Hedging Primer: How to Mitigate Financial Risks
In a complex and interconnected world, risks are everywhere. Companies that fail to effectively mitigate the most significant risks risk wreaking havoc on financial projections, budgets, and the company’s ability to meet stakeholder expectations. A recent Citizens Commercial Bank Risk Management study of 350 publicly traded US companies revealed the magnitude of these risks: 78% of respondents said their organization was exposed to interest rate risk, 74% to foreign exchange (FX) and a little less than 50% in commodity risk. Yet only about half of these companies are managing their risk exposures well, which undermines their planning processes.
Risk exposure varies by industry. For example, companies in the healthcare, industrials and materials sectors are capital-intensive and have traditionally been larger borrowers, relatively speaking. Consequently, companies in these sectors are much more exposed to changes in interest rates over time. (See Figure 1.)
The extent of a company’s exposure to foreign exchange risk generally depends on the proportion of its activities carried out abroad compared to the domestic market. But other factors may come into play. The US energy sector, for example, is hedged against currency risk because international oil and refined products, such as gasoline and diesel, are traded in dollars. Americans at the wholesale level.
Basics of interest rate hedging
Our study revealed that 78% of companies are exposed to interest rate risk. Worse still, many are exposed to floating rate debt linked to the London Interbank Offered Rate (LIBOR). Only 51% of all respondents hedge interest rate risk, i.e. they convert floating rate liabilities into fixed rate liabilities through a financial instrument such as an interest rate swap. interest. This is understandable given the exceptionally low interest rate environment of recent years. But that’s not a good long-term strategy.
Now that rates have started to rise, unhedged positions have become riskier. Market sentiment is shifting towards an increasing desire for hedging. Another problem is the uncertainty as the industry is phasing out LIBOR. Most banks have stopped issuing LIBOR-linked loans, and LIBOR will cease to be listed in 2023. This can make it difficult to hedge existing LIBOR-linked loans.
For businesses facing significant interest rate risk, there are four commonly used hedging tools:
- To exchange. A swap is a contract in which one stream of future interest payments is exchanged for another. These typically involve swapping a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to interest rate fluctuations.
- Cap. An interest rate cap sets a cap on interest payments. It is a series of call options on a floating interest rate index, usually three or six month LIBOR, which coincides with the roll dates of the borrower’s floating liabilities. (A call option is an option to buy assets at an agreed price, no later than a specified date.)
- Stage. A minimum interest rate created using put options, which are options to sell assets at an agreed price no later than a given date.
- Necklace. The simultaneous purchase of an interest rate ceiling and the sale of an interest rate floor on the same index for the same maturity and the same nominal amount. These contracts protect against rising interest rates and set a floor if interest rates fall.
The Citizens survey found that of respondents whose companies hedge interest rate risk, 91% use interest rate swaps, with a smaller proportion using options such as interest rate collars (13.5%) or ceilings.
Many companies hedge 50-60% of their interest rate exposure, keeping around half of their floating rate debt. This neutral approach gives them the opportunity to profit if interest rates remain low. But with such low rates and a relatively inexpensive hedged position, some companies prefer the peace of mind of having a fully hedged position. This “all-in” rate perspective brings even greater certainty to their financial planning and budgeting process.
Currency risk increases
Currency risk is the financial exposure businesses face when they are not hedged against potential changes in exchange rates. This exposure may result in reduced profitability, missed targets and/or significant losses. Companies frequently use forward contracts, i.e. contracts that lock in the current exchange rate for the purchase or sale of currencies on a specific future date, to hedge the risk that unexpected exchange rate fluctuations can have an impact on their finances.
Increasing globalization has made currency risk a problem for businesses of all sizes. Indeed, the Citizens study found that currency risk is almost as prevalent as interest rate risk. Almost three-quarters of the companies we analyzed are exposed to currency risk, but only 54% of all respondents manage this risk through hedging. There are several possible reasons for this. The first is that management is sometimes uncertain of the extent of the company’s foreign exchange exposure. Another is the lack of familiarity with various hedging tools.
Perhaps the main reason why nearly half of companies with currency risk do not hedge these exposures is that many companies simply do not realize they are exposed to currency risk, either because it is is slipped as the business grows (organically or through acquisitions) or because they are not fully aware of contractual terms that allow customers and suppliers to reprice goods and services. Although interest rate risk is fairly obvious, currency risk can remain hidden.
For example, a business may start small, using only domestic suppliers. Over time, as it grows, the company could tap into the global supply chain. The company may start working with foreign suppliers by insisting that all its overseas transactions must be denominated in US dollars, but later it may recognize the advantages of buying and selling in foreign currencies. Its foreign customers may prefer to make purchases in their local currency, as it reduces the complexity of the transaction for them. On the purchasing side, the business can understand that requesting invoices and making payments in vendor currencies will provide more accurate information about what they are paying for, and thus give the purchasing function more control over procurement processes. general purchase.
Hedging this new risk is an important way to bring more certainty to the financial planning and budgeting process. The Citizens survey found that, among respondents who hedge currency risk, futures contracts are the most popular method. However, more advanced strategies are also gaining traction, with 27% of firms using currency swaps and 22% choosing options. (See Figure 3.)
Commodity risks can be difficult to hedge
Commodity risk is the least common of the risks we have studied. Only 49% of companies are exposed to commodity risk – most of these exposures being related to energy, as opposed to metals and/or agricultural products – and only 31% of companies hedge this risk.
These results make sense given the relative decline in the share of the industrial, manufacturing and other commodity-consuming sectors in the US economy. Even for companies in commodity-dependent industries, commodity exposures are often difficult to hedge, as highly fragmented markets result in multiple underlying price indices, which are not always hedged.
The percentage of companies hedging their commodity risk could soon increase if commodity prices and volatility continue to soar. Oil prices, which briefly traded in negative territory during the pandemic, are trading north of $100 a barrel at the time of writing. At the same time, natural gas prices rose so much in Europe last fall that some plants closed. If these events are any guide, commodity volatility will persist even as the global economy continues to shift from fossil fuels to green energy.
Thus, senior executives have recently paid more attention to commodity risk. Unlike interest rate and currency risk, which are managed by the CFO or treasurer, commodity risk is typically managed at a lower level in the corporate structure, by the purchasing department. But now companies that are energy-intensive, such as cement, steel and fertilizer makers, are beginning to elevate those discussions to the executive level. And many other companies are suddenly realizing the true extent of their energy exposure, especially companies that own large fleets of vehicles or depend on other companies for transportation.
How to review your hedging strategy
Whether or not a treasury team has used derivative hedges to mitigate financial risk in the past, now is a good time to review some of the long-held assumptions that guided those decisions. Key questions to ask include:
- Do we fully understand the risks our business is exposed to, whether interest rate, currency and/or commodity risk?
- Are we properly integrating these risks into our planning processes?
- Are our current risk management and mitigation activities adequate to manage the risks our business faces today and will face in the future?
- Do we have the right internal risk management capabilities to meet today’s challenges?
As part of the budgeting and financial planning processes, treasury groups need to assess business risk exposures with the goal of uncovering untapped opportunities or hidden risks. The more risk a company can take, the more likely it is to achieve its financial plans and meet stakeholder expectations. Engaging a partner with hedging expertise to assess these risks can be an important first step towards implementing a new risk management strategy.
Rich Aidala is co-head of global markets at Citizens. Since joining the bank in 2007, Rich has held a variety of positions including Head of Sales for Global Markets.