Volatility is a key variable in calculating the cost of risk management through derivatives contracts.
Today, the volatility component of many classes of risk is low — surprisingly so in some cases. Take FX risk, for example: Bob Tull, Senior Managing Director, Global Head – Financial Risk Management at Fifth Third Bank, says he has never seen a time in in the FX markets when volatility has been this low for such an expanded period of time — one year implied volatility on the Euro is around 5.7% — while there is so much geopolitical uncertainty. Those global factors include upcoming key elections, trade tensions and questions about monetary policy from the world’s leading central banks, all amid slowing global growth.
This should give pause to companies with FX exposures. Should they move now to lengthen (or "ladder") the tenor of their FX risk strategies to lock in the low cost of these options?
“Low volatility doesn’t mean there is no risk on the horizon,” says Tull. “I would argue the opposite: the storm is coming, we are just in the preceding calm.”
Of course, knowing when the financial “storm” will arrive is unclear. When it does, Tull says the cost of hedges will spike. “When volatility increases it won’t be incremental. The price of hedging will increase quickly as it will become a one-way trade.”
Companies should also look beyond currencies. While there is almost universal consensus that the next move from the U.S. Fed rate will be to lower rates, many companies are looking to hedge a portion of their debt out the curve.
“The Fed appears to be on hold, for the time being. This means short-term rates may stabilize a bit but the long end of the curve can steepen based upon inflationary factors that can help accelerate growth. We are seeing many companies lock-in longer-term rates before this steepening process occurs.”
How to Evaluate Risk Management Strategies
Tull says that many of his clients are taking a close look at the tenor of their risk management strategy during the budgeting process for 2020: “I could make a strong argument that cost of hedging in 2021 and 2022 will be higher next year than it is today, hence the cost of hedging out the curve is price-effective.”
However, he also concedes some companies may not want to buy risk management products if they take a view that volatility – and the underlying risks – are likely to remain subdued. “A do nothing strategy is still a strategy – but it’s one with a lot of potential downside. Companies should quantify their risk exposures and then make a conscious decision to accept the risk, and do nothing. The downside, the open position could end up costing the business a material amount of money.”
The third approach is to run a risk management strategy that is completely agnostic to the current market dynamics. Proponents of this approach argue that corporates inevitably add risk by eschewing a programmatic approach to risk management—that is, one that is both agnostic to market conditions and valuations.
The benefits of such an method—as opposed to a more opportunistic strategy—include:
- It helps one avoid the temptation to play markets—and remain more safely within the core competencies of a company or treasury team.
- The necessity to adopt corporate-wide risk management strategies that reflect a company’s full and integrated risk exposure. Opportunistic changes to aspects of a company’s risk management program without taking a firm-wide perspective can actually increase aggregated risk.
There are also more technical reasons that extending risk management programs on a whim could backfire. For example, asset-liability mismatches, over-hedging a position can be an approach exposed by such — thus creating earnings volatility.
Taking a Cautious Approach to Future Planning
While adding tenor to risk management instruments would seem like an obvious tactical response to a fall in volatility, one needs to be thoughtful from a market and amalgamated corporate-risk perspective.
Fifth Third Bank works proactively with many corporate treasury and risk teams to ensure that apparent opportunities to implement or amend risk management strategies make sense from an individual contract and broader programmatic approach. Those that want to develop risk management strategies due to the pricing opportunities currently available, now may be the time to consider extending both tenor and the size of the underlying risks being managed.
Foreign exchange, interest rate and commodities risk management products offered through Fifth Third Financial Risk Solutions (“FTFRS”), a division of Fifth Third Bank, National Association, which is a provisionally registered Swap Dealer with the Commodities Futures Trading Commission and National Futures Association. The information presented herein is not, and should not be considered to convey, investment advice, a recommendation or an opinion to enter into a specific transaction. Please carefully read the Disclosure of Material Information for Swaps that is provided prior to entering into swap transactions for important information regarding the material risks, characteristics, incentives and conflicts of interest that may be associated with swap transaction.