FXRegionalRisk Management

The Option to Use Options: Hedging FX Risk in Emerging Markets

By July 1, 2021July 4th, 2021No Comments

FX risk managers rely on flexibility at a multinational that wants to participate in beneficial currency moves.
 
The ability to use options is essential for an FX risk manager at one NeuGroup member whose company wants to participate in favorable currency moves when hedging exposures in emerging markets. He described the company’s approach at a spring meeting sponsored by HSBC.

  • The bank cited research showing that “the incentive to hedge EM risk has increased over the past 10 years” and “bouts of EM currency weakness have become more frequent and recoveries less marked.”
  • “It has been worth spending the carry on [Latin American] and [Central and Eastern Europe, the Middle East and Africa] currencies,” the HSBC presentation said.
  • However, “passive blanket covering is too onerous over the long run,” according to the bank. “A tactical approach” creates a better balance of “risk reduction vs. the cost of hedging.”

The optionality option. The NeuGroup member’s tactical, opportunistic approach includes options, which can allow the company to benefit from market volatility. “We really do value the ability to participate, so we really like to use option structures to help us in emerging markets,” he said.

  • Because the company reports earnings in US dollars, “I protect against strong USD and try to benefit when the dollar weakens,” he added. The company does not want to “miss weak dollar cycles.”
    • “By using options, if the [EM] currency appreciates, I’m only out the premium spent and I can continue to gain on the underlying exposure,” he explained.
    • “It is really a risk management strategy whereby the company is comfortable with spending some amount of money to protect earnings while still being able to gain in the event the currency moves in our favor.”
  • The member favors using options to hedge high-carry currencies, usually over a three-month time frame. He first considers, separately, each currency where the company has major exposures. The countries include Brazil, South Africa, China, Mexico and Chile.
  • It then creates a portfolio of the entire bucket of EM currencies it hedges and examines “how we’re doing relative to year-over-year,” the member said.
  • “We’ve done a lot of back testing with HSBC and other partners to look at our portfolio of emerging market currencies, trying to establish an efficient frontier,” he said.

Balancing act. In response to a question from a peer about indicators, the member said the FX team has regular meetings and conversations with the treasurer and the CFO so their views and opinions can be overlayed into the analysis of the relative value of currencies.

  • The team spends considerable time analyzing local mobility data to uncover trends as well as talking extensively to counterparties to learn their views.
  • The group looks at worst case scenarios and whether “we can live with it, knowing we want to be able to participate,” he said.
  • The company’s outlook has shifted from being extremely bearish on USD to a view that incorporates the US outperforming other economies (dollar bullish) in the short-term as well as a longer-term view that is more bearish.
  • “We’re balancing the different views and that’s where the option strategy helps us please everyone,” he said. “With all the uncertainty coming out of Covid, we really want to be able to participate.”

More systematic. The member said the company is moving from a very flexible, dynamic and opportunistic stance heavily based on market views to something more structured but still relatively loose.

  • “We’re still pretty risk tolerant, but maybe not as much as we were,” he said. The goal now, he said, is to be a bit more systematic but still flexible.
  • That means having the ability to lock in forwards or extend duration, he explained. But also having guardrails around the budget to spend on option premiums.
  • The member said this new framework should provide his team “more certainty about what we can produce” and reduce Monday morning quarterbacking that may arise when hedging decisions are questioned after currency moves.
Justin Jones

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