Market Maniac

Unnatural Hedging

Continued high currency volatility and costly lessons learned over the years has certainly driven more and more companies to increase their focus on FX risk management. Our third annual FX risk management survey found that as many as 66 (out of 100) companies had documented risk management policies; this was up from 54% last year.

Of course, simply having a risk management policy is hardly a sufficient condition for effective risk management. Policies must be both tailored to the company’s operations and have a sound understanding of the market environment in which the business functions; again, the effectiveness of the policy must be reviewed from time to time to ensure that it remains relevant in the hard light of market realities.

Many companies begin the evolution of a policy with the statement that they want to minimize the risk they carry, and so need to build in as much of a natural hedge as possible. While I fully agree with this statement, there are two practical issues that limit its effectiveness. First of all is the unwritten fact that everyone – or, almost everyone – wants to capture opportunity; in fact, 77% of companies in the survey acknowledged this. Running a natural hedge limits this possibility.

The second issue is that many companies misunderstand the concept of a natural hedge, as a result of which they sometimes end up increasing rather than reducing the risk on their businesses. The most common misconception is that you can “naturally” hedge payments due on foreign currency loans with export receivables. Indeed, some companies go so far as to determine their borrowing currency based on the currency of net revenue inflows. A dollar is a dollar is a dollar, they say, so we can minimize our risk by simply matching dollars (or euros) in with dollars (or euros) out.

While this is true on a cash basis, in reality a dollar earned out of exports is not the same as a dollar to be paid in debt service since each of these two streams has a different business genesis and, most likely, a different target rate. For instance, if you contracted a dollar loan when USD/INR was 40 and your then 1-year rupee borrowing cost was 10%, your obvious FX risk management goal should be to ensure that you buy dollars at no higher than 44 to repay this loan. In contrast, the exchange rate at which you need to sell your export dollars would, in all likelihood, be different than this rate since it would depend on the rate prevailing at the time you contracted the export, the sensitivity of your costs to USD/INR, the sensitivity of your dollar selling price to USD/INR, and so on.

In other words, you have different target rates for the payment and the receipt, which means that each exposure should be hedged at different market levels. So, while you obviously shouldn’t buy and sell at the same time, simply netting the export against the loan payment is not the correct solution – doing that results in subsidizing one side with the other. If the rupee depreciates sharply, your export sale subsidizes your borrowing (which you should have hedged at no worse than 44), and vice versa.

Perhaps more importantly, carrying unhedged foreign currency debt on the balance sheet (with the intention of paying it off with export receivables) would lead to substantial ballooning of liabilities if the rupee weakened. This could trigger a whole raft of structural issues having to do with covenants on borrowings, leverage limits, etc.

The situation is compounded in the case of companies with commodity exports, since the dollar price of many commodities is directly linked to the strength (or weakness) of the dollar resulting in possibly significant economic risk. A critical case we studied was of a Brazilian sugar exporter that had taken on significant dollar debt believing it was naturally hedged through its large USD exports. Now, Brazil is the largest sugar exporter in the world, as a result of which the global price of sugar is very highly correlated (88%) with the value of the Brazilian Real. In other words, when the Real depreciates against the dollar, the price of sugar also falls; and vice versa.

In the case of this company, when the dollar appreciated by nearly 25% in 2008, the price of sugar fell dramatically, and the net value of its sugar exports in Real rose only modestly – by about 5%. As a result, the company’s Real earnings grew by just 5% while its debt service payments in Real increased by around 25%.

Clearly, the “natural” hedge turned unnatural; the company almost went bankrupt and was recently taken over.