CFOs should consider micro and macro elements when hedging FX

A comprehensive new report by Deutsche Bank on FX hedging helps treasurers and CFOs to decide when and how to hedge their currency exposures.

Volatile foreign exchange (FX) and currency values twinned with changing regulations have raised the stakes for companies’ FX hedging strategies. But, according to a new report from Deutsche Bank, FX hedging goes far beyond mitigating currency risk; a successful FX hedging strategy can and does increase shareholder value, support a firm’s competitive position, and reduce stock price sensitivity to exchange rate movements.

But this means getting it right, and in practice, creating value from FX hedging is easier said than done. Large currency deviations from budgeted rates -- all too common with today’s uncertain exchange rates -- increase the impact of currency moves on balance sheets, income statements and cashflows. In other words, as the importance of hedging has increased so has the financial cost of hedging risen, as has the cost of getting it wrong.

Despite the difficulties, more than 90% of the Fortune 500 companies use financial derivatives, with currency risk the most widely hedged exposure, according to the latest 2009 International Swaps and Derivatives Association (ISDA) derivatives survey. Hedging can, after all, enable firms to avoid transaction risk, or mismatches to their foreign currencies to their cashflows, and reduce balance sheet and income statement exposure to exchange rate volatility, or translation risk.

However Deutsche Bank’s report also identifies four further strategic considerations when it comes to hedging relating to its impact on shareholder value and on a company’s strategy and competitive position against its peers. Indeed, FX hedging can increase equity valuation, as volatile cashflows can increase financing costs. “All else constant, a less volatile stock price can also have a positive impact on a firm’s equity valuation because empirically, investors show a preference for smooth returns when making capital allocation decisions,” said the report. “Low earnings volatility has historically been associated with greater analyst following, a larger number of institutional investors and smaller borrowing costs.”

Having established that hedging can benefit a firm in more ways than simply mitigating currency exposure, the report then recommends treasurers to keep in mind two distinct approaches to hedging. Micro, or bottom-up hedging, revolves around identifying the exposure to be hedged, the time frame, frequency and hedging instrument, and also takes into account accounting and credit considerations. “The bottom-up hedging decision involves a large number of parameters, the optimal mix of which is unique for each firm. While it is true that many firms share the same exposure profile, each firm’s strategy can vary dramatically depending on its objectives and constraints,” the report said.   

Meanwhile, macro, or top-down hedging can be divided into short, medium and long-term decisions, and may take into account investor sentiment, monetary policy, interest rate differentials over time and purchasing power parity. “Unlike the multiple parameters involved in the micro hedging decision, the macro decision boils down to one variable: where does the treasurer or CFO expect the exchange rate to be over the relevant hedging period?”

Companies should consider both micro and macro elements when deciding whether and how to hedge. “Broadly speaking, the gains or losses to hedging are greater when carry is high, when currencies are set at valuation extremes or when they are trending strongly,” the report concluded. “The macro environment should not just influence the decision to hedge, however, but also the type of instrument to be used. Generally speaking, we find that forward contracts generate the highest returns, but on a risk-adjusted basis options contracts may be preferable.”

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