Portfolio FX hedging: does it make sense?

Portfolio FX hedging: does it make sense?

When multinational companies present their financial results, material foreign exchange (FX) fluctuations are often cited as a cause of the unexpected results.

Recently, the weak dollar has been a much-debated topic for euro-based companies with sales in the US. For example, when Akzo Nobel presented its Q2 2018 financial results, the company’s net income fell by 10 percent due to adverse currency effects and non-recurring costs. The impact and sensitivity of this topic means it is important to discuss FX risk management at C-level.

Structured approach

Within a company, treasury is often mandated to manage FX risk and is therefore well positioned to advise the companies’ board on FX risk management. This is not an easy task as FX risk can be managed in different ways and this is mostly dependent on the business profile of the company. Treasury should create a structured approach towards FX risk management by determining parameters such as the types of FX risks to be managed, the hedging strategy, FX instruments to be used, etc.

More advanced risk management functions, supported by sophisticated tooling, have the means to implement portfolio hedging strategies for hedging FX exposures. By means of FX portfolio hedging, the correlations of the different currency pairs optimize the required hedging transactions to manage the aggregate FX exposure. For example, when a euro-based company is long in USD and short in HKD (correlation close to 1 as the HKD is pegged to the USD), and aims to fully mitigate the FX risk, it will only hedge the net exposure. This is a very simplified approach, but the portfolio hedging strategy also works with imperfect correlations. A portfolio of diversified, non-perfected correlated FX exposures, can be hedged via a proxy FX portfolio materially reducing hedge costs. This strategy can create much value for the company as the number and net amount of FX transactions can be optimized.

Careful consideration

However, there are aspects of FX portfolio hedging that should be carefully considered, and one is the determination of the correlations between the currency pairs. In times of stress, the past has taught us that correlations do not always hold. As a result, the envisaged result of the hedging strategy might not be effective and could even increase the company’s FX exposure if correlations move from positive to negative or vice versa.

So does FX portfolio hedging make sense? As you may suspect the answer to this question is a bit unsatisfactory, as (unfortunately) no approach fits all. It is paramount for each company to analyze which approach or approaches are suited to the company’s currency pair exposures. Different hedging strategies can be chosen for different currency pair characteristics (e.g. stable versus exotic currency pairs). These factors should be considered before deciding if FX portfolio hedging makes sense for your company.

Weigh up each option

Treasury should be well equipped to determine an effective FX hedging strategy before advising the board on the chosen approach by transparently presenting the benefits and risks of each option. To avoid material adverse FX effects in future, it is vital to keep up to date on market developments and adapt to changing marking conditions.