Shifting currency exposures create treasury dilemma

There have been a number of unwinds by European fashion retailers, according to Deutsche Bank

Many treasurers have found themselves with higher than expected hedge ratios as a consequence of reduced revenues caused by coronavirus restrictions.

Where corporate treasuries run anticipated cash-flow hedging programmes based on sales/costs forecasts, under normal circumstances they tend to be under-hedged to allow for forecast errors on these programmes. But given the unprecedented impact of coronavirus on the global economy, there will be cases of corporates that are over-hedged for their revised forecasts.

As with so many other aspects of the pandemic, the effects on treasury have been unevenly distributed.

Many businesses exporting from Europe were running small hedge ratios anyway due to low volatility and fairly high hedging costs.

Those forced to temporarily suspend production tend to see their cost base as stable from a long-term perspective and therefore treat any potential over-hedge more like a timing mismatch than an actual open position.

Misalignment

There have also been cases where there is an expectation of a ramp-up effect towards the end of the year, says Ole Matthiessen, head of cash management corporate banking at Deutsche Bank.

“Specific industries such as travel, leisure and fashion retail have been impacted much more heavily than others in terms of over-hedging,” he says. “Virtually all clients in these sectors have reported misalignments between their hedging instruments and their underlying business forecast.”

Fabio Madar, co-head of currencies at Natwest Markets, says as many as a quarter of treasurers could be over-hedged, although those whose business has been delayed rather than cancelled have in many cases simply rolled their hedges forward.

“If there is certainty that the hedge is now ‘orphan’, they might need to cancel them and pay or receive the difference with the current FX spot,” Madar says. “The treasurer would then have to wait for more clarity to initiate new hedges. If they are not sure that the hedge will be useful and have little visibility about their real exposure, they could choose to transform their forwards into options.”

Strategies

Strategies available to treasurers to reduce their exposure when they are over-hedged in a specific currency or currencies depend on the profile of their order books explains Xavier Gallant, co-head of rates, FX & local markets corporate sales EMEA at BNP Paribas.

“Companies with ‘in the money’ hedges could monetise their positive mark to market by closing out their over-hedged positions or roll their hedges to a future date,” he says. “This can be attractive especially in emerging markets, given the price action of these currencies against the euro this year.”

If the portfolio is out of the money, a roll to a future date could be considered but would trigger negative cash flows on day one if the rolls are done at market as the client would need to pay the current mark to market.

Adjusting tenors and aligning hedge ratios in terms of maturity profile has become a more common practice over recent years 

 – Ole Matthiessen, Deutsche Bank

An alternative solution is to look at restructuring the hedge portfolio to reduce the monthly hedging commitment and spread it to longer maturities.

Matthiessen says he has seen a number of unwinds by European fashion retailers as many had positive market values in their portfolio due to long-dated USD forward purchase contracts, leading to a windfall gain that partially compensated for reduced business activities.

“Adjusting tenors and aligning hedge ratios in terms of maturity profile has become a more common practice over recent years,” he adds. “We have seen a lot of this activity over the last three months, both in terms of tactical solutions, but also through strategic portfolio alignments.”

Francois Masquelier, vice-chairman of the European Association of Corporate Treasurers, has referred to how over-hedged positions create problems under hedge accounting rules, with complex delinking and reallocation of hedges. However, he also warned that this might not necessarily be a good time to unwind hedges.

Reviews

Gallant similarly cautions against removing hedges for currencies to which corporates have limited exposure, recommending instead a review of hedging practices (such as hedge ratio and duration) and adjustment of the product mix in the hedge portfolio.

“Options could be a way to address the lack of visibility in future cash flows, as they remove any obligation for the corporate to transact should the exposure not materialise,” he says. “Other simple strategies, packaged as zero-premium solutions, may offer flexibility on the hedged amount as well as on the timing of settlement, removing the two main sources of uncertainty in the hedging decision.”

Gallant also notes that the pros and cons of these strategies need to be considered in the context of each company’s objectives, liquidity needs and potential pressure on FX/rates lines and agrees that hedge accounting repercussions should also be carefully analysed.