Is There Such a Thing as “Too Expensive” to Hedge?

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It is said that the two happiest days in boat owners’ lives are the day they buy the boat, and the day they sell it. If you own a boat, you understand this ism based on the money and effort it costs to keep a boat. Executives feel the same fervor when their operations expand into fast growing economies with large populations. Like boat owners, executives focus on the good times and unlimited horizons that lie ahead. However, also like boat owners, executives make a major commitment to the costs and risks of operating in emerging economies. A great example is the variability of currency values and the cost of hedging in such economies. 

In a recent article, we casually and cryptically asserted that the cost of hedging high cost currencies is commensurate with the risk hedged – over the long run. If the long-run performance of hedging and not hedging is the same, then the value of greater certainty of outcome augers in favor of hedging – even when the cost appears to be high in absolute terms. This assertion was likely met with cringes, dubious reactions, and raised eyebrows, because it pits financial theory against market behavior and psychology. If true, it puts treasurers in the complicated position to advocate paying a “high premium” to create certainty of future periods’ performance by hedging such exposures.  

In this article, we provide some evidence that long-run outcomes justify the high cost of hedging. But, let’s be realistic. There will never be a definitive conclusion whether the negative cost of carry is justified

  • in a given currency pair

  • for a given tenor or

  • over a future horizon.

Our purpose is not to respond definitively, but to highlight there is reason enough to refute those who hold staunch views that the cost of hedging high negative carry exposures is “too expensive.” Instead, we find hedgers actually get what they pay for, with the added benefit of reduced variability.  

 

Self-Insure or Pay Negative Carry?

When hedging, companies commonly lock in forward rates for settlement on future dates, and the forward rate serves as the expected value in financial markets. The cost or benefit of hedging is based on the differential between interest rates in two currencies.[1] When the interest rate differential causes the forward rate to be much less favorable than the current spot rate, the condition is known as negative carry, which is viewed as a cost of hedging.[2]  

For instance, take this example of the Indian rupee versus USD. At year-end 2017, the USDINR spot rate was about 63.8, and the one-year forward rate (to hedge incoming INR to the end of 2018) was about 66.2. So, hedging future INR receipts would cost your company a premium of about 3.75% versus the spot rate for a year.  

Sadly, many companies evaluate hedging results based on whether hedges are continually profitable rather than by the predictability and certainty hedging delivers. Consequently, some executives believe companies should self-insure against such high-risk exposures, because the cost to hedge is uneconomical … but is it?  

 

Assumptions & Analysis

Our analysis was not overly scientific, because our objective was to demonstrate that risk management could be viable, even in the case of substantial negative cost of carry. But we did attempt to minimize bias due to time period, region, and complicated assumptions of strategy. Randomly, we chose three currencies that are “expensive” to hedge versus USD to illustrate: BRL, ZAR and INR.  

  • The time period was chosen to avoid bias due to the global financial crisis (post-2008/2009), that would tend to favor hedging of high risk financial positions

  • At each year-end between 2010 and 2017, we assumed 100 million of each non-USD currency would be received at the end of the following year

  • Each hedge assumes a sale of 100 million of the foreign (non-USD) currency 

  • Each hedge settled at the end of the following year

  • For comparison, we calculated the conversion value of the foreign amount assuming it was simply converted at the year-end spot rate

  • We tallied the USD value of each year’s FX amount under hedged and unhedged scenarios

 

You Get What You Pay For

Over the analysis horizon, for the selected currencies, companies experienced a better economic outcome by hedging – despite negative carry, and even before adjusting for risk (i.e., the variability of the unhedged outcome). Though each currency experienced some years when the unhedged outcome was better, the total USD value achieved over the entire horizon was superior for the hedged scenario.  

We asserted that over the long run, your company is better off to transfer the risk of high risk / negative carry currencies by using financial hedging rather than to self-insure. Our purpose was to refute reasons why executives elect not to hedge, and the results universally supported our assertion.  

 
Hedging INR would have produced about USD 0.049 million (0.38%) more proceeds than not hedging expected receipts.

Hedging INR would have produced about USD 0.049 million (0.38%) more proceeds than not hedging expected receipts.

Hedging ZAR would have produced about USD 3.9 million (5.48%) more proceeds than not hedging expected receipts.

Hedging ZAR would have produced about USD 3.9 million (5.48%) more proceeds than not hedging expected receipts.

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Hedging BRL would have produced about USD 8.1 million (2.74%) more proceeds than not hedging expected receipts.


Considerations 

While we do not purport to have provided a comprehensive analysis, there are several issues we specifically did not attempt to address:  

  • We made no attempt to employ a strategy to manage year-on-year results, so they vary greatly despite the assumed hedge strategy 

  • We did not consider currencies for which the native central bank “pegs” the exchange rate, and for which the risk profile is different from free-floating currencies

  • We made no effort to risk-adjust results, because it was not necessary to support our claim. Depreciation in the illustrated currencies outpaced the high cost to hedge, thus we don’t need to risk-adjust our results to decide whether the cost of reducing variability is worth the reduction of variability. Though, if we did risk-adjust our results, it would provide amplified support for hedging  

  • The analysis is not intended to imply that companies that are short the non-USD currencies would be economically better off by not hedging

 

Summary

Faced with many evaluations of which expenditures make economic sense, executives are prone to using “gut reaction,” especially when it seems a cost is too high to be justified. But even a cursory analysis might refute the validity of such impressions when it comes to managing FX risk.  

While executives’ opinions of the cost of hedging certain exposures might initially deter you from hedging some of your company’s most volatile exposures, it is important to keep the focus of your risk management efforts on factual data, such as the value of certainty provided by risk management programs, and the reality that, in the long run, there is a reason why it is expensive to manage highly volatile currencies.  


[1] See How to Use Probability to Manage FX RiskApril 10, 2019

[2] Many such currency pairs involve a currency that is not directly convertible, i.e. hedges are non-deliverable.  As such, hedges are cash settled, and the cost of hedging is not strictly related to the interest rate differential between the currencies involved.  This is beyond our scope and does not change the results of our illustration. 



About the Author

Chuck Brobst is the Managing Director of Analytics and Innovation Strategist at OANDA Corporation. He teaches graduate courses on risk management and banking at DePaul University. Previously, he founded GFM Solutions and spent 15 years in global markets divisions of BAML and ABN-AMRO Bank.


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