Currency management with financial instruments during the crisis

With sharp volatility increases in the currency markets, the urgency for hedging measures has grown strongly. These price changes also offer alternative ways beyond the traditional and inflexible "concrete" hedging solutions.

Since 2008, the currencies of the world have been on a veritable rollercoaster ride. A look at the forecasts being used by the professional players in the market shows the current lack of consensus and that anything is possible. For the next 12 months, the highest projections put the EUR/USD exchange rate at 1.6000, while the lowest come in at 1.0750. Consistent with this, the medium-term forecast lies precisely in the middle, although there are certainly no expectations that exchange rate developments will be smooth!

Figure 1: Reuters-FX forecast EUR/USD

Since interest rates are at similar levels in the US and the euro area, the spread cannot be used as a significant indicator for future rate movements (current rule of thumb: spot = forward)^[1]. It is often said nowadays that exchange rates increase arithmetically, but fall geometrically^[2] (figure 2). This asymmetry in exchange rate developments is among the most difficult factors to predict. 

Figure 2: Plot – arithmetically rising and geometrically falling exchange rates (USD/CHF).

With all of the uncertainty out there, however, the markets may not permit the common approach that says “we have to take our time with this,” or “in a few days, I’ll talk over some ideas with the bank”. Figure 3 clearly shows that the EUR/USD exchange rate in 2008 statistically underwent changes of +/- 200 points in a matter of days (e.g. 1.3000 → 1.3200). One year previous (blue), the probability of this was substantially lower.

Figure 3: How many days did it take for a statistical change of 200 points?

(Probability of EUR/USD +/- 200 pip change 2007 vs. 2008)

Consequently, anyone putting off hedging transactions can end up being penalized with an unfavourable rate. Of course, the volatility also represents an opportunity, and not everyone is an exporter, there are importers out there as well. Waiting and hoping for “better conditions”, however, is more than just prudent caution – it’s speculation.

Companies are not only faced with the erratic swings of the forex markets, there are real economic factors at play as well, like:

1. Bankruptcies of suppliers or clients; to be found, e.g. in the automobile and mechanical engineering industries
2. Forecastability of sales; fall-off in exports by 20-40% in some regions & sectors; elimination of production capacities
3. Relative competitiveness; The currencies of countries on all sides of the euro area are on a downward slide

The idea that “crises call for new approaches” is certainly valid in this context. A return to conventional home currency invoicing or simply hoping for better conditions (i.e. doing nothing) is no alternative.
So, what are the “new approaches” in light of the current situation?

1. Hedging is a virtue!
2. Not only concrete solutions in the form of currency forwards should be taken into account, but also incorporation of participation (= return potential)
3. Longer maturities (in excess of 9 months), for strategic reasons, beginning on 1 January if possible.

Below is an example that will hopefully make the process more clear:

The monthly volume of USD 1 million is the continuous base amount. Any so-called “peaks” that exceed the base amount are either left open, in the case of minimal volumes, or hedged short-term via forwards or options.

In the case of order-specific transactions, a longer-term hedge overlay may also be taken into consideration. Often, an aggregated base amount can be calculated on the basis of several orders (e.g. in the steel, mechanical engineering industries). Derivatives can be used as a supplement to bring forward or postpone a hedging transaction, which also serves to increase flexibility in this context.

What about an example using actual figures?

In sals.a, the hedged transaction (Exports to the US) is captured using the menu item “FX Free-Cash-Flow”:
Without hedging, the current (as per 23.3.2009) monthly receipt of USD 1 million equates to the EUR sum in the column “Amount Currency2”.

In order to flexibly hedge this transaction, two financial instruments are now used:
1) A forward currency transaction (hedge): sale of USD 1 million/month at a fixed rate of 1.3000

2) Purchase of a EUR/USD put option (participation in the falling EUR/USD exchange rate): the option to buy USD 1 million monthly at a rate of 1.2600

This strategy comprising transactions 1 & 2 is not cost neutral: As can be seen in the “NPV 1” fields, the net present value of the two transactions results in a premium of [EUR -167,549 + 430,476 =] approx. EUR 263,000. The premium is payable by the customer up front for this hedging solution.

The key to calculating the premium is the option volatility, which increases in line with quoted volatility (implicit volatility) on the market.

In summary: Without hedging, the exporter has no planning reliability, since the EUR/USD exchange rate (based on the forecasts) can move within a range of 1.6000 to 1.0750. Figure 4A shows the potential risks and rewards of exchange rate movements without hedging. The brown line indicates the maximum and minimum forecast values from the latest Reuters poll.

Figure 4: Situation prior to (A) and after (B) hedging

Figure 4B illustrates the maximum exchange rate risk spread after flexible hedging with integrated participation. The exporter has reduced the maximum risk from foreign currency payments to a corridor between the option price (1,2600) and 1,3000 (red area).

Various exchange rate development scenarios:

1. The exporter is protected in the case of market rates above 1.3000: If the exchange rate for EUR/USD is, e.g. at 1.3800 on the payment date, the effective exchange for the customer is 1.3000.
2. As long as the EUR/USD rate is within the corridor on the payment date, the forward rate of 1.3000 applies for the exchange – which is roughly 240 points higher than the current market rate.
3. If the rate is below 1.2600 on the payment date, the participation takes over. The participation was acquired (= purchase of EUR put option@1.2600) through forfeiture of the forward market rate starting at 1.3000 and payment of an upfront premium.
4. The buyer, however, does not benefit 100% from a lower market rate. If the rate is, e.g. 1.2200, the following final rate applies for the customer:

   [1.3000] minus [option proceeds (1.2600 – 1.2200) = 400 points] = 1.2600

In practice, the parameters for the hedging solution can be approached as set out below: The exporter should ask the question, “What is the maximum amount in EUR that am I willing to lose from currency translation in one year?” This figure (usually relatively small) is equated to an exchange rate. For the planned hedging transactions, this serves as a worst case or reference level.

The exchange can be calculated as follows: On the basis of the forecast rates (minimum, maximum, median forecasts and rates in between) we determine the monthly upward/downward movements in comparison to the initial rate (spot price). The monthly sub-totals are added together, in order to generate an isolated scenario for the impact on profit and loss for one year.

The scenario results (12-month observation) can thus be assigned to the correct exchange rate level (see adjacent table) If the exporter is willing to accept, e.g. a maximum loss of approx. EUR 280k, this equates to a hedging level of EUR/USD 1.3000.

Based on the above example, practical alternatives can be structured with lower premium payments or without additional payments. The table below shows three possible alternatives:

Ultimately, a consultation between the customer and a bank is required to determine the optimum solution. This should include a clarification of the changes in market value under the various structures. In the second two alternatives, the customer comes very close to the postulated premium-neutral hedging with participation.

These long-term flexible hedging strategies can be summarized under the heading “hedging volatility peaks without forfeiting market rate opportunities”.

Figure 5: Long-term flexible hedging

The red line depicts the worst case hedge. The green areas indicate the participation range.

The right selection of currency scenarios enables a meaningful simulation of potential risks and rewards from currency positions. A reasonable question in this context however, is: What does such a scenario entail?

This is the topic of our next issue in May.

1. Some experts consider fundamentals (GDP, stimulus programmes, bank recapitalisation etc.) to be more significant indicators.
2. The Economist 22 January 2009: “In 2007 Dick Fuld, the former head of Lehman Brothers, observed that whereas credit grows arithmetically, it shrinks geometrically.Much to his cost, he was later proved right.”