If you’ve been following our CFO Series of articles, you’ve hopefully developed a best practice strategy for managing your FX risk. Now – it is crunch time. Time to start locking in FX deals to achieve your risk management objectives.
You’re feeling well prepared until your FX provider presents you with this array of choice: Forward Contracts, Vanilla Options, Structured Options, or Swaps. Within these categories, there are dozens of variations. You could be offered a straddle, strangle, or spread. A knock-in or knock out. An improver, extender, or accumulator. A ratio, cap, collar, or participator. A TARN or a TARF. A butterfly, seagull, or rainbow. You might now be feeling a little less prepared. What do these words mean? How do they differ? Which ones will work for me?
Today we will take you through the process of selecting the right hedging instrument for your needs.
First things first: it is important to note there is a difference between a hedging strategy and a hedging tactic. Strategy is what should come first – and this covers your plan or process, agreed upon by key stakeholders.
The tactic is the instrument that is used to implement the strategy. Whilst some instruments have strategic value inherently, they are not, on their own, a strategy. Learn how to develop a strategy here.
This article will discuss a range of hedging instruments that are known as ‘Over the Counter’ or ‘OTC’. This means the instrument is tailored to you and is not subject to a standardized set of terms, which allows for an endless array of hedging instruments. Here, we focus on the common categories.
The most common hedging instrument is a Forward Exchange Contract (FEC), otherwise known as a Forward Contract or just a Forward. This is where you lock in a fixed amount, at a fixed rate, for a fixed future date. Whilst there is some flexibility in terms of pre-delivering (using early) or extending (using late), the operative word here is ‘fixed’. You are contracted for the specified amount at that rate and have little flexibility.
Sometimes referred to as the Rolls Royce of hedging, this type of instrument was also named a ‘Vanilla’ option because of its plainness (like vanilla ice cream).
A Vanilla Option gives the contract holder the right, with no obligation, for a fixed amount of currency, at a fixed rate, at a fixed future date. The key difference with this contract are the words ‘no obligation’. This gives the contract holder the freedom to walk away from the contract and deal at a more favourable spot rate if they choose. Sounding too good to be true? The catch is the cost – Vanilla Options come with a premium.
The premium makes this style of instrument comparable to insurance. You pay a premium, have the insurance up your sleeve and hope to never use it. The premium can be expensive (hence the Rolls Royce analogy), but the ride with a Vanilla Option is the smoothest on the market.
Many organizations will incorporate the use of Vanilla Options within their hedging policy. There might be funds specifically allocated to purchase Vanilla Options, or perhaps they are used more actively (you can contact us for more on the active use of Vanilla Options).
Vanilla Options are also great tools for a tendering process, where you might be submitting a bid or proposal to provide products or services for a large project that may or may not be accepted. For a nominal premium, you can secure a guaranteed rate for a tender process. If you win the tender – you either use your insurance or start again at the better spot rate. If you lose the tender – you either use your insurance and cash it out to recoup some of the premium or your option lapses and you’re left with only a lost premium. This is a far better result than winning a tender but securing no margin due to FX losses.
This category contains the most practical and well-balanced instruments on the market. Here, you can find your Toyota Corolla of hedging – as basic and reliable as ever. You can also find your Holden Commodore – a reliable classic. Or maybe your Mercedes Benz – something more tailored to your sophisticated needs.
In this category, you will also find your Tesla (latest and greatest), your Formula One Ferrari (fast and dangerous), and your Mack Truck (far too big for your needs). Unfortunately, some in the market may offer you a second-hand, sawdust-filled rust bucket. So, it is important to understand what you are buying.
The choices in this category are endless – therefore, here are some Golden Rules to help you make your selections.
Tie it back to the underlying strategy. The first question you should ask yourself is, “Does this contract fit with my plan?” The second question is, “Does this assist in meeting my objectives?”
Your FX provider or bank should provide a detailed outline of the instrument outcomes, risk and rationale. If you don’t understand these outcomes (as some instruments can get highly complicated), you should avoid the instrument.
Another tip: if the contract sounds too good to be true, it probably is!
Certain instruments can result in you having an obligation to exchange a larger or smaller amount of currency than you require. Improper use of leverage can result in you being over-hedged. Certain Knock-Out style contracts or TARN or TARFs can result in outcomes where you’re underhedged.
Rule three should have already been addressed by rule one and two, but it is worthwhile reiterating this point – your plan to manage risk should always come first; being over or underhedged results in more risk for your business.
“I don’t have time” means “it’s not a priority”. Often, FX decisions can have a significant impact on your business. Your choice of hedging instrument could have a huge impact on your financial performance or position – often more so than many other decisions. What is the dollar value associated with 5 or 10% participation across your FX book? Is that worth your time?
If your hedging plan, strategy or policy has a strategic or active approach, you should invest some time to understand which instruments are going to work for you. You don’t need to fully understand the dozens of instruments available – that is the job of your FX dealer. A good FX dealer will understand your FX plan and know which instruments will work for you. It is the right selection of instruments that can help you achieve your strategic objectives more effectively.
Markets are inherently unpredictable. One way to conquer unpredictability is to ensure you strike the right balance of contracts. I’m sure you’ve heard of the saying “don’t put all your eggs in one basket”. I had it drilled into me as a youngster, and now I attempt to drill this into all hedging decisions: allow for balance.
True hedging instruments offer 100% protection from adverse movements in the exchange rate. At one end of the spectrum are instruments that offer better exchange rates but no potential to participate in the spot market. For example: Forward Exchange Contracts – suitable protection as long as you’re comfortable securing a rate knowing that you will miss out if the rate moves favourably after you have locked the contract in.
At the other end of the spectrum are contracts that offer either less favourable exchange rates or attract premiums. However, these allow uncapped levels of participation if the exchange rate moves favourably. For example: Vanilla Options – suitable if you’re happy to pay a premium to ensure you’re protected while remaining open to uncapped participation in favourable exchange rate movements.
Structured options fit in between Forward Exchange Contracts (no participation) and Vanilla Options (100% participation). They are typically structured with no premium payable, however, the exchange rate secured will be worse than the comparable Forward Exchange Contract. This less favourable exchange rate funds the potential to participate if the rate were to move in your favour. Participation might be up to a pre-determined exchange rate, or on a portion of the contract, or contingent on the spot rate reaching certain levels. The less favourable the rate, the more potential you have to benefit from favourable movements in the exchange rate. The key to success is finding the right balance between protection and participation for you – in other words, the sweet spot.
If you’re not satisfied with the instruments your FX dealer is offering, ask them to change the balance. Structured options are tailored instruments and it’s likely something can be done to better suit your needs – just remember that there’s a trade-off in play.
There is a range of structured options which offer enhanced rates – even better than the comparable forward exchange contract rate. Sound too good to be true? Can’t comprehend how this is possible? You might want to refer to Golden Rule Two – if you don’t understand the benefits and risks, then don’t buy it. But if you have the time to invest (Golden Rule Four), it’s worth finding out if enhanced rate instruments can work for you.
Enhanced rates are generally achieved through a process called leverage – where instruments have a higher face value of obligation vs protection. In other words – you might end up obligated for more than you have been protected for.
Structures that offer enhanced rates are generally more sophisticated. They often form part of an active hedging approach and are sometimes included in a strategic hedging strategy. We will be publishing another article on enhanced rate instruments later this year.
From time to time, we hear feedback that different hedging instruments were invented for one thing: to make the bank or FX dealer more money.
Where there is smoke, there is fire, and unfortunately, this reputation is likely a result of bankers or FX dealers charging wider spreads on different instruments. But this is an unfortunate way to tarnish a category or instruments which can offer many benefits. A wide or unreasonable spread is not something that is automatically a part of these instruments.
The spread you are charged is typically driven by the relationship with your FX dealer, and the culture within the organization you are dealing with. Ask yourself: is the culture of that business focused on putting revenue first? Are they announcing record profits? Or is the culture about putting the customers’ best interests first? And forming long-term relationships?
If you apply the ‘Golden Rules’ when choosing an instrument, you will understand the benefits the instruments offer (Golden Rule Two) and be able to measure these against any trade-off in protection levels. In time, you can learn to see the difference between risks and benefits, opportunities and opportunity cost, and protection and participation.
In Australia, New Zealand, and Canada, businesses like EncoreFX operate in a highly regulated environment. On top of normal consumer protection laws, financial service providers like us are bound to act in the best interests of our customers by financial market regulators. This includes ensuring the instrument you are choosing is suitable for you and commensurate with your needs. Further to this, your provider should be able to provide you with a Product Disclosure Statement (PDS) highlighting the risks and rationale for each instrument. Make sure your provider has issued you with the appropriate disclosure documents.
The priority in FX risk management is to implement your plan and meet your risk management objectives. By following a few Golden Rules, you can manage your risk whilst confidently implementing a wide range of instruments that add value over time.
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