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Risk Management

Navigating Available FX Strategies

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August 09, 2016

FX risk management is getting tricky as currency volatility increases.

econ and currency240FX risk management remains a hot if not the hottest of topics today among global corporations’ treasury executives. This is backed up by sentiment within the NeuGroup network, where treasurers and FX managers alike have revealed that their bosses are increasingly focused on FX issues, amid a backdrop of regulatory constraints, bank-driven reductions of available liquidity, and the cost of hedging against volatility and a strong dollar featuring prominently. And at a recent NeuGroup Assistant Treasurers’ Group of Thirty Peer Group meeting, members discussed some of their concerns, while meeting sponsor and host, Chatham Financial provided the firm’s views on the market, the hotspots, and approaches to effective FX management and strategy.

In terms of deal-contingent hedges, some of the least-known banks are the best at pricing them, said Amol Dhargalkar, managing director at Chatham. He suggested members look for banks with large portfolios of deal-contingent hedges reducing their risk and pricing. But it’s critical to have active involvement from legal, as terms are critical and require active legal-team involvement. That’s because a cheap premium may result in a steep bank fee if the acquisition founders. Entering into a separate ISDA is possible, but most companies enter into a long-form agreement within the transaction itself. Long a favorite of private equity firms, deal contingent hedges are growing in popularity among corporates, he said.

It was also suggested to AT30 members that they consider using the long-haul method, which can help organizations expand hedge accounting capacity. According to Aaron Cowan, Chatham’s executive director of corporate hedge accounting, this can also be accomplished by scrutinizing the company’s organizational structure and its various currency exposures. After that, members were instructed to figure out what type of hedge is required and drill down to find all the instances where designated hedges can be applied.

Mr. Cowan noted four tools to increase hedge accounting capacity: direct designation, indirect designation, split designation, and rolling exposure buckets, which can alleviate capacity constraints stemming from forecasting uncertainty. Chatham provides a data-gathering guide to clients and then digs in to find where hedges can be applied—a USD-functional subsidiary with GBP revenues, for example, calls for a directly designated hedge and is low-hanging fruit.

Chatham looked at alternatives to hedge translation risk, and each required tradeoffs. Fixed-income forwards are agreements to forward purchase a US Treasury security with the proceeds of that contract, and the mark-to-market value is recorded in equity. However, not all accounting firms allow the transaction to qualify for hedge accounting. But Chatham found uneven acceptance by auditors. For instance, it has seen situations where the same fact patterns presented by different clients to the same audit firm have received different interpretations.

More accounting-friendly, said Mr. Cowan, are prepaid FX forwards, where the bank prepays one leg of the forward at inception and the client pays the other leg at maturity. A pre-paid forward is not considered a derivative under ASC 815 and will be accounted for as local-currency borrowing.

Chatham also reviewed the benefits of its Vine-Copula Modeling, which seeks to view a range of exposures holistically. Companies’ senior management tends to view models with skepticism, noting correlations can change, but those correlations aren’t held constant in the model developed by Chatham’s quants, said Mr. Dhargalkar, and it seeks to replicate what happens in real life. A midstream energy company Chatham works with uses the model to allocate capital to its different business units. “Each business unit takes a different amount of risk based on the return it generates,” he said, adding the model can be applied to whatever metric matters to the company.

FX will likely remain a top concern for MNCs for the foreseeable future. FASB is amending its hedge accounting rules, providing more flexibility to achieve hedge accounting and impacting deal-contingent hedges as well as partial-term hedges. It is also prompting MNCs to move to the long-haul approach to achieve hedge accounting, one of several ways to expand hedge capacity.

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