According to a new study, a majority of businesses are not protected against many of the key financial risks they face. Chatham Financial’s 2020 State of Financial Risk Management Study found that fewer than half of public companies that face exposure to interest rate or commodity risks and slightly higher than half that face foreign currency risks utilize a hedging program to manage these risks. At the same time, businesses’ grasp of hedging techniques is slightly on the rise compared to three years ago, signaling that sophistication in risk mitigation is growing, albeit slowly.
The study, which reviews the financial risk management practices of more than 1,400 U.S. public companies, was conducted via a deep-dive analysis of 10-K filings made in 2018. These filings were examined manually to account for companies’ risk exposures, hedging strategies, capital markets activity, and hedge accounting practices. The subsequent conclusions represent the latest and most complete analysis of U.S. public companies’ hedging behaviors.
Chatham Financial’s study found while 91% of U.S. companies face exposure to interest rate risk, only 43% of these companies are actively managing this risk through a hedging program. Of the 47% of public companies that are exposed to commodity risks, just 37% hedge against this exposure. U.S. companies are far more likely to hedge their currency/foreign exchange (FX) risk, with 59% of companies that face this risk employing hedging techniques. All told, three in four (73%) of companies are exposed to FX risk.
“While the majority of financial risks that companies are exposed to can be easily addressed through hedging programs, we find that many businesses are choosing – even if not deliberately – to stay open to these risks,” said Amanda Breslin, Executive Director at Chatham. “In doing so, they may be exposing their businesses and investors to undue negative financial impact.”
Interest rate and FX risk hedging is on the rise
While it remains that a relatively low percentage of firms are addressing their risk exposures through hedging programs, risk mitigation efforts do seem to be on the rise. Compared to data from 2015 (the last time Chatham’s State of Financial Risk Management Study was conducted), companies are now more likely to hedge interest rate risk (37% in 2015 versus 43% in 2018) and FX risk (55% in 2015 to 59% in 2018). This may be attributed to the rise in volatility seen in interest rates and FX markets in recent years.
“The upward trend in hedging is a sign that more companies are concerned with their assessment of risks in the face of higher volatility and are actively engaged in managing negative impact to their financials,” said Breslin. “This is also an indication that business stakeholders are demanding greater attention to risk visibility and mitigation, and derivatives can be an extremely effective tool when operational measures within the business have been found to be insufficient.”
“These firms are in the difficult position of being exposed to complex risk asset classes while simultaneously not having the luxury of dedicated in-house resources to address these risks.”
For this reason, many smaller firms decide – or default to – taking a “wait and watch” approach to hedging risk or relying on natural hedges across their businesses (risks that naturally offset one another) to mitigate exposures. While the strategic employment of natural hedges can be an effective risk management technique, small growth companies can be further burdened by a rapidly changing risk profile.
“For example, as companies expand their global business footprint, they tend to gain FX exposure in terms of both magnitude and complexity,” said Basu. “This can introduce an entirely new challenge for a treasury department that is already stretched thin. By working with third-party financial risk management planning and execution experts such as Chatham Financial, these firms can forego the need for additional dedicated and specialized internal resources.”
Use of hedging techniques and hedge accounting
Among the companies hedging FX risk, a strong majority (63%) opt exclusively for FX forwards, which typically have no out of pocket costs to hedge. On the interest rate risk management front, swaps are consistently the product of choice. This year’s study revealed that 90% of businesses choose swaps to options with only 3% of businesses using an option-only strategy. The primary driver for this is that swaps offer a fixed rate without any premium payments, which many companies have found attractive considering the current, historically low interest rate environment. On the other hand, options or cap strategies involve an upfront (or sometimes deferred) premium payment for the flexibility to participate when rates are low while establishing the worst case if rates were to go higher.
Companies have also historically favored applying hedge accounting to their interest rate hedges, with 78% of companies in 2018 (compared to 81% in 2015) doing so. Additionally, the implementation of new accounting guidance had more of an effect on FX and commodity hedge accounting practices.
“With the introduction of improved hedge accounting standards, coupled with more companies embracing data-driven strategies, we hope to empower companies with greater access to financial risk management.”
The 2020 State of Financial Risk Management Study was conducted through a deep-dive analysis of the 2018 annual 10-K fillings of 1,402 publicly listed corporations with revenues ranging from $500 million to $20 billion. The study analyzed how companies manage risk exposure by asset class as well as the type of hedging program utilized and the application of hedge accounting by type of risk. This data was combined with insight gleaned from Chatham Financial’s client base of more than 3,000 companies to provide a comprehensive look at the financial risk management issues facing organizations today and how they are being managed. Data were compared to the results of Chatham’s previous State of Financial Risk Management Study, which analyzed 10-K reports filed by public companies in 2015.
The study also explored hedging practices and behaviors across ten industry groups, including manufacturing, professional and business services, trade, transportation and utilities, financial activities, information, natural resources and mining, leisure and hospitality, construction, education and health services, and other services. For a complete overview on industry-specific hedging practices and behaviors, request the 2020 State of Financial Risk Management Study.
About Chatham Financial
Chatham Financial is the largest independent financial risk management advisory and technology firm. A leader in debt and derivative solutions, Chatham provides clients with access to in-depth knowledge, innovative tools, and an incomparable team of nearly 700 employees to help mitigate risks associated with interest rate, foreign currency, and commodity exposures. Founded in 1991, Chatham serves more than 3,000 companies across a wide range of industries — handling over $700 billion in transaction volume annually and helping businesses maximize their value in the capital markets, every day. To learn more, visit chathamfinancial.com.