In a DerivSource expert Q&A, Chris Towner, Director, at Chatham Financial, explores how financial institutions, including corporates and funds, can adopt strategies and procedures to ensure they have the flexibility required to hedge FX risk in light of changing market conditions and ‘unknowns’, including the coronavirus or COVID-19.
Q: Is Coronavirus the biggest market risks financial firms are preparing for in 2020?
A: Coronavirus so far is the biggest story of 2020. The financial markets are constantly trying to price the risk of the economic damage that something like the coronavirus can cause to GDP, not just to the Chinese economy, but also the global economy. Economic damage in China will show up quite clearly in the first quarter GDP. Considering how much the coronavirus is impacting trade and travel, 3% growth would be a good result for China in the first quarter 2020, while a decade ago, we expected growth levels of 10%.
Before the coronavirus hit, it looked like the U.S. Presidential election and the UK-EU trade negotiations would be the biggest risks firms needed to hedge against. These are known risks – firms know when the election will take place, and the end date for the negotiations. But the coronavirus outbreak is a known unknown. We know that these things happen; we just don’t know when, or what kind of impact they will have on the market.
Q: What are the strategies and tactics you advise your clients to adopt to ensure they manage financial risks and market unknowns effectively?
A: We advise firms to use flexibility for both known and unknown risks. Rather than hedging FX risk with an outright forward – which comes with complete obligation and no flexibility – they could use a more flexible hedging tool, like an FX option, or a combination between a forward and an FX option. This allows a fund to manage risk in a more flexible way, so that if revenues for the business don’t meet expectations, the fund is not 100% exposed to the hedges, and is only 50% exposed to the amount of volume it has hedged.
At the same time, not all businesses can hedge 100% of their risk on an ongoing basis, so we also work closely with businesses in writing FX policies, so they can both use flexible tools and also have flexibility in the percentage hedging they use over time.
Businesses are usually able to forecast the next quarter, but beyond that, it can become a little cloudy. One option is to have a lower minimum threshold of hedging as time goes on and to cap the maximum amount of hedging they have in place. We write bespoke policies for each business based on their net risk to the markets: What kind of volume they are exposed to; what their objectives are; and how much hedging they should have in place – in order to keep a good amount of hedging but not to be overhedged, because risks do crop up in businesses, both internally and externally.
We’ve seen that with the coronavirus. If you were a travel agent, or just doing trade with China at the moment, then you might not be able to meet your forecasts. Hopefully this is a very short-term risk, but you need to be able to be flexible and adjust your forecast. Flexible hedging tools and the flexible policy to approach these kinds of risks put firms in a better position to do this than if they hedged everything with inflexible tools.
Q: Are there any new, or just very useful, sophisticated approaches or tools that you are seeing firms adopt to stay on top of the market risks as they evolve? Or is it more using what they always use, but doing it very strategically?
A: I think it’s more the latter. Very complicated derivative structures can completely restrict firms or leave them worse off economically. When hedging risk, as well as keeping things flexible, it’s also important to keep things simple and not use overly complex tools. Insurance tools such as plain vanilla options, or a combination of plain vanilla options with FX forwards, can give a very neat strategy, with enough protection but at the same time enough flexibility to cope with anything that can happen in the market.
“Insurance tools such as plain vanilla options, or a combination of plain vanilla options with FX forwards, can give a very neat strategy, with enough protection but at the same time enough flexibility to cope with anything that can happen in the market.”
It’s not just about coronavirus, or this year’s known political events. An internal decision or external event could take the market by surprise anywhere, at any time. At the beginning of 2015, the Swiss Franc strengthened by 30% in a number of minutes because the country withdrew the protection that was capping the strength of the currency. The market priced in a strengthening Swiss Franc and it strengthened dramatically.
Companies should always be monitoring and hedging risk. Some risks are easy to measure and quantify. Funds can see what’s happened to that exposure historically and quantify the impact that risk could have on their business. They can even start to quantify how the risks will look in the future. With known risks, financial models can quantify that risk. The coronavirus is a risk that is extremely difficult to quantify. If it spreads dramatically, the economic impact will go up. If governments decide to stem trade and travel in an effort to contain the virus, that invites the possibility of a global recession.
Q: What can market participants learn from past experiences to ensure they best hedge their financial risks in the coming year?
A: There will always be some form of volatility in the financial markets. Firms should never wait for a disaster to happen before they start looking at what their risks are. Looking back to the Brexit referendum in 2016, when it was expected that the UK would vote to remain in the EU, many businesses didn’t look at the risk until after the referendum. That’s far too late. A business should be looking at how to manage exposure risks when the market is quiet, when there isn’t an extreme event going on, because it is easier to plan.
The next step is to bring in the board and make a decision together. The onus of the financial risk shouldn’t be on any one person. The whole board has a responsibility to make sure that that risk is managed within the business.
Firms should remain very flexible, because we don’t know what’s coming around the corner. A high degree of flexibility is always required.
Understanding how much financial risk is inside the business is essential and makes it a lot easier to hedge that risk in the external markets. The external markets will always be impacted by economic data, political events and disasters. The first step is understanding what the risk is and how big it is. Is there any way within the business or fund to reduce that risk before looking at hedging it in the financial markets?
Q: Are there newer types of technologies that firms can look towards to help in managing financial risks?
Technology requires a lot of investment, and it’s always changing. It’s essential for enabling clients to match their current risk with the value of their hedges, to make sure that they are hedged against external volatility inputs.
Technology also enables firms to monitor their margin thresholds so they can know when the bank will call them for more money. Cash management is essential for every business, so having visibility on the forecast for short-term cash requirements is absolutely key.
Lots of funds have risks that are not liquid. When dealing with non-liquid assets, there are different routes available to protect the fund’s cash, be it negotiating large thresholds with the banks or having lines or sub lines that enable funds to access or borrow cash quickly if the need does arise, in order to avoid being a forced seller of a non-liquid asset.
Post-financial crisis regulations have made it imperative for all businesses to be monitoring margin thresholds. Some funds and businesses have to post margin daily to the banks and vice versa. Knowing the margin requirements on a daily basis enables funds to be prepared and to manage their cash effectively, which is the lifeblood of a business or a fund.
Q: As an expert in financial risks, what is your top advice for our readers?
Be prepared for anything; be flexible; make sure you have access to the data needed to understand your risk; have access to valuations and to cash and seek independent advice from hedging experts.
