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Containing the Cost of Hedging

By October 31, 2019 December 20th, 2019 No Comments

Zeroing in on the cost of carry can help companies get a handle on hedge costs.

Volatile markets require an effective hedge program while ensuring the cost is reasonable for the level of risk reduction. At a recent FX Managers’ Peer Group meeting, in a session co-led by a member and a sponsor’s risk advisory team, the group pondered ways to contain the cost of hedging and the trade-offs.

A critical takeaway was that one of the first things practitioners must do is to consider the cost of carry. This is determined by the interest differential between the two currencies in the hedge (this, rather than basis spread, is the main driver of carry cost). In the currency market environment at the time of the meeting (September), that would indicate favorable hedge costs for long G10 exposures (ability to lock in a hedge gain with a forward contract) while hedging emerging markets (EM) currencies the same way would result in a loss. For companies with primarily short FX exposures, such as the presenting FX member, the scenario would be the opposite.

What’s your hedge “value for money?” Another way to view cost is using the ratio of dividing the carry gain or loss by the implied volatility for the considered hedge period. The higher that ratio is, themore value for money it is to hedge that currency risk. This ratio varies over time and can often tip from favorable to unfavorable, especially in EM currencies. And, the more volatile the currency, the more the timing of the hedge transaction matters.

What about correlation? Members were shown how the carry cost of developed markets (DM) currencies were strongly correlated to 3-month USD Libor where carry cost of EMs were not. Not only that, but because short-term rates are linked to economic cycles and central bank policies, forecasted rates changes are, more often than not, better indicators than forward curves. As one banker noted: “It’s good to look at forecasts, because banks are not always wrong.”

What’s the implication for corporate hedging? Because of correlation effects, offsetting exposures generally benefits those with both long and short exposures. For one member who revealed primarily short FX exposures, it pays to consider groups of currencies more, in this case DM/G10 vs. EMs. In periods like those of the last 12 months, when EM currencies have been negatively correlated vs. the USD, and the size of the exposure relative to the G10s is lower, there is a case for little to no hedging, unless a gain can be locked in from the get-go. For more material exposures (G10 for this company) where the correlations are also higher, a more careful approach is needed when the FX team is also mandated to contain the cost of hedging.

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Christina Popik

Author Christina Popik

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