Hello Hedgers!
What can a CFO or treasurer do to hedge currency exposure in this current market situation?
From a technical analysis point of view, it seems that the increases in the exchange rate over the past two weeks are only a technical correction as part of a downward trend.
EUR/USD, Weekly graph
October 20, 2021
Source: NetDania
Yet, decisions on whether to hedge or not shouldn’t be based on technical analysis but instead on a systematic currency risk management policy.
However, the discretion of a CFO or treasurer about choosing the preferred hedging instrument from many alternatives is proper and accepted among companies engaged in the import and export of goods and services.
Since no one really knows the future exchange rate trend, we will represent hedging alternatives for importers and exporters.
In addition, we will present possible consideration examples for choosing a hedging instrument, both for importers and exporters.
Use case:
- Company A – exposed to the decline in the EUR/USD exchange rate.
- Company B – exposed to the rise in the EUR/USD exchange rate.
Company A’s CFO and Company B’s CFO are obligated to execute hedging transactions today, under their company’s currency risk management policy.
Both agree that the EUR/USD exchange rate rise over the past two weeks is only a temporary technical correction as part of a downward trend.
Given the above, what hedging strategies can the two companies’ CFOs implement?
The basic hedging alternative is a forward transaction, and it serves as a benchmark for any other hedging transaction.
Company A
Company A’s CFO, whose company is exposed to a decline in the EUR/USD exchange rate, believes that the trend is a downward trend. Therefore, he is interested in hedging as close as possible to the forward rate.
He is willing to protect on a slightly lower rate than the forward rate in exchange for the possibility of an upside if the exchange rate trades against the exposure direction, i.e., an exchange rate will rise. From his point of view, the upside is that in the scenario of an exchange rate rise, the hedging instrument will not create a loss.
The implementation is a Forward Extra hedging strategy:
Spot: 1.1627
Forward rate for half a year: 1.1677
Strategy characteristics
- Company A has the right to sell euros and buy dollars at the exchange rate of 1.1618. I.e., Protection from a rate that is 0.5% lower than the forward rate.
- An obligation to sell euros and buy dollars is also at the rate of 1.1618, but it is a conditional obligation. The obligation will kick in only if on the expiration date and at a specific time, the spot rate will be equal to or higher than the trigger rate of 1.1880.
If the exchange rate at the expiration date is, for example, 1.1879, then company A has no obligation to sell the euro at the exchange rate of 1.1618. Therefore, the hedging strategy will not result in a loss, and the company will benefit from the high spot rate.
Company B
Company B’s CFO, whose company is exposed to a rise in the exchange rate, apparently enjoys seeing the downward trend since May 2021. That is because the exchange rate has traded against his company’s exposure direction.
The current exchange rate is probably comfortable for him; however, he will enjoy another drop. He also believes, as mentioned, that the trend is a downward trend. Therefore the CFO is not interested in fixing the current forward rate through a forward transaction.
A possible hedging alternative for him is a wide “Risk Reversal” strategy. To create it, the CFO will set a “must-have” protected rate (call strike), which is higher than the forward rate.
The higher the call strike (comper to the forward rate), the lower is the put strike. That is, if the exchange rate does trade in a downward trend, the hedging transaction will only start to create a loss after the exchange rate falls relatively significantly.
The implementation is a Risk Reversal hedging strategy:
Spot: 1.1629
Forward rate for half a year: 1.1681
Strategy characteristics
- Protection – Company B has the right to buy euros and sell dollars at the rate of 1.1914. This rate is 2% higher than the forward rate.
- Obligation – Obligation to buy euros and sell dollars at the rate of 1.1436. This rate is about 2.1% lower than the forward rate.
The strategy protects a rate that the CFO has defined as a “must-have” protection rate, and in return, can benefit from a fall in the exchange rate to 1.1436. Thus, this implementation aligns with his CFO’s belief that the exchange rate trend is downward.
Pre-execution stage
To plan and examine hedging alternatives before execution, a CFO or treasurer would do well to use a ???? currency derivative pricing calculator.
Since most of the hedging is done in the OTC market, prices are not transparent to all market participants. This “see” the prices a calculator alone will not be sufficient. The calculator must be input with market data from the OTC market, emphasizing on implied volatility (standard deviations).
Post-execution stage
Another advantage of this ???? calculator is the ability to calculate the position value in real-time. And more than that, determine the currency derivatives value for financial reporting without hiring an external value appraiser.
Disclaimer:
This post does not constitute advice or recommendation.
Anyone who uses the information presented here does so at his own risk.
‘Calc fellow’ is not a consulting firm and does not provide a liquidity source for derivative transactions.
‘Calc fellow’ provides tools to companies to help them manage their currency risks (Software as a service). We offer a derivative pricing calculator. We also offer policy tracker and FX derivatives inventory management tools.