Businesses today are tasked with managing risk in uncertain environments. Learn about risk management strategies when examining options for FX hedging.
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The spike in financial market volatility caused by the global spread of the Coronavirus has been an echo of what happened in 2008 during the Global Financial Crisis. As in 2008, businesses today have been challenged to manage risk in an uncertain environment. Corporate earnings can be severely impacted by swings in market prices, so it's more important than ever for businesses to proactively hedge their underlying financial risks.
Following the 2008 crisis, there was an increase in the attention given to corporate risk management strategies. In particular, companies gravitated toward those measures that contained the earnings impact from financial risks—such as exposure to costs and revenues in foreign currencies—while leaving flexibility. With such an approach, companies found they could capture any favorable currency (FX) fluctuations while still defining worst case scenarios.
Risk management strategies that use options are one of the most effective ways to implement such flexible hedging strategies. Companies can mitigate the balance sheet impact of negative swings in the price of underlying exposures, while avoiding being fully locked-in to a future price in case the market moves in the company’s favor.
Companies that implemented sophisticated options-based risk management strategies after the 2008 crisis are rediscovering the benefits of such programs in the current pandemic environment. And many finance and risk professionals who have entered the workplace in the past decade are, for the first time, discovering the financial advantages of FX options.
The judicious implementation of FX options aren't just useful in volatile times, either—they're useful tools in the corporate risk management armory during tranquil markets, too. Risk professionals looking to mitigate their organization's exposure to currency fluctuations can benefit from learning—or re-learning—the key features and benefits of such a program.
What are Options?
FX options are flexible tools to manage currency exposures. Unlike forwards, which lock-in future exchange rates, options can control negative price movements by creating price floors, while leaving room for companies to benefit from positive price movements.
Companies’ specific risk tolerance can also be accommodated through the creation of bespoke options contracts, including strategies like setting specific price triggers, nominal sizes and length of the contract. Options vary from the simple (aka “vanilla”) to the more complex. Still, important differences exist within FX options. For example, American-style contracts allow the holder to trigger the contract at any point up to maturity, while European-style contracts can only be exercised at expiration.
A company looking to implement FX options can follow a two-step program in determining its best course of action.
Step 1: Identification
Since FX options exist in an over-the-counter (OTC) market, companies typically work with counterparties such as Fifth Third Bank to structure and price the optimal options strategy for their company’s unique mix of currency exposures. The first step, then, of all FX risk management strategies is to identify the company’s foreign currency risks or exposures.
“We spend a lot of time with clients to help them understand what their FX risk exposures are,” says Paul Choi, Director of Foreign Exchange at Fifth Third Bank. “Often, this includes a considerable data accumulation issue, but it is a critical first step to ensure that the identification of the underlying risk is as concise as possible. This ensures that the options are calibrated accurately.”
Choi notes that it is critical to net-out the company’s FX exposures. For example, if the company has multiple businesses or subsidiaries, then these may have different FX exposures. For example, one area of the company might be "long" a currency (has future revenues in that currency) and another is "short" (has costs in the same currency). In this scenario, it will be more efficient simply to hedge the net exposure rather than engage in two different hedges.
“The good news is that as companies move to options-based hedging strategies, there is deep liquidity among the developed as well as some emerging market currencies,” adds Choi. “The FX market is the largest and most liquid asset class for options and therefore is typically the most efficient asset to hedge via options.”
Step 2: Mitigation
Once the FX risks have been identified and quantified, companies can then pass some or all of the risk to the options market. The specific strategy—the combination of different options types and their contract terms—will reflect the individual company’s risk tolerances. Options programs can be configured to enable FX exposure to move within narrow or wide bands, or to create floors while leaving the upside open.
Companies can also manage in the short-term or the longer-term, depending on the profile of the underlying FX risks and the overall risk management aim of the company. Typically, optimal tenor for FX options programs is between 12-36 months.
“Manage where you have confidence in your exposures,” states Choi. “Beyond 36 months there is often a lack of clarity or reduction in confidence in the underlying exposure.”
Choi notes that many companies employ a rolling program, keeping the frontier of the risk management strategy at a consistent tenor by pushing out additional tiers to the program on a quarterly basis.
Choi also notes that options are also often used to manage large one-off FX risks (such as that presented by cross-border mergers and acquisitions (M&A) activity), as well as for operational FX exposures from ongoing business operations.
“The design of the options strategy is as unique as the company’s individual FX risks, and we work with all types of companies to ensure they implement options strategies that are efficient in terms of cost while ensuring it creates the level of future price certainty that aligns with the firm's risk management philosophy,” says Choi.
Communicating the Benefits of FX Hedging
The flexibility inherent in options creates a powerful incentive for companies to minimize negative impacts to their balance sheet while allowing upside risk to be captured. Options offer a more sophisticated approach to risk management than is offered by forward contracts. That can be a powerful selling point for both internal and external stakeholders alike.
Critically, companies may need to educate their internal stakeholders in order to fully realize those benefits. For example, the accounting impact of using options can be increased short-term reporting volatility, since the cost of the instruments are booked ahead of the financial benefits. It's important to communicate to stakeholders that this is, in fact, expected and strategic volatility. The goal is long-term benefits, including enhanced corporate reputation from a professional corporate governance perspective.
Beyond the Risk: Insight
As finance professionals become more comfortable in options-based risk management strategies, there are additional benefits beyond the mitigation of future cost and risk. The options market is a vast, liquid market and provides a large amount of market intelligence about expectations of future currency movements. For example, if there is clustering of pricing bands in the contracts for particular currency pairs, then this can provide important insight into the market’s sentiment regarding where that pair is likely to go.
And it’s not just the pricing triggers that can reveal useful clues for market sentiment—one of the major components of options pricing is implied volatility. When this element of the premium increases, it reveals how volatile the market thinks a currency pair will perform.
The advantages of moving to options-based strategies are usually well worth the effort it takes to move to a more sophisticated risk management strategy. The financial benefits that flow to a company from a more tailored risk approach, as well as the reputational enhancements and the greater market insights that can be derived, prove that the shift to options may endure well after the markets move beyond their current volatility.
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