29 October 2021

Complex Financial Derivatives – Buyers and Sellers Beware

Publicity surrounding Deutsche Bank’s potential mis-selling of complex financial derivative products to an unsuspecting Spanish company highlighted, again, the risks associated with hedging foreign exchange. 

Publicity surrounding Deutsche Bank’s potential mis-selling of complex financial derivative products to an unsuspecting Spanish company highlighted the risks associated with hedging foreign exchange.  The first point to make is that if these hedges had worked as intended, there wouldn’t have been any publicity and certainly no lawsuits. It is only when positions go against you that the focus comes on whether these were appropriate hedges or not.

Treasurers have always spoken about how no one congratulates them when they get their calls right – but everyone wants to know what happened when the calls go the other way. Blame is easy – clear-eyed analysis after the event is more difficult. As with most cases of mis-selling, there is often fault on both sides. But how does a company get into this situation and how can they avoid it in the future?

Complex Financial Derivatives don’t belong on spreadsheets

A good start is making sure you have a Board approved Treasury Policy that stipulates the hedging products that can be entered into and on what basis. If it’s not an approved instrument, you either can’t enter into these hedging arrangements, or you need specific approval from the directors to do so.

If the hedging instrument is within the Treasury Policy, then it is the Treasurer’s responsibility to understand these instruments and their likely impacts. If it isn’t, and you need to seek approval from the Board, then you should be able to understand the product well enough to explain it to the directors, including what the likely implications are under different scenarios – changing cashflows and moving exchange rates being the obvious ones

This leads to the other key facet of entering into these products. If you can’t adequately record, report, value and model these instruments then you probably shouldn’t be entering into them in the first place.

Spreadsheets don’t cut the mustard when managing foreign exchange risks. Tools like Hedgebook, provide the ability for mid-sized corporates to capture not just plain vanilla products like FX forwards and simple options, but also more sophisticated ones such as TARFs (target accrual redemption forwards), which are at the centre of the Deutsche Bank claim.

You can’t set and forget

Being able to monitor these complex instruments on an ongoing basis is crucial but just as important is to look at the impact on your positions if exchange rates move or expected cashflows/exposures change. Foreign exchange hedging shouldn’t be set and forget, especially if you are using complex hedging instruments. How does this impact your mark-to-market valuation? Will you have too much cover or too little? Will you still be able to beat your budget rate?

All of this may seem obvious but without the right tools to monitor and react then the danger is the market moves against you and the first you know about it is when the bank calls up looking to restructure the positions because you are so far out of the money, asks for more collateral or just wants to close them out. Ouch!

That’s when the recriminations start and possibly the lawsuits. Banks have a responsibility to their clients when selling complex financial derivatives to them. Equally the client shouldn’t be entering into arrangements they don’t understand or can’t easily monitor their current and future impact on the business. Buyer and seller beware.

If you’d like to take a look at how Hedgebook can help you better manage your FX hedging risk take a quick look at our FX Exposure Tool overview video.

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