Weak Earnings Prompt U.S. Companies to Shift Currency Hedging

In response to a rising U.S. dollar, more corporates are looking at using options rather than forwards to manage forex exposure.

CBOE Opens After 3.5-Hour Systems Malfunction Shuts Exchange

Traders work on the floor of the Chicago Board Options Exchange (CBOE) in Chicago, Illinois, U.S., on Thursday, April, 25, 2013. The CBOE opened for trading three-and-a-half hours late today after a software malfunction shut the derivatives market as its top executives were away at an industry event in Las Vegas. Photographer: Tim Boyle/Bloomberg

Tim Boyle/Bloomberg

Stung by the rising dollar, U.S. companies are rethinking their hedging strategies. They need to think fast. Nondomestic sales comprise 33 percent of total revenue on average at big listed companies, Citigroup reports. In January, CEO Alan Lafley stated that the strong dollar would shrink Procter & Gamble’s fiscal 2015 sales by 5 percent and its net earnings by 12 percent, or at least $1.4 billion.

Corporates typically protect themselves from forex volatility with forwards, contracts that lock in the exchange rate for the purchase or sale of a currency at a future date. The upside of a forward is that it has no up-front premium, but there’s no backing out if the locked-in rate proves adverse — as companies that had predicted a weaker dollar discovered when they suffered heightened losses due to the rapid appreciation of the greenback last year.

Dealers are now seeing corporates look to vanilla options that give the holder the right but not the obligation to buy or sell an underlying asset at a predetermined price and time. The catch: There’s an up-front premium. Just 5 to 10 percent of North American companies use options as a currency-hedging strategy, according to Andrew Kresse, head of North American corporate derivative marketing and cross-asset structuring at J.P. Morgan in New York.

“U.S. corporates have had some difficult times,” says Alexis Besse, London-based global product head of macro structuring and head of forex, rates and credit structuring for Europe, the Middle East and Africa at UBS. Besse explains that corporates usually seek to exploit currency volatility, but this strategy hasn’t worked lately due to the dollar’s continued appreciation. UBS is now seeing a lot more interest in options from businesses, he notes. “Their old strategy was very much linear, primarily using forwards and looking to exploit dollar weakness,” he says. “Spending premium these days is difficult for everyone, so there’s still a bit of education to be done, but they are more and more convinced about options strategies now.”

A common misperception among corporates is that options are expensive, says Russell Francis, head of North American corporate forex sales at Citigroup in New York, because the expenses incurred from taking investment positions like forwards, known as the cost of carry, are often overlooked. A well-managed forex hedging program that includes options will usually outperform a policy of using forwards exclusively, Francis adds. Citi research shows that, over the past ten years, consistent use of options has yielded better returns than forward hedging.

“One treasurer we’ve spoken to said it’s going to be very frustrating to continue to talk about the strong dollar headwinds if they don’t do anything about it,” Francis says. More corporates are now willing to take some short-term earnings volatility from derivatives as a trade-off for longer-term economic benefits, he adds.

Another problem was that the velocity of the dollar move took corporates by surprise, and many companies didn’t hedge far enough out. Historically, on average, businesses with currency risk would hedge anywhere from 30 to 40 percent of their future exposure from three to 12 months out.

“Some corporates weren’t as conservative and as a result have had more material losses than others,” notes one head of structuring. “Now that you’ve seen the dollar appreciate and volatility go up, you’ve seen the costs of forwards and options go up. Even if you wanted to do something now, the issue is that it’s more expensive, and as a result people aren’t doing much more at this point.”

Corporates now need to look at extending their hedge tenor to at least three years in addition to using more options rather than forwards to help smooth out volatility over time, Francis says. According to several dealers, corporates are more open to such strategies on the back of the stronger dollar. Jim Colby, New York–based assistant treasurer at Honeywell, says most of the U.S. multinational’s hedging takes place for the following calendar year. But sometimes Colby and his team have hedged further out, and they’re considering doing that more often.

Although it may appear easy to switch from forwards to options, this strategy has its problems. One of the biggest challenges for corporates is that they can’t get hedge accounting treatment for net income hedging, Francis says. If a company enters into a derivative to hedge its net income, it must take the current market value of that hedge straight into earnings.

Hedge accounting allows a firm to defer the gains and losses on a hedge until the period in which the underlying exposure occurs, Honeywell’s Colby says: “We were able to hedge the U.S. dollar expenses of our foreign business units and not hedge all of the U.S. dollar revenues.” By selectively hedging Honeywell’s cash flow transaction exposures, the firm mitigated transactional and translation risk in a way that works under current accounting rules. Translation risk is the exchange-rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets.

Many corporations don’t allow options strategies in their hedging programs because it takes a long time to get approval from the board or senior management, J.P. Morgan’s Kresse says. Companies focus on their core expertise as opposed to investing time and money in financial instruments, which can be intimidating for those unfamiliar with them. However, Kresse says firms are hiring more staff with such experience in a bid to manage their financial exposures.

This year for the first time in recent history, Honeywell hedged its earnings translation exposure as an extra precaution. When it comes to revenue and expenses, Colby says, the firm has always hedged forecast cash flow transactions, those in a currency other than the functional currency of a company’s business units. “But this year, given our view on the dollar, we decided to hedge exposure to earnings translation of our foreign business units’ results into U.S. dollars.”