This article was written by Alison Fletcher and Yon Valtchev, Corporate Treasury Markets Specialists at Bloomberg.
The recent increase in financial markets volatility, driven by an expectation of continued rate hikes along with an unprecedented choice of financial markets instruments, makes hedging any corporation’s FX and rates exposure a challenging task. One essential decision is to consider if trading into one market produces a more cost effective hedge over another, and if so, how can that be evaluated?
Pricing from different markets
According to the BIS Triennial Central Bank Survey of 2016, 97.5% of foreign exchange forward outright contracts traded have a maturity date of less than one year. Typically, corporate treasuries contact their banks electronically and ask for a forward outright (or a batch/strip of forward outrights) with varying maturing dates. For maturity dates with shorter tenors, the price of the forward outright comes from two desks within the bank, the spot desk and the forward desk. Importantly, these desks sit under the FX department and clear their trades in the OTC currency market.
One of the key components in the negotiation of non-centrally-cleared trades is the negotiation of add-on charges. These charges may include liquidity, credit, funding, margin and capital. What is considered “fair charges” can be estimated with the help of liquidity and credit calculators. These charges generally vary based on several factors, including the volatility of the currency pair and counterparty credit. FX desks normally don’t include many additional charges due to the fact that most FX trades settle in less than 12 months, as noted above.
This situation changes quickly when you look to obtain pricing for longer term trades. As liquidity in the market beyond a certain point dries up, the FX forward desk is no longer the pricing source for forward outrights and it shifts to the swaps desk.
Optimizing credit and capital charges
Hedging FX exposure of known or relatively well forecasted cashflows can be structured in several ways. Natural hedgers should never limit themselves to asking for a quote on a single instrument, such as an FX forward, especially when there are multiple ways to structure the economic hedge. It is a worthwhile exercise to look beyond the obvious instrument and develop an understanding of what actually happens in the background, thus opening the opportunity to monetize potential pricing discrepancies or arbitrages.
There are several reasons why such pricing arbitrages exist:
- Market inefficiencies which can lead to certain hedging instruments trading away from their assumed equilibrium for extended periods of time
- Intervention by monetary authorities that can distort prices
- Differing regulatory regimes which can mean two instruments designed to provide the same economic hedge are quoted with different prices
Regulatory capital requirement distort the prices of hedges with maturities of longer than 364 days and these distortions can grow as the maturity date of a hedge is extended. Coupled with the fact that some developing market currencies lack liquidity altogether, this leads to a market where such add-on charges are largely negotiated rather than being transparent.
An additional consideration is the fact that some banks may not offer the full suite of instruments or for all tenors, thus prompting the need to transact with several counterparties in order to cover 100 percent of a specific exposure.
Evaluating your choices
With the multiple reasons that pricing diverges across the different markets explored above, treasurers need to thoroughly evaluate their choices. A unique aspect of corporate treasuries, subject to their own internal treasury policies, is their ability to deal into either the FX or rates markets and choose whichever provides the most cost effective hedging solution.
One of the key considerations in hedging is the accounting treatment the hedge will receive. While in the past hedging decisions might have been limited by the ability for the hedge to qualify for hedge accounting treatment, with the recent relaxing of accounting rules there has been an increased number of hedging strategies that qualify for hedge accounting.
To illustrate, take into account the example from above where we consider two distinct hedging approaches, both offering the same economic outcome and eligible for similar accounting treatment. Depending on how your relationship bank is set up, the act of transacting could involve asking for a price for a strip of FX forwards from your Corporate FX Sales Desk or asking for a separate price for a cross currency swap from your Corporate Rates Sales Desk. These desks will not only price differently, but they will also have to apply different capital and/or regulatory charges. Thus, an arbitrage opportunity between the two approaches exists and could be explored to produce a more cost-effective hedging outcome.
Based on Bloomberg tools and analysis presented at a recent webinar, when you take into consideration pricing in both the FX and rates markets and the potential credit and capital charges on both, FX hedges are proven to be more economical. However, this could change based on shifts in the factors discussed above.
Given a corporate treasury’s remit to hedge efficiently against fluctuating markets, evaluating which market produces the most cost effective hedge is an analysis that should be undertaken when deciding on a hedging strategy. Whether to mitigate against the risk of volatility, hawkish or dovish markets, or appreciating or depreciating currencies, the outcome of an effective hedging strategy can have a significant impact on an organization’s financial health. Firms like Bloomberg can provide extensive tools and Market Specialist support to assist corporate treasuries in conducting the necessary analysis required to make informed hedging instrument decisions.