Corporate financial risk managers should be reassessing long-held assumptions as they look to redo their hedging.
Add a weakening US dollar to the growing list of reasons risk managers at multinational corporations need to take a long, hard look at their hedging programs and strategies.
- That takeaway emerged at a NeuGroup Virtual Interactive Session last week featuring Societe Generale global strategist Albert Edwards, known for his provocative mid-1990s “Ice Age” thesis of bonds outperforming stocks.
- Christophe Downey, a director in the bank’s market risk advisory practice, explored possible changes to FX risk policies for NeuGroup members looking to protect themselves or benefit from a weakening dollar and a strengthening euro.
Japanification? Mr. Edwards’ thesis of a weaker USD (and deflation in the near term) is set against this backdrop:
- The unprecedented intervention by the Fed directly into the real economy and not just the finance sector is backed by massive levels of fiscal stimulus that, like in Japan, will end up on the central bank balance sheet.
- “We have crossed the Rubicon” Mr. Edwards said, from quantitative easing to something more like Modern Monetary Theory (MMT), and there is “no way we can go back.”
- It has been increasingly apparent that risk managers and other NeuGroup members should be brushing up on the implications of this unprecedented monetary policy and the tenets of MMT.
- The developed world has coasted on having weaker currencies than USD to help support their economies; but now, one by one, the reasons for dollar strength are vanishing.
Dollar doldrums. One of those reasons—along with the expansion of the Fed’s balance sheet—involves the collapse of the interest rate differential between the US and Europe that has underpinned the carry trade and has long played a key role in the FX rate outlook of many risk managers.
- COVID-19, of course, is a key reason for the collapse of that rate differential as the US economy’s relative strength versus the rest of the world declines.
- The eurozone has recently taken away the need for a weaker euro support with the decision to issue community debt to support fiscal stimulus. This will allow the euro to strengthen, and Mr. Edwards thinks the dollar might weaken about 10% against it.
- Along with the outlook for the dollar, the economic fallout from the pandemic and the havoc it is wreaking on supply and demand means corporates must reevaluate their FX exposures.
Action levers. Assuming the risk management policy allows a view on currency direction to influence hedge decisions, the three levers for change FX risk managers have are hedge ratio, tenor and instrument choice. How they use them depends on if they need to buy or sell dollars (see table).
- Hedge ratios have already been challenged because of the pandemic’s impact on business and exposures; but even if business has not been severely affected, dollar weakness may still prompt a look at hedge ratios, specifically lowering them for short USD exposures.
- Shorter tenors are another response to forecast uncertainty, or an unfavorable carry on the currency.
- Both of these approaches are risky in case of FX headwinds, as most corporates are looking to protect downside risk, Mr. Downey noted.
An optimal instrument mix. Assuming short USD exposures, SocGen back tested a two-year program with 24 hedges layered in monthly (for an overall P/L smoothing effect, all else equal).
- In the tradeoff between smooth earnings with neutralized FX impact where forwards work best but realize large FX losses at times, and an all-put option strategy with premium costs but unlimited upside once recouped, those with policy flexibility should consider analyzing their exposures and currencies to determine where on the spectrum they will feel the risk is acceptable for their desired risk management outcome.
More optionality. Societe Generale is recommending that corporates with short dollar positions incorporate more options into their product mix to capture upside from cash flows converted back to a weaker dollar with limited incremental volatility.
- A vanilla put strategy (option to sell foreign currency/buy dollars) would provide the best trade-off between volatility and incremental cost (the payment of a premium is part of the cost of the strategy, like the carry cost of the forward strategy).
- A collar (combination of a purchased option and a sold option to reduce the overall cost of the hedge) with sufficiently low delta would likely deliver the best P&L and hedge level in a multi-year USD weakening trend; but would come with some increased volatility.