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One of the difficulties companies face when using path dependent options, such as leveraged collars or participating forwards, is that the amount of cover in place will alter under different market conditions.
- NZ based exporter hedging USD receipts to NZD
- FX product = leveraged collar
- Leverage ratio = 2 for 1
- Protection amount = US$1 million
- Participation amount = US$2 million
- Expiry = three months
- Protection rate = 0.7200
- Participation rate = 0.6500
The spot rate at the expiry date of the leveraged collar will impact the amount of cover:
- if the spot rate is less favourable than the protection rate (i.e. higher than 0.7200 in this example) the hedged amount will be US$1 million at the protection rate.
- if the spot rate is more favourable than the participation rate (i.e. lower than 0.6500 in this example) the hedged amount will be US$2 million at the participation rate.
- If the spot rate is in between the protection and participation rates there is no obligation to transact
Therefore, depending on where the spot rate is at expiry, the exporter could end up with US$1 million at 0.7200 or $2 million at 0.6700 (or zero if in between the protection and participation rates). The primary reason for entering this type of hedging instrument is to improve the protection and/or participation rate than could otherwise be achieved without leverage.
From a risk management perspective, the company hedging their foreign currency cashflows needs to understand the impact alternative scenarios can have on hedging cover, both amount and rate. Often there are policy limits to adhere to, so having visibility over these, and ensuring limits are not broken, is important.
The FX Exposure Report in Hedgebook gives the user visibility over their hedge position under alternative outcomes. Hedging percentages, weighted average hedged rates and policy compliance under the best and worst case scenarios can easily be compared. The Currency Impact Report shows the potential dollar impact on the bottom-line under a number of alternative exchange rate scenarios. Both are available from the FX Reports drop-down menu in Hedgebook. Some of the output from these reports is shown below.
Hedgebook gives users of structured options greater confidence that these complex instruments are being recorded, valued and reported appropriately.
If you are an existing user and want some training, or you are interested in a demo of the Hedgebook software, contact us here: https://www.hedgebookpro.com/contact/.
Traditionally, the typical Hedgebook user has focused their foreign exchange hedging activity at the vanilla end of the spectrum. Forwards, purchased options and options that are in one-for-one collar relationships have been the staple diet of importers and exporters. To be honest, even purchased options are not particularly common as there is a distinct unwillingness to write out the cheque for the premium.
However, we have seen an increase in Hedgebook users that are using non-bank FX providers for their hedging and, as a result, an increase in “structured option” hedging products.
Structured options can allow the importer or exporter to achieve enhanced outcomes while still retaining an element of protection against adverse currency movements.
When entering structured options it is crucial that the importer/exporter understands what the outcomes may be. For example, a knock-out option may leave the importer/exporter without any hedging cover at exactly the time they need it most.
At Hedgebook we have recently expanded the FX hedging universe to include two of the more common structured options – participating forwards and leveraged collars – as well as improving the functionality to capture one-for-one collars.
The most common form of a one-for-one collar is the zero cost collar (“ZCC”). So-called as they are structured such that the importer/exporter has no premium to pay.
They are created by buying an option for a pre-determined amount of foreign currency at the protection rate and at the same time selling an option for the same amount of foreign currency at the participation rate. The premium received from the sold option offsets the premium paid for the purchased option.
Effectively you lock in a range of outcomes, a best case (participation rate) whereby the sold option is exercised by the counterparty, a worst case (protection rate) whereby you exercise the option that you have bought, or, if the exchange rate is between the ranges at expiry, neither option is exercised and you are free to do a spot FX deal at the current exchange rate.
Until recently users had to enter the two options individually into Hedgebook, then link them in a collar relationship. This is no longer the case.
A leveraged collar differs from a one-for-one collar in that the amount of foreign currency is different for the protection rate than for the participation rate.
The benefit of a leveraged collar is the ability to achieve more favourable protection/ participation rates than a standard collar.
An example is a 2:1 leveraged collar that gives you a nominated amount of foreign currency hedging at the protection rate (say USD1 million) and twice the amount of hedging cover at the participation rate (USD2 million).
Entering leveraged collars in Hedgebook is easy!
A participating forward allows the importer/exporter to have protection at a known worst case rate (the protection rate) but participate in favourable movements in exchange rates for a portion of the foreign currency amount.
A participating forward is structured with two options. The purchased option gives the importer/exporter protection for a pre-agreed amount of foreign currency at the protection rate. The sold option is for a percentage (“obligation percentage”) of the purchased option notional.
If the spot rate is less favourable than the protection rate at the expiry date then the importer/exporter will exercise the option for the full notional.
If the spot rate is less favourable than the protection rate then the importer/exporter will be exercised upon by the counterparty and be obligated to transact the obligation percentage at the protection rate and have the choice to transact the balance of the notional at the more favourable market rate.
See how to enter a participating forward in Hedgebook
Hedgebook provides greater comfort for importers and exporters entering more complex FX structures. Part of the challenge of taking advantage of the benefits on offer from the more exotic end of the hedging product spectrum is having the ability to easily record, value and report the instruments. Hedgebook endeavors to take these obstacles away.
Hedgebook was delighted to be selected as one of twelve companies to pitch at the NZTE showcase event in Hawke’s Bay on November 2. The Rockit Apples pack-house in Havelock North was transformed into an exhibit hall and host to 150 angel investors seeking investment opportunities. There was a broad selection of companies on show and at various stages of their growth cycle. From Hedgebook’s perspective, funding is being sought to fulfil our lofty growth aspirations both within NZ and further afield. The issues faced by NZ importers and exporters, the instruments used to hedge and the approach to risk management are the same in other countries. Hedgebook is focused on Australia and the UK in its next growth phase.
It was awesome to see a bunch of other exciting, innovative and ambitious companies from diverse backgrounds being supported by the experienced team at NZTE. Hedgebook was able to use the opportunity to increase brand awareness, letting businesses facing FX risks know that there is an alternative to error-prone spreadsheets.
As New Zealand’s food bowl there are many businesses exporting from the Hawke’s Bay and having to manage FX fluctuations – including the NZTE Ready for Launch showcase host Rockit Apples who subscribed to the Hedgebook software on the spot. A great anecdote for the investor pitch later in the day!
Companies will often hedge foreign currency exposures against harmful exchange rate fluctuations. Having decided to enter financial instruments, such as forward exchange contracts and options/collars, it is necessary to evaluate the performance of the hedging programme. There are a number of reasons companies will transact hedging not all of which are about “beating the market”. Stabilising selling prices or input costs, reducing volatility of profits, gaining a competitive advantage or displaying strong controls and risk management to key stakeholders are all good reasons to hedge FX.
Regardless of the reason for hedging, an evaluation helps with understanding whether the company has achieved its FX hedging goals. It confirms whether the hedging strategy has been successful, determines whether the choice of hedging instrument was appropriate, challenges whether anything could be done differently e.g. perhaps paying some premium for options might have delivered an enhanced result.
There are a number of metrics for assessing the success of an FX hedging strategy:
- Was the prevailing market rate at the maturity of the contract better or worse than the rate the contract was entered at?
- What is the P&L impact at the maturity of the contract?
- What is the weighted average rate of all FX contracts that matured in the last month/period i.e. the average conversion rate?
- Did the conversion rate beat expectations/budget?
- Would the company have been better off doing nothing?
It is important to address these questions otherwise the success of the hedging is too subjective. So how can a company easily understand the impact of its hedging decisions? Systems such as HedgebookFX can provide most of the answers. For example HedgebookFX’s Matured Deals Report includes the prevailing market spot rate at the maturity of the contract, the P&L impact and the conversion rate for the month.
Comparing against a benchmark
Having a benchmark rate to compare against is also helpful. The company’s monthly conversion rate can be compared to alternative hedging approaches such as no hedging (spot rate), passive hedging (mid-points of policy risk control limits, if the company has one) or some other mix of hedging instruments and/or duration of hedging.
The chart below is automatically generated for Hedgebook users. In this example the actual NZD/USD conversion rates are plotted against two alternative measures:
- No Hedging (spot)
- A mix of spot, six month and 12 month FX Forward contracts
The chart allows an objective consideration of the impact of hedging decisions.
Using a passive benchmark allows the business to understand the value added by the decision makers i.e. hedging decisions are captured within the actual conversion rate. The conversion rate is the outcome from active FX risk management. Critically evaluating the outcomes from hedging allows the business to gauge the success of its hedging programme.
Want to know more about managing your FX? Download our free guide “Dollars & Sense”, which covers how to better manage FX Risk. Understand what constitutes FX risk, whether you should be hedging against it, the common financial instruments involved and the technology tools available to make the process easier. https://www.hedgebookpro.com/hedgebook-fx/