Which Currency Hedging Strategy Performed Optimally in 2012?
By Mark Frey, Cambridge Mercantile Group
December 3, 2012 – It’s been a challenging year for hedgers and risk managers tasked with navigating the currency volatility embedded within the business models of their respective firms. We’ve not only been witness to some rather extreme volatility and uncertainty over the past 12 months, but there has been very little consensus from market analysts on the direction of currency markets as well. Moreover, when there actually has been consensus, the prevailing view often turned out to be wrong, or at least too late to be of value from the standpoint of being able to guide a risk-based decision-making process.
When asking questions such as which type of currency hedging strategy delivered the best financial performance (or added the most “value” in 2012, irrespective of the currencies involved), and which is the best strategy in general, we still need to be careful in how we frame the response. While these are simple questions, they can be incredibly difficult to answer with any degree of confidence or accuracy, as the success or failure of a currency risk management strategy depends entirely on the stated objectives of the regime itself.
For some firms, risk mitigation, regardless of marked-to-market performance (MTM), is the key measure. For others, the aversion of a single catastrophic loss is the goal, while still others may seek to enhance the income statement with “winning” MTM hedges or trades.
Consequently, the key in determining how best to manage the risk inherent within your business depends on gaining alignment between your strategy and your stated corporate objectives. Without proper alignment between what you are aiming to achieve and what your strategy is designed to deliver, the financial impact stemming from your chosen treatment of risk could be worse than the costs of the inherent risk itself. This is a situation, in fact, that many corporate treasurers and risk managers found themselves in over the course of 2012.
Hedging decision makers are typically grouped into three distinct camps — systematic, active and reactive — based on the respective strategies that guide their decision making.
The Systematic Hedger
Systematic hedgers are process focused, aiming to execute their transactions with discipline in accordance with the rules and ratios that have been previously developed and agreed to by a committee or at the board level. The calendar typically governs their decision making, and every effort is made to preclude emotion and market forecasts from impacting trading decisions.
Overall, when evaluated against their stated goals of reducing or fully mitigating the currency risks that impact their business, systematic hedgers faired reasonably well in 2012. That said, a calendar and/or rule-based approach was in many cases characterized by a number of small “wins” in choppy, non-trending markets, but was likely to be caught off-side from a purely MTM perspective on some big trending moves on the EUR amid the panic over fiscal issues in Greece and Spain.
Systematic hedging systems deliver strong results when the goal is oriented around protecting a budget or securing cost of goods sold. However, when gauged against market-price action and MTM gains and losses, a systematic hedge is the process equivalent of an index fund, with what can be fairly steep transaction costs from a great number of small trades.
In short, using such a strategy, you won’t have any big wins, but you shouldn’t have any large losses either. Interestingly enough, that is the principal aim of most corporate hedging doctrines. Therefore, in order to achieve optimum financial performance, a balance must be struck in terms of managing risks and transaction costs in order to ensure that fees and bid-offer spreads aren’t eating into the financial benefits of your hedging strategy.
The Active Hedger
Active hedging systems, if there is in fact a semblance of a system involved, can take many forms. In aggregate, those who are aiming to enhance their bottom line, or add value through “winning” MTM trades,would fall into this camp. Some active hedgers are really just proprietary traders with an inherent or fixed position that they increase or decrease based on their market view.
Hedging decision makers who use Texas or Pat Hedging would actually seek opportunities to add to their existing risks if they like their natural position in being long or short a foreign currency. Corporate hedgers employing this doctrine often take an active and opportunistic view of the market. Active decisions are made to not only enter and exit positions, but to stand pat and do nothing at all if the natural risk position is aligned with the manager’s prevailing view.
Hedge ratios, defined as the percentage of the risk that is being mitigated, will vary widely depending on the price action and the existing MTM exposure of the hedges already placed. What’s more, an active hedger may seek to lift or offset a hedge in a gain position with the intent of putting it back on, if and when the market retraces.
That said, market participants (note that we’re not calling them hedgers anymore) with such an inclination are often subject to the same old issues that dog proprietary traders — i.e., the perception that they cut their gains short and too often let their losses run. Keeping this in mind, a position with a positive MTM balance is often treated as a trade (thereby harvesting the profit for the FX gains/losses line on the income statement), while a position with a negative MTM value is often treated as a hedge that gets buried in the COGS or top line.
In short, the gains and losses achieved by such risk managers should be reviewed with a higher level of scrutiny than someone employing a more rules-based approach. The success or failure of such a regime, over time, is largely dependent upon the acumen of the individual pulling the trigger. Gains can be significant, as can the losses, but in its more aggressive forms, this is a style that can at worst add risk to a business (as opposed to mitigating it) and at best allow for the possibility of swapping one form of market risk for another.
The Reactive Hedger
Most corporate treasurers and risk managers fall into the final camp: the reactive hedger. Reactive hedging is characterized by waiting, watching, analyzing and, ultimately, too often acting only after a risk has become a negative financial impact. Whereas active hedgers often err in allowing their ego or greed to drive their decision making, reactive hedgers adopt a more passive or defensive approach to decision making, thereby allowing fear and second guessing to creep into a process that should be treated more like a science and less like an art.
In many cases, this passive approach can work well in a range bound or choppy trading environment, like what we saw with the commodity currencies over the past year. If your cash flow is flexible, and you can afford to “wait and see,” a range-bound market will often present a mean-reverting move that will allow you to execute at a price level consistent with what your financial projections have been built around. Further, such a passive approach undoubtedly produces fewer transaction costs to eat into the benefits of a winning strategy.
The flip side is that reactive hedgers often fail to act quickly enough when a trending market begins to move away from them. The overwhelming faith in mean reversion, a reluctance to place hedges at mildly unfavorable levels and a paralysis in decision-making (while data is further analyzed) can combine to form a lethal cocktail that catches many firms flat footed when the ground begins to shift.
For example, many passive hedgers that didn’t get out in front of a declining EUR in the first half of 2012 took large losses on the way down, only to crystallize them at or near the bottom, ahead of the second half rally that saw the common currency retrace back up to 1.30 (against the U.S. dollar). The challenge then with such an approach is to be disciplined enough to at least take some of the risk off of the table in a somewhat systematic or active fashion, while applying one’s best judgment to the residual risk that remains.
The System Must Match Your Objectives
When working to devise a strategy best suited to your business, the goal should be to create a program that deals with at least a portion of the risk in question in a systematic fashion. Retaining flexibility (from both a cash flow and hedge ratio perspective) is of paramount importance,and the “rules” put in place should act as a guide as opposed to a law, especially in situations where technical and macro-economic factors are both leading to an alternative course of action.
Currency hedging, from a best practice perspective, remains a custom-tailored discipline that is mostly based on science, with a varying degree of art mixed in depending on your risk tolerance. In terms of creating a recipe for success, that would translate into three parts systematic and one part proactive/reactive, depending on your natural inclination, the stated objectives of the firm and your overall appetite for risk.
Mark Frey is the chief market strategist at the Cambridge Mercantile Group. He is responsible for developing and implementing foreign exchange risk hedging strategies and payment solutions for the firm’s corporate customers across North America. He joined CMG as vice president of payment and risk solutions in July 2011. Prior to joining CMG, he held a number of senior positions — including vice president of global trading and regional director of the Canadian FX business — at Custom House and Western Union Business Solutions. He can be reached at firstname.lastname@example.org.