Published: 13 April 2007

Uncover the Value Drivers of Your Hedging Strategies   
By Anders Åslund, Commerzbank AG (Originally published in The Euromoney Foreign Exchange & Treasury Management Handbook 2007)  

A well-designed hedging strategy and approach aligned with corporate requirements is incredibly valuable. Moreover, it enables more effective communication about the business and economic rationale for the use of derivatives in hedging treasury risks.    
 

Corporate treasury risk management is an incredibly complex area. It requires a thorough multidimensional and multifunctional understanding of the company including its internal and external environment and its exposures to the financial markets.

Moreover, corporate strategy, operational infrastructure, risk exposure and risk appetite are some of the factors that determine the appropriate approach to corporate treasury risk management, and they are all company specific.

Consequently there are no 'one size fits all' solutions. This is particularly true with regards to hedging strategy and approach - a key treasury activity with strategic implications.

Hedging - a Key Strategic Decision

Hedging can contribute greatly to a company's success and value creation. It also has the potency to destroy value; hedging/absence of hedging has been a key factor of some companies' demise, so it certainly warrants some serious thinking and consideration.

Approaching hedging as a strategic issue requires a structured, rigorous and analytically based approach. For example, perhaps a 40/60 floating/fixed mix and hedging 70% of foreign exchange exposure the next 12 months is the right hedging strategy, but why? A typical answer to this question indicates that hedging strategies sometimes are based on a mix of intuition, rule of thumb, informal benchmarking of a peer group of companies, and previous experiences.

All of these are important factors that should be taken into account. After all, corporate treasury risk management is as much akin to art as science given the company specific mix of numerous hard and soft factors that determine the appropriate approach.

However, combining these with a rigorous analytical approach will ensure a hedging strategy and approach that is aligned with and contributes to the corporate strategy and ultimately creates value for the company and its stakeholders.

It will also generate valuable insights that enable more effective communication with external and internal stakeholders on the economic and business rationale for the use of derivatives as hedging tools. An increasingly important aspect of treasury risk management given the increased transparency and disclosure required by IAS39/FAS133.

How Does Hedging Add Value, If At All?

As mentioned, hedging has the potential to create significant value, but it also has the potential to destroy value if it is not based on an appropriate strategy.

Locking in the entire US dollar cost base only to watch the US dollar depreciating, while the company's competitors have chosen not to hedge their US dollar cost base, could severely impact a company's competitive position.

It could even threaten its survival in extreme cases. Leaving all debt floating at a company that experiences counter cyclical cash flows with weak financial performance coinciding with a high interest rate environment could negatively impact a company's access to funds for working capital and capital investments, at a time when it potentially needs it the most.

There are plenty of academic articles and other papers suggesting that hedging is not a value adding activity. The main arguments for this position typically are:

• By holding diversified portfolios investors/shareholders have a cheaper and more effective and cost efficient tool at their hands, to mitigate any specific/unsystematic/diversifiable risks.
• Hedging has to produce improved risk adjusted returns to be value generating, not merely reducing earnings or cash flow volatility. This is impossible/difficult given the cash and opportunity costs of hedging and the efficiency of financial markets in pricing risks and disseminating information.
• It is rare that companies have privileged and valuable information about markets and risks.

Nonetheless, there are equally good arguments for why and how hedging can add value, given an appropriate hedging strategy and approach. As a matter of fact, most companies choose to manage their treasury risks more or less actively, which in itself is a compelling indication that hedging is a value adding activity. For instance, hedging can generate value in the following ways:

• Hedging can both increase borrowing capacity and increase the flexibility with which companies can access funds for investments. As a consequence, this enables them to make investments in positive NPV projects when such investment opportunities arise, regardless of timing in the corporate and credit cycle;
• Hedging can reduce tax liabilities in countries with progressive tax scales;
• Minimising earnings and cash flow volatility could reduce expected costs of financial distress and conflicts of interest between bond and shareholders in highly leveraged and/or financially distressed situations; and
• Companies do have privileged and valuable information about their markets and risks that enable them to effectively and efficiently mitigate these risks.

There are clearly valid arguments to be made that a company can both over and under hedge. In approaching hedging as a strategic issue, both of these differing positions need to be considered.

Exploring the company specific merits and relevance of these arguments generates valuable insights that a value adding hedging strategy should be based on.

Hedging Policy - the Neutral Position and the Appropriate Flexibility/Hedging Band

A hedging strategy has both short, medium and long term implications and is typically an imperfect solution driven by sometimes conflicting objectives.

The holy grail of any hedging strategy formulation is to determine the right level of hedging that balances these conflicting objectives, the neutral position, and the flexibility or band around that neutral position that is appropriate.

In other words, to define the crucial parameters which translate a hedging strategy into actionable guidelines and measurable benchmarks.

In understanding the value drivers of a company's hedging programme it is important to recognise that hedging an exposure does not necessarily reduce or eliminate the risk, but most likely transforms one risk into another.

For example, by hedging forecasted foreign exchange exposure price risk is transformed to forecast risk. In addition, all hedging has the potential to alter a company's competitive position, for better or worse.
 

Exhibit 1: Neutral Position

source: Commerzbank Corporates and Markets
 

Exhibit 2: Hedging Flexibility

source: Commerzbank Corporates and Markets
 

A Framework for Determining an Appropriate Hedging Policy

I propose a framework for how these questions could be approached analytically in a structured way in order to explore how a new or an existing hedging strategy adds strategic value.

This framework and approach is developed by leveraging the main arguments for and against hedging. It assumes that a thorough treasury risk map has already been established and an in-depth understanding of the company's inherent treasury risks.

This is an important point as hedging of any exposures that are not properly identified or thoroughly understood is just as likely to magnify as mitigate risks.

The following is conceptually the logical sequence of this approach, but in practice it is likely that some iteration is required to gradually solidify some of the views and decisions as more insight is gained throughout the process.

Step 1: Determine the objective with the hedging policy

A natural starting point is to determine the objective with the hedging policy for the relevant treasury risks. This needs to be aligned with the overall corporate strategy. There are several, potentially conflicting, aspects to consider doing so, including:

• In what order of priority is the aim to hedge earnings, balance sheet, cash flow and economic value?
• Is the objective to postpone market price impacts, reduce volatility or to beat the market by, for example, securing cheap funding and/or locking in cyclically favourable foreign exchange rates and/or commodity prices?
• How to balance the risks and benefits of hedging treasury risks between the company's main stakeholders: shareholders, bondholders and other debtors, management and employees?
• Any restrictions and/or sensitivities that would need to be taken into account such as, for example, taxation, accounting, treasury resources/budget, operational issues, organisational and legal structure?

Step 2: Explore the potential value drivers for/against hedging for each relevant treasury risk

Key questions that are important to answer in order to understand how hedging could add value for a specific company include the following:

• Cyclicality of industry/company - Is the industry and your company cyclical, counter cyclical or non-cyclical?
• Financial leverage - What's the level of debt relative to equity capital?
• Operational leverage - What's the level of fixed versus variable operational costs?
• Competitive position - To what extent is the company a price taker or price giver in its input and output markets?
• Competitors' risk map - What are the key treasury risks of your competitors?
• Competitors' hedging strategy - To what extent do your competitors hedge their treasury risks?
• Shareholder base - Is your company's base of shareholders concentrated or broad?
• Shareholder objective - To what extent is the objective of your shareholder base to gain exposure to energy, commodity, FX and/or IR risks?
• Risk tolerance - What are the critical levels of FX and IR rates and commodity prices etc. that would risk your company's survival?
• Risk appetite - To what extent is your company's Board and management willing to accept the inherent treasury risks?
• Access to funding - To what extent do FX and IR rates and commodity prices etc. impact your access to funding throughout a business cycle?
• Natural hedges - Identify any internal, natural and operational hedges in order to only hedge net positions in the financial markets.
• Dynamic effects - To what extent is there an impact in demand for your company's products/services, for example, a high/low US dollar or euro, in addition to any transaction and translation risk?

As is evident, it will require significant work to answer these questions thoroughly. It is likely to involve quantitative modeling and would require consultation and involvement with people outside the finance and treasury departments.

In my view, exploring and documenting these aspects thoroughly and determining how hedging, or no hedging, could add value is the most important aspect of designing a new, or reviewing an existing, hedging policy.

Step 3: Determine the significance of each value driver for your company

The significance of the factors discussed in Step 2 are company specific. So, it is important to ascertain the relative significance for your company in order to ultimately conclude a well-balanced value adding hedging policy, given the objective and restrictions with hedging (Step 1).

Step 4: For each of these value drivers determine the suggested hedging policy (e.g. hedge 0%, 100% or anywhere in between those extremes)

This is probably the aspect of designing a hedging policy that is, by necessity, as much of an art as a science.

It is probably not possible to determine exactly what extent of hedging is 'perfect' for each of these factors apart from, possibly, the extreme cases when hedging none, or all of the exposure makes obvious sense.

Nonetheless, by approaching this in a structured way, engaging the right people and deploying appropriate data modelling, it is more likely that a meaningful conclusion is reached of what the hedging response to each of these factors should be.

Step 5: Establish the significance weighted hedging policy - the neutral position

By synthesising the outcomes of Steps 3 and 4 it should be relatively straight-forward to conclude a significance weighted hedging policy, i.e. a neutral position for each treasury risk.

The neutral position applies to a pre-determined time horizon for each risk. This is an important point since if either time horizon or hedge ratio is altered it effectively achieves the same thing, departure from the neutral position.

The neutral position effectively becomes an internally established benchmark that can be used both proactively, to determine appropriate hedging activity, and retroactively to ascertain if past hedging has been optimal, and consequently value generating.

Step 6: Determine the appropriate flexibility/hedging band, given the hedging objective and restrictions, around the neutral point

Once the neutral position has been established it should be considered if it is appropriate to add any flexibility or hedging band to it.

Hedging Objectives

The following are three typical hedging objectives that I am using to illustrate how they would translate to hedging policy flexibility and what the general pros and cons with them could be.

The hedging objectives and hedging strategies can of course vary for different treasury risks within a company. A company may well adopt Strategy I for their foreign exchange risk hedging and Strategy III for their interest rate risk hedging.

Strategy I: Secure short-term committed exposures

This strategy could, for example, entail hedging a fixed level of committed foreign exchange flows for the next three months or swapping a pre-determined part of floating debt into fixed for the budget year ahead. It predominately aims at achieving short-term certainty.

It buys a corporate time to adjust its operational and/or pricing strategy in order to offset impacts of changing market prices, such as foreign exchange and interest rates and commodity prices.

This strategy does not in itself reduce volatility of either earnings or cash flows, it merely postpones the impact. In order to benefit fully from this, operational management must take advantage of the time window created by treasury to adjust operations and/or pricing.

Consequently this requires well-developed communication between treasury and operational management.

Furthermore, this strategy does not aim at achieving any improved rates in the sense of attempting to time hedging transactions to take advantage of favourable market conditions. As such it does not require as close monitoring of the markets, or the same level of treasury infrastructure as Strategy II and Strategy III.

This could be regarded as a relatively passive risk management approach and would have no/limited flexibility/hedging band attached to the neutral position and typically also a fixed time horizon for hedging (see Exhibit 3).
 

Exhibit 3: Strategy I - Secure short-term committed exposures

source: Commerzbank Corporates and Markets
 

Strategy II: Reduce volatility

This strategy could involve hedging committed and forecasted foreign exchange flows for the next three, six or 18 months or swapping floating debt into fixed debt.

It differs from Strategy I in that it aims at predominately reducing earnings and/or cash flow volatility over time and could also be combined with an objective of hedging the risk of extreme levels, i.e. levels that could potentially severely impair the competitive position of the company.

This strategy is likely to be adopted by a company with a somewhat higher risk appetite than Strategy I as it requires treasury making, within approved policy limits, the right decisions on both timing and extent of their hedging transactions.

The fact that this strategy is operationally riskier than Strategy I does not automatically mean that it is less appropriate. Again, my view is that treasury risk management is company specific, and it may well be appropriate and rational for a company to accept a higher risk profile.

This strategy requires regular monitoring of the markets and an active evaluation of risks and opportunities. Consequently it demands a more developed treasury infrastructure and controls than Strategy I.

This could be regarded as being an active or pro-active risk management approach. As mentioned, it requires more flexibility than Strategy I, and so the hedging band around the defined neutral position is wider (see Exhibit 4).
 

Exhibit 4: Strategy II - Reduce volatillity

source: Commerzbank Corporates and Markets
 

Strategy III: Achieve best rates/beat the market

This strategy differs from both Strategy I and Strategy II in that the objective is to opportunistically attempt to lock in rates when they appear to be at favourable levels in the cycle.

For example, in order to achieve cheap funding or to fix foreign currency denominated cash flows at rates that are at cyclically high or low levels.

In order to achieve this, the treasury policy will need to allow significant flexibility in regards to how much foreign exchange and interest rate exposure (and other treasury risks) to hedge, and/or how far in the future treasury can hedge cash flows.

For example, it could result in being mostly/completely unhedged/floating during long periods and during other segments of a cycle/trend it could result in hedging/fixing most/all of its exposure.

This is clearly the riskiest of the three hedging strategies described. If treasury's view of the markets and its risks and opportunities is proving to be wrong it could generate the worst rate, not the best.

The company could get locked into unfavourable interest and foreign exchange rates. Again, an operationally riskier hedging strategy may well be both appropriate and rational for a company, so the fact that it is the operationally riskiest of the three strategies examined does not automatically make it the least appropriate.

This strategy requires constant monitoring of the markets and equally constant evaluation of risks and opportunities. Consequently, of the three strategies it demands the most developed treasury infrastructure and a rigorous controls framework.

This strategy could be regarded as being a pro-active/aggressive risk management approach. As mentioned, it requires more flexibility than both Strategy I and Strategy II and consequently the hedging band around the defined neutral position will be relatively wide (see Exhibit 5).
 

Exhibit 5: Strategy III - Achieve best rates/beat the market

source: Commerzbank Corporates and Markets
 

Increased Disclosure on Risk Management and the Use of Derivatives

In addition to ensuring that a hedging policy is aligned with corporate strategy and contributing to the value generating process, a structured and analytical approach to designing a hedging policy generates valuable insights.

This enables more effective communication with internal and external stakeholders about the economic and business rationale of the chosen hedging strategy and the use of derivatives.

Given the demands for increased disclosure as a consequence of IAS39/FAS133 investors, equity analysts, credit rating agencies, banks and the business press are increasingly enquiring into why and how companies are using derivatives to hedge treasury risks.

Information perceived as being incomplete and/or ambiguous has the potential to have negative implications on share price performance.

Providing confident and easily understood information in regards to complex issues such as hedging policy, the use of derivatives, plain vanilla or complex, and the volatility they potentially generate in accounts is ever more important.

This mitigates risks that some equity analysts, credit rating agencies and banks fail to appreciate the value that is added by a well designed hedging strategy and the use of derivatives in hedging treasury risks.

Conclusion

Recognising that hedging is a strategic issue the process of developing a new or reviewing an existing hedging strategy should involve a rigorous analytical approach, with the value drivers fully explored and understood.

The approach and framework I am proposing in this article is designed to generate a solid, appropriate and value generating hedging strategy taking the specific conditions of a company into account. It is a structured and analytical approach that explores the potential key value drivers of a hedging strategy and it generates valuable insights about these.

To summarise, this approach:

• ensures a hedging strategy that is aligned with corporate strategy and contributes to the value creation process; and
• enables more effective communication about the business and economic rationale for the use of derivatives in hedging treasury.

ACTSA welcomes your questions and opinions on relevant treasury topics, so please feel free to have your say by posting your comments on the ACTSA Discussion Forum.

Article courtesy of www.GTNews.com