Businesses often have limited knowledge about their financial exposures and on how to mitigate these. This can stem from a lack of resources, which consequently forces a sole focus on operations.
Financial hedging strategies may be complicated and management often rely only on the information that they receive from financial institutions. Frequently, these are not intimately familiar with their customers’ operations and thus their real underlying needs. Furthermore, the institutions have a financial motivation in the products they advise on which may not necessarily be to the client’s benefit.
Consequences of this can be erroneous or no use of risk mitigating financial instruments. This in turn can lead to unwanted risk and increased volatility in financial results and unnecessary economic losses. When establishing an optimal financial risk mitigating strategy it is essential to have a thorough understanding of the business and its industry. This, in combination with an overview of available financial instruments, is essential in developing a suitable hedging strategy.
Financial risk – why focus on this?
Many businesses are unprepared when it comes to financial risk and in some instances, companies have ended up in severe financial difficulties. A sensible financial hedging strategy increases a company’s capacity to absorb fluctuations in market prices.
The purpose of financial risk mitigation is to safeguard its underlying operations. Proper use of financial hedging instruments can minimize the volatility of the company’s underlying cash flow measured in its functional currency. Financial risks do not disappear. It is still possible to experience losses from hedging arrangements. However, you will rather obtain more predictability and stability in your financial performance.
The following sections discuss how to proceed in order to develop a fitting financial hedging strategy, how to minimize the need for financial hedging instruments and discuss some relevant instruments.
Identifying financial exposures
It is challenging to decide whether one ought to use financial instruments, and if so to what extent. As illustrated in Figure 1 it is important that any financial hedging strategy revolve around the company’s liquidity and financial situation. These dimensions must again find their outset from and act as an extension to the underlying business strategy.
Development of a sensible hedging strategy requires in-depth industry knowledge and an understanding of the company’s prospects and outlook. Only through such an understanding is it possible to exhaustively map all relevant and significant financial risk exposures. Next step is to follow this up with a strategy, which limits such risks to an acceptable level. Important for the risk assessments is management’s expectations on cash flows in respective currencies, margins, leverage, financing requirements/ covenants, risks related to operational and investment plans, any extraordinary expansion plans, etc.
It may be useful to conduct peer analyses to evaluate what strategies other industry players utilize. The balance of power between the company and its customers and suppliers is important. Is it for instance possible to transfer currency risk in the form of contractual clauses to other parties? Does there exist any particular stringent requirements from the government, lenders or others, e.g. covenants imposed by banks. There can also be other actual limitations affecting the possibility for hedging.
Once a grasp of the current situation is in place and there has been developed expectations of outlook it is possible to build an appropriate strategy that incorporates both risk tolerance and appetite.
Financial instruments come with transaction costs. Before employing hedging instruments, one ought to minimize its necessity through natural hedging alternatives. Figure 2 illustrates some natural and financial mitigation alternatives.
Effective hedging strategies involves a combination of financial hedging instruments and natural hedging. However, only a few companies appear to apply a conscious use of natural hedging arrangements.
Utilizing contractual terms to shift financial risk onto counterparties is one such approach. The success of which will depend on market conventions and negotiation power. More negotiating power allows the transferability of currency risk in its entirety to the counterparty through determining payments in one’s own functional currency. Alternatively, it can dictate limits for currency fluctuations in the period between signing and delivery or payment. It is very important to formulate such clauses precisely. If left to later interpretation this can have significant consequences. Counterparty risk also arises from the arrangements. In order to contain this to an acceptable level it may be necessary to establish bank or other guarantees.
If the proceeds in one currency are substantial, it can be sensible to move production to a country with a corresponding currency. Matching the company’s operational and financial cash flows with its respective currency can mitigate currency risks. For example, a Norwegian company with an emphasis on operational net payments in Euros may advantageously draw up loans in Euros. International groups benefit from multi-currency cash pools reducing the need for frequent currency transactions. Participating subsidiaries contribute with their bank accounts in different currencies, which link to a common grant account in one main denomination.
There are many different financial instruments. Most build on two underlying, fundamental contracts: forwards and options.
Forwards are contracts that define a future purchase or sale of an underlying asset at a specified price on a predetermined date. Forwards are traded “Over The Counter” (OTC) and tailored for the transaction. Buying call or put options give the owner a right to buy or sell an underlying asset at a predetermined price.
“Development of a sensible hedging strategy requires in-depth industry knowledge and an understanding of the company’s prospects and outlook”
When to use the different instruments?
For guaranteed transactions forwards are suitable to “lock in”, e.g. currency exchange rates. Transaction costs occur in the form of bid-ask spreads. OTC contracts may involve counterparty risk, but in most markets, this is limited by clearing houses that require daily margin calls.
If it is necessary to borrow in one’s own currency to secure better terms, or it is challenging to get the lender to issue loans in other currencies that better matches operational and financial cash flows, then basis swaps can be entered into. This can be used to achieve the same objective of matching the financial and operational cash flows in their respective currencies.
When uncertainties exist as to actual completion of a transaction, then options can be a sensible solution. Options are more costly with longer time to redemption and with greater volatility of the underlying object. To reduce transaction costs you can put together option packages. Only the imagination sets boundaries for such structures, therefore we will not explore this in the further.
Other significant considerations
After deciding on relevant instruments to use and under what circumstances, there are some additional factors to consider, as illustrated in Figure 3.
It is of importance to decide whether to hedge only cash flows or also equity.
Then it must be decided on the optimal hedging ratio and sensible time horizons. Determining factors are visibility in business model and corresponding estimate risk. Greater uncertainty could make it sensible to not hedge at all, perhaps only hedge a probability weighted amount or use only options.
Furthermore, the strategy must detail placing tactics and/or restrictions. Including the possibility to allow for tactical market assessments. These assessments must never override the overall risk strategy, but rather allow its execution to be cost effective.
Developing a financial hedging strategy can be a challenging process. Companies’ day-to-day operations always entail uncertainty and it can be challenging to identify company specific and industry risks and outlook.
The hedging strategy must balance between external requirements, internal risk apetite and capacity, as well as volatile market forces.
Mimir Consulting may, as an independent third party, assist companies through the entire process. From an analysis of the business risks to prepare holistic assessments on appropriate hedging ratio, relevant financial products and be a sparring partner in tactical discussions.
Mimir Consulting incorporates extensive industry knowledge, with a thorough understanding of financial products and hedging strategies. This, in combination with our neutrality when it comes to product recommendations, makes us a preferred partner with the sole focus on our clients results.