging costs. Granted, the frequency of FX trading changes. All in all, companies must assess trading frequency, the benefits of automation and reduce hedging costs, ideally with simulation tools. Note that all of this fits very well with a recent report by McKinsey Consultants about the strategic importance of budgeting. Budgeting should be aligned with the business and it should be aligned as granular as possible. We see that every day at play in foreign exchange layered hedging programs. We can make a rather similar argument with the so called progressiveness of a layered hedging program. Instead, here we wouldn't consider um, a linear hedging program in which the same percentage of the exposure is hedged at each execution point. Instead, an aggressive program front loads hedging by starting with a relatively high hedge ratio and reducing the increases as uh, the value date approaches. Conversely, a defensive layered FX hedging program starts with a relatively low hedge ratio and increases hedging over time. In the event of unfavorable forward points, a defensive approach makes sense as the impact of long maturity hedges is reduced. Currency Management Automations offers yet another solution, namely actively monitoring the exposure. As you may have noticed, all of the uh, layered hedging programs discussed so far are executed with time based criteria. In other words, the treasury team can conceivably go on holidays safe in the knowledge that the program will be executed according to the schedule. Whatever happens in currency markets by m actively monitoring the exposure, I.e. by setting conditional stop loss and take profit orders around the exchange rate. We introduce a markets based element into the layered hedging program. To the extent that currency markets trade inside the corridor set by stop loss and take profit orders, hedge execution is delayed and that's another way to achieve savings. In terms of forward points, as you can infer from what has been discussed so far, there is no need to go into the details of the case involving favorable forward points because they are the mirror image of the previous case. Examples here would involve European companies contracting US dollars or Mexican food producers selling to supermarket chains in the United States or in Canada. Here it would make sense not to increase the granularity of your hedging program. It would make sense to increase the length of the program and to go for an aggressive rather than uh, defensive layer hedging program. And finally, it wouldn't make sense to monitor the exposure. At this point I would like to propose an analogy with biology. How uh, do plants maximize their exposure to sunlight? The process is called phototropism. It involves photosensors within the plant that capture the sunlight and that uh, causes a hormone called auxin to change the shape of the cells and that makes the stem bend towards the sunlight. It's in a way an automated uh, process. Why do I mention this analogy? It's a way to allow us to think outside the box. Now there's nothing wrong about thinking inside the box. Maybe a way to find creative solutions with existing resources. But the fact is technology increases the amount of resources available to treasury teams. The Inside the box, 20, 40, 60, 80, 100% schedule for the hedge ratio may or not, uh, make sense for your company. But surely the flexibility that outside the box solutions in terms of the granularity of your program, the length of the program, the progressiveness of the layered hedging program and the possibility of monitoring market surely increases the number of potential solutions available. And remember, there is lots of money at stake.