In this article, commissioned by Bloomberg, Ken Monahan, senior analyst, market structure and technology at Greenwich Associates, takes a look at the tools available to corporate treasurers when hedging their FX risks and asks, ‘do they have the tools they need?’
Corporations are among the most important customers of FX trading desks. Given that trade and capital flows ultimately determine FX rates, one could argue that they are the single most important group in FX markets. What’s more, for many banks, the FX trading relationship is seen as an extension of the cash management and payments businesses of the bank. Since this is the core franchise of banks, the currency trading relationship can take on a significance beyond the FX business itself.
As with the dealers, so too with all other aspects of the market’s ecosystem, platforms and vendors are also looking to enhance their engagement with the client segment. Given its importance, it’s helpful to get a sense of the tools that companies use to identify their FX risks as well as just how satisfied corporate treasurers are with these tools.
FX risks can take on a variety of forms, so they usually require a variety of instruments to hedge them. We asked corporate treasurers to list the instruments they used and then asked them whether they felt satisfied with their access to and utilization of them. Unsurprisingly the most popular instrument was spot FX. This is the most straightforward instrument: if you have a foreign currency exposure, spot FX reduces exchange rate risk though it may leave the basis risk unhedged if the exposure derives from a transaction that will take place in the future. There is a possibility that, to some extent, treasurers conflate making payments in foreign currencies with hedging their exposure, which would also explain why spot is the most popular instrument.
The next four most popular categories—swaps, forwards, NDFs and futures—are all ways to limit future exposures, and manage the rate differential between the two currencies in the interim. These instruments can also contain a credit component. Swaps and forwards are the most straightforward tools for hedging future obligations and differ only in their payment structure with a swap presuming multiple payments and a forward paying off only at the end. A non-deliverable forward is a hedging instrument for a currency that is not fully convertible. This instrument has been growing in popularity as trade with emerging markets has grown.
After NDFs however, the use of other derivative instruments declines significantly. Futures, which are very similar in structure to forwards and NDFs, are significantly less popular despite central clearing and the fact that they trade on anonymous central limit order books. This may be because they are a fairly blunt instrument for corporate hedging needs. Futures are highly standardized products with fixed notional amounts and fixed expiration dates which typically fall within a relatively short time horizon. Corporate hedging needs are typically forecast out relatively far in the future and so would require several futures rolls. Additionally, receivables or payables that occur on fixed future dates are unlikely to match futures expiries.
Notably, vanilla and exotic options are relatively unpopular as well. Given that much corporate hedging is driven by uncertain estimates, or that some hedging needs are either conditional on the level of spot, or conditional on its direction, it is surprising to see how unpopular these are. While this is true for both vanilla and for exotic options, the difference between the two should not be overstated. For corporate purposes, “exotic” options might just possess a knock-out feature, meaning the option vanishes under certain conditions when it is least likely to be necessary. At the same time, many companies’ currency risks may not be severe enough to justify the complexity and cost of managing those risks with options. The recent increase in foreign exchange volatility may change that equation.
For the time being, treasurers certainly seem to believe that they have access to the full range of financial instruments they need to address their risks. When asked, 66% said they were satisfied with the tool set available to them. Only 3 respondents out of 50 said that they could not access all the tools they needed because their dealers did not make them available. One in ten said that they were prevented from using additional tools because they could not be booked successfully in their accounting systems. Given the difficulty of altering accounting treatment or changing Treasury Management Systems, it’s difficult to assess just how harmful this might be.
Most interesting is the fact that the difficulty of risk managing other instruments or that they fall outside risk management policy and that they lack the ability to risk-manage them. These reasons are significantly different from accounting or access issues, and one would think they should be surmountable. Risk management policies are more malleable than accounting policies are, and with the massive spike in volatility lately, are up for review everywhere. As for a technical capacity for risk managing them, a wide variety of vendors stand ready to help fill this gap. Given this, and the fact that vendors and the dealers have powerful incentives to support corporate FX clients, it’s likely that the 66% satisfaction level is going to climb.