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Foreign Exchange Hedging – Pitfalls and Peculiarities  

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The foreign exchange (FX) market is considered to be the largest market in the world, with an estimated $4 trillion dollars trading daily.  Currencies are traded in both regulated markets such as the futures market and in the largely unregulated interbank market.  Currencies are traded around the clock (except weekends) and market participants range from the major banks to small retail speculators.  It is a favorite of hedge funds and large speculators as the major currencies are very liquid, trade on low margin rates, and can be very volatile.  The US dollar and the Euro dominate the trading, accounting for about 60% of the daily volume. 

Unlike specific commodities such as corn or crude oil, where a relatively small number of producers and consumers are significantly affected by the price of these commodities, almost every company is exposed to currency risk in some way.  This is due to the simple fact that all of a company’s revenue and expenses are denominated in one home currency and affected by changes in a number of other currencies.  The degree of currency risk for a company is dependent on the mix of its revenue and expenses and the currency that most impacts the value of each of those revenue and expense items.  Even companies that do not directly export or import any products or services can still be affected by competitors that are sourcing outside of Canada.  In today’s global economy with huge trade flows, currency fluctuations affect the value of almost every good to some degree.

The objective of a currency hedge is to eliminate the impact of changes in the currency on the company’s bottom line.  For example, a simple currency hedge is a Canadian grain exporter selling a cargo of canola to a Japanese crusher in US dollars.  The grain exporter wants to fix the Canadian dollar value of the sale and so will buy Canadian dollars and sell US dollars.  This can be done with a bank in the forward market (matching the expected date of the US dollar receipts) or in the futures market.  In either case, both the dollar value and the approximate date the funds are to be received are known and unless the sale is defaulted the transaction is fairly simple.  These case-by-case currency hedges are the easiest and work very well. 
Canada’s economy is heavily dependent on exports and each of these exporters is exposed to changes in the value of the Canadian dollar relative to our major trading partner currencies.  Most commodities are traded internationally in US dollars and so irrespective of where the commodity is sold, the risk lies in the Canada/US dollar exchange rate.  Most international transactions of energy, metals and agricultural commodities are denominated in US dollars.  For example, Canadian natural gas and crude oil producers are exposed to change in the Canada/US dollar exchange rate.  Sales are made on a regular (flow) basis and therefore hedging each particular sale, as in the case of the grain exporter, makes little sense. 

Companies that are on either end of the value chain such as primary producers and end consumers are perpetually long and short, respectively.  The currency hedging decision for a primary producer is two-fold; 1) what percentage of expected production to hedge and; 2) over what time horizon.  Long term hedges in almost all commodities are difficult to execute well and can be costly to transact (see my Lessons from Hedge Disasters article).  Typically, hedges are placed out over 1 to 3 years.  The same decisions have to be made for an end consumer.

The more complex currency hedges involve a company trying to manage its overall corporate exposure, which typically involves trying to protect EBIT (Earnings Before Interest and Taxes).  Protecting EBIT from currency fluctuations still involves determining the amount of hedging to be done and the time horizon, but is more complicated because the impact of currency changes on EBIT is likely nonlinear and can be dynamic.  The best way to illustrate this is to consider the difficulties encountered by a Brazilian pulp producer hedging the Brazilian Real/US dollar exchange rate.  The Brazilian Real has been notoriously volatile and so is a good candidate for risk management with respect to its impact on a company’s bottom line. 

In 2008, Aracruz Celulose was the world’s biggest producer of bleached eucalyptus pulp, boasting a 26% share of the world market.  Its sole product was pulp, with 95% of its production being exported and priced in US dollars.  From 1999 to 2008, Aracruz undertook a hedging program to protect against an appreciation of its local currency – the Brazilian Real.  From 2003 to just before the financial crisis in 2008, the Real appreciated steadily moving from 3.8 Real/USD to 1.5 as Brazil experienced strong capital inflows.  Aracruz used a combination of different hedging instruments including futures, forwards, swaps and an exotic swap with monthly settlements embedded with short call options.  As the financial crisis hit Brazil, the Real depreciated against the US dollar from 1.6 to a spike of 2.5 during the fall of 2008 which amounted to over a 50% depreciation.  The very large hedge losses in such a short period of time forced Aracruz to exit its entire hedge position in the fourth quarter of 2008, resulting in a realized hedge loss of $2.13 billion.  With its stock price crashing 90% in 3 months and teetering on the brink of bankruptcy, Aracruz was bought by a smaller competitor in 2009. 

The Aracruz case study provides a number of important lessons for all currency hedgers:

Independent Middle Office – the CFO and his team was responsible for planning, executing, evaluating and reporting all hedging activity.  After the hedge was liquidated, Aracruz created an independent middle office.

Stress Testing – it is unclear how much, if any, stress testing Aracruz did of their hedge position.  While the Real’s drop of 50% was large, it was not unprecedented and a stress test would have revealed the very large hedge losses, especially as the short call option positions moved in the money and volatility increased.    

Complex Derivatives – the downfall of many hedgers has been a lack of understanding of complex derivatives.  In the case of Aracruz, the derivatives were not overly complicated since they included call options embedded in a strip of forwards, but its nonlinearity and short volatility meant that management was likely not aware of the potential for very large losses.  Costs and the inability to efficiently exit exotic derivatives in times of market stress must also be considered.

Leverage - the wonderful world of derivatives operates on leverage as only a small percentage of the underlying value of the position is required to initiate a hedge (i.e., the margin requirement).  However, holding on to a losing position requires a constant source of funds and many firms fail to consider the leverage they undertake in hedging until the margin calls start arriving in earnest.

Funding Risk – while in theory hedging long term exposures may be warranted, the reality is that in the short term large losses in hedging positions can wreak havoc on a company’s decision-making ability and often result in liquidation of the entire hedge position.  This is especially the case if positions have not been properly analyzed.  Of course, an inability to fund the hedge losses will necessitate liquidating part of the hedge position irrespective of its performance.   

Correlation Risk – failure to consider the correlation between changes in the exchange rate and the firm’s revenue can result in the hedge largely failing for a period of time.  This is easier said than done, since correlations can be relatively stable and then abruptly change or even reverse during periods of high market stress.  This was the case for Aracruz as the Real plunged and the firm’s revenue also decreased at the same time.  One way to deal with the potential for changing correlation during market stress is to buy out of the money call options in order to create a hedge that responds in a nonlinear fashion and thereby better matches the changes in EBIT.   Aracruz did the opposite – they sold call options which contributed in large part to the losses. 

Hedging as a Profit Center – Aracruz greatly increased its hedge position in 2008 being 3 times greater than required and not consistent with previous hedging activity.  It is unclear why the managers of Aracruz overhedged the company’s FX exposure just before the storm hit, but the hedge profitability during the previous years could contribute to using the hedges as a profit center as the expectation was the Real would continue to appreciate.  It is also possible that errors were made in measuring the total hedge size as the derivatives were more complex. 

Quantity Risk – often overlooked is the difficulty in determining the optimal hedge size.  Since EBIT is impacted by both revenue and expenses and can be a small percentage of total revenue, the amount of currency to hedge is a volatile quantity.  Revenue is a function of both quantity and price, both of which need to be forecasted.  What is the relationship between the firm’s price and the exchange rate?  Hedge quantity is directly related to the correlation risk.      

Use of Natural Hedges – Aracruz’s hedge position was too large just prior to the financial crisis and the funding risk was much too high.  The use of natural hedges such as long term fixed interest rate borrowing in US dollars would protect EBIT while at the same time reducing the funding risk.  Margin calls are difficult to predict unlike the cash outflow from long term fixed borrowings.

In summary, Aracruz was a perfect candidate for a currency hedging program as the company was heavily exposed to changes in the value of the Real which was very volatile.  The poor hedge design, excessive size, lack of independent monitoring, lack of adequate funding and difficulty in managing EBIT with a hedge, all contributed to its downfall.  It is ironic that those risks that need to be managed such as a volatile currency are going to be the ones that test the hedge design and can force a complete failure.  If the currency or commodity is worthwhile hedging then it is volatile enough to warrant running a series of stress tests and scenarios.  Currency hedging EBIT is especially tricky and requires careful analysis before executing the hedge.

Iebeling Kaastra, CFA FRM

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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