Harmony in hedging

An integrated approach to hedging is essential, argues the head of Derivative Structuring and New Products at SSB.

Is your company getting its money's worth when it hedges against risk? If you are not coordinating your various hedges, the answer might be no.

Like patients who take prescriptions from different doctors, companies that hedge multiple risks without considering how those risks and hedges might interact with each other can suffer unfortunate side effects. At the very least, they might end up over-insuring themselves and paying for risk protection they do not really need. They might even find they have hedged the exposures shareholders are seeking when they buy the company's shares.

The solution is to adopt an integrated approach to risk management that results in cleaner, more cost-effective hedges - hedging by taking advantage of the correlation between different types of risks.
A simple example illustrates the point. Consider a Japanese importer of German cars that has borrowed in floating-rate yen to expand its operations. The importer is thus exposed to the risk of rising yen interest rates and to the strengthening of the Euro against the yen, which increases the company's cost of buying Euros.

In the absence of an integrated hedging strategy, the company's assistant treasurer in charge of currency hedging might be instructed to buy Euro calls to protect against Euro appreciation beyond the option's strike level. Meanwhile, the assistant in charge of interest rate hedging might be told to buy interest rate caps as a hedge against rising interest rates beyond the cap's strike.

The position of the company once the two hedges are in place is illustrated in Fig 1. No matter how well the two assistant treasurers do their jobs, the treasurer will end up with an over-hedged position as far as the total cost of buying Euro's and servicing debt is concerned.


Fig. 1

The red area in Fig 1 represents the area of over-hedge. Suppose the company is not hedged and point A is the combination of Euro costs and interest rates that prevails in the market. In that case, the company will be paying a higher interest rate, but higher interest expense is more than offset by the lower cost of buying Euros, and the absence of a hedge has no negative impact on the company.
In fact, for all the combinations of interest rates and Euro cost that fall on or below the equivalent line in Fig 1, the total cost in yen of servicing the debt and buying Euros does not exceed the budget allocated to these activities.

The practical question, then, is what are the likeliest combinations of yen interest rates and Euro costs? The answer depends on the correlation between the two. If we believe that when Japanese interest rates rise, demand for yen generally increases (causing the Euro to weaken), this correlation would be negative. Accordingly, the combinations of yen interest rates and Euro costs that one would observe will most probably be in the shaded ellipse, or confidence region, as shown in Fig 2.


Fig. 2

Consequently, hedging each exposure separately will result in substantial over-hedging. This argument also makes intuitive sense. If Euro costs and yen interest rates are negatively correlated, they tend to move in opposite directions, that is, when yen interest rates are high, the Euro tends to be weak, and vice versa. Thus the two exposures tend naturally to offset one another. As such, the hedge should cover only the instances where this relationship might not hold - a full-blown hedge of the two exposures is not needed.

Another integrated hedge structure that takes advantage of the economics of the situation and provides a more appropriate hedge is a yen semi-fixed swap with a Euro trigger. In this instance, the company enters into a swap where it receives floating-rate yen and pays one of two rates (Fig 3). It pays a below-market rate when the Euro is strong and the company is in a less favourable financial position, due to the increased cost of purchasing Euros.


Fig. 3

But when the German currency is weak and the company spends less yen in buying Euros, it will pay a higher coupon - at the exact time it can afford to do so.

Unfortunately, many corporate treasuries are not designed to look at exposure management on an integrated basis. Often, one department is in charge of interest rate risk management while another looks after foreign exchange risk, and so on.

While such divisions of labour provide more market focus, they fail to take advantage of some naturally offsetting exposures in the business and lead the company to forego the benefits of a portfolio approach to risk management.

A move towards a comprehensive approach to risk management, including efforts to integrate various hedging activities, could require political as much as financial skills. Some parts of a company that see it as an encroachment on their territory and/or a dilution of their independence and authority may resist it.

Sometimes, treasurers and senior management ask whether their hedges are making money. But that is not the question they should be asking. The return they should expect on a "fairly" priced hedge is simply the cost of putting that hedge on. To illustrate the point, consider the case of a company with a floating-rate loan whose rate (Libor) will be set in three months.

The company has a number of alternatives:

  • It can do nothing and live with the uncertainty of where the rate will set;
  • It can enter into a forward rate agreement (FRA) and fix the interest rate, thus removing all uncertainties;
  • It can buy an interest rate cap, thus keeping all its upside should the rates be set below the cap strike, while limiting its downside to the cap strike. In return, the company pays the cap premium;
  • It can buy an N-cap (a standard cap with two strikes that depend on the setting of Libor) and pay a lower premium. In this case, the company keeps all its upside. However, the protection is reduced if the rates are set above the barrier level of the N-cap;
  • It can use a collar strategy by buying a cap and selling a floor. The premium from the sale of the floor is used partly or completely to offset the cost of buying the cap. While the collar strategy would limit the company's downside risk, it would also require it to forego some of its upside;
  • Finally, it could buy limited protection by purchasing a "corridor", ie, buying one cap and selling another with a higher strike. In this case, the company keeps all its upside but has limited protection against rising rates - up to the strike of the second cap.

All these hedging alternatives, if fairly priced, will have the same expected value. In other words, using probability jargon, if the company follows any of the above strategies, in the long run it is expected neither to make nor lose money. This begs the question of what is accomplished through hedging. In effect, the distribution of the outcomes is changed.

In the above example, each hedging strategy results in a different distribution of outcome. If the company follows the first alternative, it will be exposed to the full range of values that Libor can take. On the other hand, the second alternative of entering into an FRA reduces the distribution of the possible outcomes to a single value, thus eliminating all uncertainty. With the third choice, that of a cap, one tail of the distribution collapses, thus limiting the downside for the company. Fig 4 illustrates the various distributions of the outcomes for the different hedging strategies.

Fig. 4