Balancing Risk Management and Volatility

Today, the volatility component of many asset classes grinds back to 2019 lows. Take FX risk, for example: The JPM Global FX Volatility index is down to 6.8% from a March 2020 high of 15%. Despite this reduction in volatility, macro risks abound. The delta variant of Covid 19 has caused many regions to tighten restrictions on gatherings and businesses. Decade high CPI inflation data casts doubts on when the Federal Reserve will begin the process of raising interest rates, which can affect the value of the dollar vs foreign currencies.

This should give pause to companies with FX exposures. Volatility is low for now, but there are plenty of risks on the horizon. With volatility low, it could be a good time to consider hedging FX exposure now in case volatility picks up later this year or in 2022.

How to Evaluate Risk Management Strategies

The first approach to managing risk would be to hedge, or extend the tenor of hedges due to low market volatility. The simple logic is that it is relatively cheap to hedge now for potential unknown risk in the future.

Clients who believe the low volatility will continue may choose to do nothing. 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 a 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.