Introduction to hedging

To understand hedging, you must first understand the interest rate, foreign currency, and commodity markets, how they function, and how treasury teams operate within those markets. Below, you will gain an overview of these markets, key risks corporations face, and some common derivative products for mitigating those risks. Next, you will learn the mechanics of common derivative products and gain a conceptual understanding of how transactions are priced. You will then learn about risk management practices and how to implement them in real world situations.

Interest rate markets

The current market upheaval has created extraordinary uncertainty and risk. Looking at the headlines in today’s interest rate environment, we see rates slashed across the globe by most central banks, and even discussions of negative rates here in the U.S. In fact, some countries, including the U.K., issued government bonds at negative interest rates. The below charts illustrate some key interest rate drivers around the world, including factors that the Fed looks at when they assess industry conditions and think about setting interest rate levels.

Inflation

One of the Fed’s dual mandates is inflation. In the above inflation chart, we see that the Fed’s stated target was maintaining inflation at around 2% in the United States. At the end of last year and beginning of this year, we saw inflation rates rising toward that 2% mark. However, in late February and early March when the COVID-19 crisis hit, we began experiencing deflationary trends as inflation moved downwards. The way interest-rate setting works is when inflation rises above the target, the Fed tends to think about raising interest rates, and when inflation is low, the Fed can consider cutting rates.

Unemployment rates

The other key factor in the Fed's dual mandate is the unemployment rate. In the unemployment rate chart, you can see we were at historic lows in the U.S., especially toward the end of last year and beginning of this year when rates were around 3.5%. Due to the current crisis, the unemployment rate has skyrocketed to historic levels, roughly about 20% at this point of the crisis.

Gross Domestic Product (GDP)

Another factor that the Fed looks at when thinking about setting interest rate levels is economic factors, such as GDP. Recently, the Fed has been looking, not just at the U.S. GDP growth level, but also at the global economic environment. In an unprecedented move last year when the U.S. GDP was strong but there were threats from a sluggish global economy, and countries such as Japan, U.K. and Germany experienced slower growth or negative growth, the Fed cut interest rates preemptively in an effort to ward off the negative impact on U.S. GDP levels.

Industrial production

The last factor shown here is industrial production, which was very strong because the GDP was growing. However, because of the current crisis the production has also plunged. Based on all these factors, the Fed made the decision to cut rates in order to inject liquidity into the market, support economic growth and, hopefully, reverse the trends seen in these indicators.

Interest rate risk framework

The below chart illustrates Chatham’s framework for how to think about interest rate risk, including four key categories for approaching the interest rate market.

Maintaining business profile awareness means understanding what your organization’s exposure to interest rates looks like, knowing the different products available to manage your risks, and creating a predictable program. Once you understand the solution, you can manage it on a consistent, ongoing basis from a market awareness standpoint. To maintain your business profile, start with identifying the right risks, understanding their tolerance levels, and identifying any natural hedges. If you are exposed to rising rates, for example, you should determine whether any natural hedges exist in your business that benefit from a rising rate environment. This creates a natural offset where you would only need to address your net exposures to these risks.

Once you identify the risks, the next step is hedging solution awareness – knowing the right tools for mitigating those risks. Selecting the right products to help you manage your risks and bringing them to a tolerable level for your organization is an important component. Then, the final step is creating a predictable program with consistent communication to all stakeholders, which can avoid an emotional reaction to rates. Having a strong policy for managing risks, where you define the objectives, creates a structured way of managing risks in any market environment.

Foreign exchange markets

A prominent story over the past few months has been how coronavirus and the global pandemic affected foreign currency markets. At the beginning of the pandemic, we saw a sharp strengthening of the dollar as investors rushed to safe-haven assets and adopted more risk-off attitudes. While the U.S. dollar index has come down from pandemic highs, it has maintained some of its year-to-date gains. However, the market is still noisy as it evaluates federal and other central bank decisions – looking at potential trade tensions and, ultimately, at the recovery outlooks as we move forward.

A variety of factors drive foreign currency markets. The largest and, perhaps, most impactful is the economic growth outlook and how it affects the demand for various currencies. Other important factors include the trade balance, political landscape, and central bank decisions on interest rates. Additional policies may serve as market indicators, revealing what governments think about the economic health of their economies and how that would impact demand. We have seen that play out again over the past few months as banks made various decisions on how to manage the uncertainty caused by the COVID-19 pandemic.

In the top right of the above chart, we see the Euro (EUR) and Sterling (GBP) exchange rates as well as Aussie dollar (AUD) and Canadian dollar (CAD). Again, we saw large movements at the beginning of March, when there was about a four standard deviation move on the USD/CAD exchange rate, and an over five standard deviation move on the AUD/USD exchange rate. We have also seen unprecedented volatility in these exchange-rate markets with some currencies reaching market volatility levels previously associated only with commodity markets.

FX market framework

Given the volatility and uncertainty experienced over the past few months, it is important to have a framework for how to think about foreign currency risk, along with a strong market environment awareness. What are the markets you operate in? What are they prone to reacting to? How do they react? What are some historical lessons on how they have changed over time? From that information, you can take a closer look at your business profile and understand your FX portfolio.

Consider the context of your portfolio and how your different exposures relate to one another. Take a closer look at currency correlations and your various business positions as risks change. It is important to understand your organization’s risk tolerance and how you should manage to that. Once you understand how much risk you are willing to take on and how much you would like to take off the table, then you can look at types of products and different efficiencies for how to set up a program identifying different hedging solutions.

The last component in this framework is understanding predictability. When we reevaluate the risk profile in our current strategies on the FX side, we commonly see an operational FX hedging program utilized. Once your operational program is up and running, the process is more steady state. However, after operating an established program, you may wish to take a closer look to ensure it continues to operate as efficiently and effectively as possible and continues to reflect your level of forecast certainty.

Commodity markets

Commodity markets have been even more volatile than the foreign currency markets. In the past few months, we've seen historic lows where oil prices have gone negative for the first time in history as WTI plunged below the zero mark in in April. We saw oil jump almost 5% or more than 10% for a few days and we saw a lot of movement in the agriculture market, where demand has grown and waned over the last few months.

Across the board, the commodity markets tend to be more volatile compared with the other two asset classes. There are the key reasons for this. Unlike the foreign exchange or interest rate markets, commodities are a physical product that must be stored, and there are implications along the supply chain. Additionally, global supply and demand rise and fall, which is a key driver. For example, the pandemic has resulted in a global demand shock for some of these commodities. As consumption has fallen, the demand has fallen as well. Conversely, the precipitous drop in oil prices began because of a supply side shock. In this case, Saudi Arabia and the Russia got into a production negotiation and couldn't agree on production cut terms, which resulted in a trade war where each side increased production. This illustrates that there can be drivers on both sides of the supply and demand curve.

The negative prices, surprisingly, stemmed from a storage capacity glut. As WTI futures mature, participants must take physical delivery. People realized there wasn't enough space to store all the oil reaching maturity in that contract and rushed to sell off these futures, which resulted in the negative oil price. There are other shocks, such as supply chain disruptions caused by natural disasters and other events. There is also the political landscape with trade wars and commercial sanctions on certain countries, which all impact price changes in these commodities.

Commodity market framework

When thinking about commodity risk, one key focus is the nature of these markets. Commodities tend to be highly volatile with 30% to 40% volatility ranges (and even higher for some commodities). Historically, they have tended to experience a somewhat bounded movement since, commodities have an actual physical cost to produce, whether it's digging gold out or producing oil. Therefore, producers have tended to refrain from selling below cost for some of these commodities. But because of the mechanics of different markets, those lines are getting blurred. And, in the short term, everything is driven by supply and demand dynamics in these markets.

On the business side, in forecasting for these commodities, it is important to get strong feedback on sales performance, which informs forecasts on the procurement side. Knowing the portfolio context is key. Typically, commodities correlate strongly with FX. Some of these commodities are priced in U.S. dollars. If we have a European entity purchasing these commodities in U.S. dollars, there is strong correlation with FX. Some countries tend to have commodity-driven economy, such as Australia, Brazil, and some other Latin American countries, which gives their currencies a strong correlation with commodity prices. Therefore, FX exposures are another aspect to consider when you assess commodity risks.

On the hedging side, one thing to point out with commodities is the importance of identifying the appropriate index. For instance, oil has several different indices to which you can track. Knowing the correct index to hedge is critical for commodities compared with the other asset classes. This also has implications for hedge accounting.

Finally, to create program predictability on the commodity side, you must have a good dialogue between procurement and treasury. Typically, if commodities represent a significant exposure for firms, commodity risk management is housed within the procurement side, where financial risk is typically managed on the treasury side. Therefore, having a good dialogue between these two functions and incorporating it into the budgeting process is key to achieving a successful program.

Introduction to derivatives

The definition of a derivative is a contract whose value is derived from the value of an underlying asset. More colloquially, derivatives are tools to adjust risk profiles. Organizations use them to minimize their exposure to fluctuations in interest rates, foreign currency rates, and commodity prices. Derivative products can range from simple "vanilla" structures to ones with substantial complexity. Below, we will address some of the different structures. However, even the most basic products can have complexities, such as opaque pricing and varying levels of market liquidity when you execute these transactions.

A derivative is considered a hedge if you use it to manage a financial position or decrease risk. The easy way to think about it is that a derivative always represents a good news, bad news story. If your derivative is in an asset position, your underlying exposure is going to be worse off and vice versa. A derivative is speculative when you use it to make a bet on where you think the market is going or to increase exposure to a given risk.

Derivative products

Products to lock in prices

Products that lock in prices across the different asset classes include interest rate swaps, FX forward contracts, and commodity futures contracts. These products are meant to lock in a price today or at a point in time in the future, providing protection from prices moving against you. This removes the uncertainty associated with that payment or exchange of foreign currencies. Other advantages include no out-of-pocket upfront costs and it is usually hedge accounting friendly. With these products, however, there is no upside participation. If markets were to move in your favor, you would still be locked in at the price where you executed the contract. If the markets move drastically, the hedge can be a large liability since you are locked in that price. Also, these transactions require credit. You should consider these advantages and disadvantages when making your product selection.

Products with optionality

Products with optionality, such as an interest rate cap, an FX option contract, or commodity call contract, offer downside risk protection, locking in a worst-case result while offering participation in the upside should the rates move in your favor.

In the below graph, the dark blue dotted line represents the actual movement of rates, in this case the three-month LIBOR rates, along with the realized rate achieved with a cap. This shows an option product, an interest rate cap with a strike of 2.245%. When you strike the cap at that rate, the worst-case interest that you will pay is capped at that price of 2.245%. However, if rates move lower than 2.245%, you can participate in the upside and take advantage of a lower effective interest rate. Conversely, if the rates move beyond that, your worst-case risk is capped. The optionality enables you to keep the upside while protected from the downside. Advantages of this product include locking in a worst-case result while benefitting from favorable rate environments. It also doesn't require any credit compared to locking in prices with a swap or forward, which require available credit with your bank.

There is, of course, a cost for providing this protection and optionality in the form of a premium, which can either be paid upfront or deferred. These premiums offset upside gains, so the net benefit of a given structure should be evaluated. Therefore, it is important to conduct an analysis to determine whether these products are appropriate and beneficial for the risk profile that is being targeted.

Combination products

If volatility is high, the premiums on option products can be high as well. Combination products are used to lower the cost of these premiums. For example, you could decide to purchase a cap but then give some of your upside away in exchange for a reduced premium cost. Typically, in the interest rate world we see an interest rate collar used where you buy a cap to protect your organization from rates rising above a certain point. Then, you also sell a floor so that if rates go below a certain number, you give up that upside in exchange for a lower premium on the combined product.

In the FX world, we see a similar structure, using an FX collar where you have two different strikes. For commodities, it could be a call spread where you give up some upside of benefits in order to lower the premium.

The advantages of these products are the certainty they provide. You know both your best-case and worst-case scenario going in and you'll be floating between those two scenarios. You can also structure these so that there are no out-of-pocket costs, effectively reducing the premium to zero. In certain circumstances, the disadvantage is the weaker downside protection provided. Additionally, combination products can be a liability and, therefore, require credit capacity.

The risk management lifecycle

Having covered all the commonly used derivative products, we will address risk management in practice and how some of the topics herein are applied throughout the risk management lifecycle.

Some of the challenges in managing derivatives programs include:

  • How to measure hedging strategy effectiveness, including what metrics to use, and how to retroactively determine if the program managed to a sufficient risk tolerance
  • Accurately forecasting future risks and exposures
  • Understanding your business landscape and evolving the program to keep pace with business changes
  • Determining which risks are static and which risks should be considered on a growth factor basis.
  • Understanding how to make the right decisions from both an economic and a hedge accounting perspective

The below case studies illustrate the concepts discussed in this article. As you review them, consider the risk frameworks discussed in the context of each asset class and business context.





Chatham Financial Corporate Treasury Advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with your organization’s objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.

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Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0189

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