17 05. 2016
Optimal Hedging Strategy for Corporate
According to certain historians, contracts for future delivery of commodities can be traced as far back as the Roman Empire. However, use of derivatives as risk management instruments by corporates probably commenced during the 1970s and grew exponentially through the past few decades. Common uses of financial derivatives by corporates include hedging for
- FX exposures resulting from international trade
- Interest rate exposures arising from floating rate loans
- Commodity price exposures from production / manufacturing inputs (e.g. steel, oil and coal)
Based on semiannual OTC derivatives statistics compiled by the Bank for International Settlements, notional value of OTC derivatives has shrunk by almost 30% from USD 673 trillion in June 2008 to a recent low of USD 493 trillion in December 2015, in part due to a decline in interest rate contracts by non-financial customers (likely due to the low interest environment globally). Regardless, there is no doubt that swaps and other derivatives will continue to be important tools used by corporates to hedge against financial turmoil, especially in light of the recent plunge in commodity prices.
Global OTC derivatives notional amounts outstanding (USD Billion)
Many companies are guided by a fundamental risk management principle which dictates using financial hedging instruments solely for mitigating overall financial risk exposure and reducing earnings and cash flow volatilities. For most international Public-Private Partnership (PPP) projects, it is market practice to execute a 100% hedge for the full term of the project, especially if no natural hedges exist. However, whereas a well-executed hedge will yield financial and operational benefits, a poorly designed one may be costly and ultimately value destructive. In particular, there are several hedging issues which companies will do well to take note of.
1) Understanding the hedge rationale
It is not uncommon for a debate, amongst senior management and board members, on the costs vs. upside of a hedging program to evolve into an argument on various macroeconomic possibilities (e.g. will the Feds adopt negative rates, will OPEC succeed in raising crude oil prices etc.). Such arguments tend to be counterproductive as it is impossible to predict with any degree of accuracy how macro events will ultimately play out. Rather, management may benefit from better understanding the sensitivities of business margins and cash flows to different drivers (e.g. raw material prices, financing costs etc.) and hence identify potential material risks to the company under different scenarios. This will help to ensure that time and focus are spent on hedging material net risk exposures (e.g. avoid cash shortfall for critical capital expenditure) rather than on arguing about uncontrollable events or seeking to eliminate all risk exposures (regardless of impact to a company’s performance).
2) Selecting a suitable hedge ratio
A 100% hedge may sound appealing to companies seeking to avoid earnings volatility (especially those facing shareholders’ scrutiny) but may in fact be difficult to achieve and non-ideal in practice due to
- Market structural constraints (e.g. odd notional amount)
- Need to maintain flexibility (e.g. allow for loan prepayments)
- Marginal improvement in the overall risk profile vis-à-vis incremental transaction costs
Under certain circumstances, over-hedging (e.g. due to unscheduled prepayments on an underlying loan exposure) may also result in expensive hedge termination fees or negative P&L impact (i.e. when the company has to take the mark-to-market valuation impact of the excess hedges through its income statement).
As such, determination of an optimal hedge quantum may need to take into consideration industrial norms as well as the specific business model and operating environment unique to each company and will often require management’s sound judgement rather than based solely on a formulaic outcome. In addition, adopting a suitable range of hedge ratio may allow the company’s treasury staff to possess greater operational latitude and avoid unintentional breaching of policies.
3) Selecting the hedge counterparties
There are generally two main approaches which a company can take in executing the hedges:
- Appoint a single coordinating bank
- Manage a competitive process (with multiple bank counterparties)
Bankers typically pitch the first approach to their corporate clients, especially those who are using hedging instruments for the first time, as a less complicated process and involving less administrative overhead. Whereas there are advantages to appointing a single coordinating bank, above all avoiding the hassle of negotiating ISDA agreements with multiple counterparties and being able to complete the entire hedge in a single transaction, the latter approach which involves executing the entire hedge quantum in smaller tranches, may yield certain benefits:
- Achieve transparency, control and “best pricing” (i.e. by executing a tranche with the bank offering the best quote)
- Ability to manage bank relationships and ensure participation by key banks
- Less likelihood of credit and counterparty risk concentration by controlling the share of hedge transaction awarded to each bank counterparty
- Compare mark-to-market valuations provided by different banks
In summary, the competitive process may help to achieve better pricing, greater control over the hedge counterparties (that the corporate wishes to deal with) and better management of credit and counterparty risks.
A holistic approach towards effective risk management should go beyond simply relying on hedging instruments to remove sources of volatilities which lie outside of a company’s core expertise and control. Other strategic tools which management can potentially deploy include negotiating for better pricing power (especially for companies operating in highly regulated industries where tariffs are revised periodically based on the cost of capital) and building more flexible operational capabilities (i.e. to cut output in tandem with rising costs or raw materials).