Five Questions You Must Ask Before Hedging Your Exposure
The unprecedented global collapse of interest rates and extreme volatility of numerous asset classes has forced many businesses to consider managing their market risk exposure. We are receiving an influx of similar questions: when is the ideal time to hedge? Does hedging make sense in the current environment? Simply put, it is always a good time to consider your risk. But every institution has unique exposure, so there is no one-size-fits-all solution for hedging. Nonetheless, businesses must ask a few critical questions at the outset to capture a robust hedging strategy. Here, we consider our top five.
Are We Truly Hedging Our Commercial Exposure?
It sounds economically intuitive, but corporates frequently fail to thoroughly examine this question before hedging their exposure. Some businesses unknowingly neglect to consider overall exposure when making their hedging decision. In some instances, we find that a company would have been better had it avoided hedging its exposure due to other offsetting exposure within the same business. Another example of improperly assessing commercial exposure is inaccurately relying on proxy hedges. For instance, hedging a SAR long-term financing (SAIBOR based) with a USD long-term hedging (LIBOR based) transaction could have painful implications, considering the soon-to-shift landscape of the floating rate indices.
Do We Have a Hedging Policy?
This is perhaps one of the most critical questions on the list. An enterprise-wide hedging policy cultivates a culture of sound risk management and proper governance. It greatly helps the organization swiftly anticipate, identify, quantify, manage and report related market risk exposure. The policy also fosters organizational accountability and sets the tone for all stakeholders to follow the decision-making procedure carefully. The policy should never be static, but instead dynamic and evolving.
What Is the Magnitude of the Mark-to-Market Volatility?
Don’t be fooled by this question’s specificity; it becomes more relevant with complex financial derivatives with opaque pricing and valuation. The Mark-to-Market (MTM) is a measurement of the fair value of the derivative instrument, which fluctuates over time depending on the underlying asset class’s movement. The MTM could be an asset (positive number) or a liability (negative number).
When the institution correctly applies the methods to stress the potential MTM paths, it reduces the chances of entering into products that falsely appear to be serving the purpose but carry significant inherent risks. Such stressing methodologies manifest any hidden leverage and promote a culture of open deliberations within the institution. The exercise should look at both the hedging instrument (a financial derivative) and the hedged item (an underlying exposure).
Do We Need Independent Advice?
Hedge providers are incentivized to market their products. So, to avoid a conflict of interest, they cannot take an advisory role when selling derivative instruments to their clients. There will always be an objective mechanism to follow if the institution lacks the necessary calibers and wishes to understand the full spectrum of risks involved or the hedge’s effectiveness. As such, there is a healthy incentive for any institution to seek an independent third party’s advice.
Hedge Accounting: Are We Considering It?
This topic could be a nightmare for CFOs and Treasury Managers. Hedge accounting is a way of accounting that reduces the volatility of financial statements in the entity’s bookkeeping. When hedge accounting is applied, we reduce the profit and loss (P&L) statement volatility created by repeated adjustment to a hedging instrument’s fair value (MTM).
Hedge accounting follows a well-defined accounting standard that must be applied for a successful designation. Otherwise, the hedging instrument’s fair value would directly impact the P&L statement. Some institutions prioritize and look at accounting implications over the economic benefits and vice versa. For this reason, this question is highly relevant before taking any hedging decision.
We can think of more questions to ask. In fact, the list could continue endlessly. But if you take away only one thing, it should be this: relying on subjective judgments or expected market direction to make a strategic decision such as hedging the market risk exposure is highly risky. Do everything within a proper governance framework and a clear plan within the institution.