Welcome to the next installment in our CFO Series of articles, where we are covering best practice foreign exchange hedging. This month we are looking at a specialized category of foreign exchange hedging instruments, which we are classifying as Enhanced Rate Instruments. These instruments help to achieve exactly what the category describes – enhanced rates or rates that are better than comparable instruments. The instrument might offer rates that are better than the spot rate, or better than the forward rate. Or it may offer improved strike rates on your structured option. The enhancement can be significant, adding dollars to your bottom line.
A common reaction, when someone first sees an enhanced rate on offer, is that it sounds too good to be true. But not only is it true, but enhanced rate instruments are also readily available from banks and foreign exchange providers. However, remember the adage, ‘high risk, high reward’. Whilst these instruments do offer a high reward, our goal today is to offer you some insight on how to use these instruments. This may be the perfect time to remind you of the golden rules.
If you saw our article from June on Choosing a Hedging Instrument, you will recall the Five Golden Rules when choosing a hedging instrument. These are the rules that also apply to choosing enhanced rate instruments:
Once these boxes are ticked, we can move into learning more about how these instruments work.
Rates on hedging instruments can be enhanced through several different mechanisms. The adage of ‘higher risk, higher reward’ is true for all enhanced rate hedging instruments. So, when looking at enhanced rate instruments, it is important to ascertain how the FX providers can enhance the rate, as there will be a risk payoff.
That said, once you understand the risk, you can entertain a huge range of instruments that are capable of adding significant value to your foreign exchange hedging program. Three common mechanisms used for enhancing rates are outlined below, with a couple of examples.
The use of leverage is one of the most common practices used to enhance exchange rates. Leverage is a term that is broadly used in financial markets, so for the sake of clarity, we are referring to leveraging a structured option; this may be referred to differently at other institutions.
Leverage is achieved when you enter a hedging agreement where your potential obligation to trade is for a greater value than the protection that instrument is offering. For instance, you might agree to a structured option that offers protection for USD 1 million but has the potential to obligate you to trade USD 2 million. As a payoff for this potential higher level of obligation (risk), you are offered an enhanced rate (reward). This example can be said to have a 2:1 leverage ratio, which is often the maximum ratio banks and FX hedging providers offer.
When leveraging, the excess potential obligation that you face is commonly dubbed a contingent amount. This is because this excess potential obligation is contingent on an exchange rate movement or outcome.
One of the difficulties with leverage is matching the contract value to your exposure. Using the 2:1 example above, where you would be protected for USD $1million and potentially obligated for USD $2 million:
Some FX providers and banks, including EncoreFX, will allow you to pre-deliver the protected portion of a leveraged option. However, the contingent amount cannot be pre-delivered, as the outcome of that contingent portion is not known until expiry.
Leverage is commonly used where businesses are looking to achieve an enhanced rate and have the capacity to operate a flexible hedge ratio (eg 50-100%). Alternatively, it is used where businesses can roll any contingent portion of a contract into future months.
Let’s say you are an importer of goods with a monthly exposure of USD 1 million dollars. You’re considering taking cover of USD 250k. The 3-month forward exchange contract rate is 0.6525 cents.
A 3-month Ratio Forward offers an Enhanced Rate of 0.6600, representing a potential advantage of NZD 4,354. Here’s how the instrument works:
One of the common styles of enhanced rate instruments is a ‘Knock-Out’ style. For clarity, we refer specifically to instruments where any protected amount within the contract can be terminated if a pre-determined rate level is struck. By nature, these instruments do not offer a true hedge – instead, they offer an opportunity to deal at an enhanced rate.
The obvious difficulty with this style of instrument is the potential they have to leave you unprotected from adverse currency movements. Additionally, these structures cannot be pre-delivered.
These structures offer some of the highest levels of rate enhancement available, however, are only suitable for businesses who can accept a lack of coverage, should the structure be terminated.
Perhaps you are lucky enough to have exceptionally high gross margins and can afford to have a more active approach to your FX hedging.
A New Zealand based exporter with high gross margins has been frequently using the spot rate for exchanging their currency. Given the low level of the New Zealand dollar, they decide to consider coverage for 25% of their monthly exposure: USD 500k. The 6-month forward exchange contract rate is 0.6550.
A 6-month Knock Out Forward offers an Enhanced Rate of 0.6450 – representing a potential advantage of NZD 11,835. The reward is high – but there is also a chance of this contract fully terminating before expiry, meaning it is also a high-risk product. Here is how the outcomes work:
There are several other instruments which offer enhanced rates, but also allow you to remain protected and avoid leverage. The protected (or worst case) rate levels on these types of instruments are lower than what is available on a comparable forward exchange contract, and the enhanced rates are usually contingent on an exchange rate outcome. The question here is, are you comfortable giving up the certainty of a better forward rate for the opportunity to deal at an enhanced rate?
Enhanced rate instruments are now widely accessible in the market. Many financial service providers and banks offer an array of these instruments. Given this, it is vitally important that:
If you are wanting to learn more about how these instruments can enhance your rate outcomes, please contact one of our FX experts at your nearest branch.
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