Multi-Currency Balance Sheet Hedging: Dispelling Myths & Finding Efficiencies
Multi-Currency Balance Sheet Hedging:
Dispelling Myths & Finding Efficiencies
As an FX salesperson, widely held beliefs around natural hedging can drive me crazy. The reality is that unless your FX exposures align perfectly in amount and timing within a reporting period, it is not necessarily prudent to rely solely on a “natural hedge” approach.
That said, there are correlations within baskets of currencies that can present ‘natural hedging’ opportunities that are often overlooked. These can present material benefits in lowering risk, transaction costs, and administrative burdens. I am going to take you through a hypothetical situation where this can occur. This hypothetical is inspired by a process we undertook with a client.
Diversification & Correlation – Not Just for Investment Portfolios
It’s not uncommon to come across multinationals with an array of currency exposures and who are at a loss as to what to do with them. In our example, the company has a rolling monthly exposure of $18M USD of foreign currencies on their accounts receivable (AR) and accounts payable (AP) ledgers across 30 currency pairs.
The notional amount is reduced to $16.47M USD after running a netting cycle and identifying some offsets. By aggregating the currency exposures together, we identified a monthly Value at Risk (VaR) of $2.56M USD at a 95% confidence interval.
We could have left it there; a lot of businesses might have. But the reality is that certain currency pairs have correlated return streams, so combining the individual VaRs of these currency pairs without taking that into account overstates the FX risk in the business.
In short, if the business were to hedge the individual VaR exposures, they would actually increase their exposure to FX risk, while at the same time increasing both transaction costs and the administrative burden of managing a hedge program.
Individual VaR versus Component VaR
Looking at our VaR analysis we can see a $542K USD difference between the VaR of each individual currency pair together, and the VaR on the portfolio level which takes into account the offsetting correlations amongst currency pairs (i.e., at the component level).
This highlights the diversification and correlation benefits to the business of having an array of currency exposures. Perhaps more importantly, this analysis outlines which currency pairs are the biggest drivers of variability. This was truly enlightening, as initially the management team wanted to hedge every currency exposure, even the pairs that made only a minimal contribution to risk. Hedging every currency pair would not only increase their total risk exposure, but also introduce additional transaction costs into the balance sheet hedging program.
Implementation
In this hypothetical situation, we started with a 30-currency balance sheet. After analysis, we not only uncovered correlation benefits, but also identified that the lion’s share of the risk came from just a handful of currency pairs. This made it clear that there were significant benefits to a more targeted approach.
We opted to run a monthly hedging program for the top currency exposures weighted for their contribution to overall risk, not to the notional size of their exposure.
This drove a sizeable reduction in the monthly Value-at-Risk to the business’s margins, which also meant a reduction in transaction costs and a lower administrative burden.
Hedging at a portfolio level
Examining the risk profile of the portfolio — the Component VaR, rather than risk derived from each individual currency pair — changes our perspective and allows us to consider different hedging approaches.
This is admittedly a bit self-serving: this process underlines how finance teams may often operate under assumptions or a lack of expertise that may lead to suboptimal results...
…assumptions that a friendly FX sales expert (such as the author of this article) can help to dispel and to leverage to drive real value that otherwise would be missed.
Read the next article in the series: Netting and Working Capital Management
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