A crisis of predictability
The pandemic has upended the world of FX hedging, with revenue shocks and lack of cash visibility creating unwanted speculative positions. It’s increased the pressure on treasurers, forcing them to throw out time-honoured policies, reach deep into the derivatives toolbox and build better forecasting systems.
Government mandated population lockdowns from early last year to stop the spread of the Covid-19 pandemic wreaked havoc on many industries. Overnight, treasurers found themselves grappling with new variables, few had ever anticipated. For instance, cash flows suddenly no longer matched hedges whilst others expired too soon in the face of intense market volatility.
It was a call to battle stations: “The first step was to get visibility of our cash, second on access to our cash and third, a very relevant one, revisit cash flow forecasting. After that we reviewed our investments and then, in the end, we re-analyzed our cash pooling mechanism.” said Andrea Sottoriva, Group Treasurer and Finance Director at SITA, an aviation IT services company.
Speaking at the 2021 International Treasury Management Virtual Week, he explained that hedging strategies had to be reviewed – basing them on historic data had become redundant. “This time, the future looks like something completely different from the past,” he said. The approach towards hedging shifted to a detailed net currency exposure in view of the expected business to be signed. This required the involvement of the geographic business.
Manufacturing businesses exposed to the economic cycle also felt the brunt of the pandemic as GDP plunged at its fastest pace in recent history. “We have many plants across the world, out of them 500 sites with FX exposures, and we are impacted by changes to the economy in these locations,” said Andreea Laplace, Head of Global FX and Commodity Hedging at Eaton, a multinational power management company.
Laplace said the biggest change in the company’s FX hedging strategy was in its cash flow hedging programme although balance sheet hedging remains the largest activity by size. According to the company’s 2020 annual report, Eaton had $5.2 billion notional in balance sheet currency hedges at the end of December versus $946 million in cash flow hedges.
What helped Eaton, is that its treasurers steadily add new hedging layers to a cash flow exposure as it nears its expiry. This makes it easier to adapt the hedge to underlying business conditions. “Layering was probably the most important item that allowed us to be effective,” said Laplace, adding that her team is proactive in challenging business forecasts.
Rather than hedging at group level, Eaton does it for the actual businesses and as it has a direct impact on those operations, there is more motivation to provide accurate forecasts.
It’s a longstanding private joke among treasurers that businesses like taking credit for FX gains but blame treasury for any FX losses. The added volatility and uncertainty during the pandemic emphasised the importance of treasurers effectively communicating their FX hedging strategies to the business as these can easily be misunderstood.
“There’s a great need, especially within treasury, to have that relationship with other departments to coach them in terms of some of the risks they should be looking out for,” said Roshun Tulkens, Group Treasurer at Mantrac Group, a privately-owned caterpillar machinery dealership operating across numerous developing countries. “There’s a huge focus on forecasting.”
Mantrac works with various departments internally to build FX forecast data to decide on hedging strategies. Tulkens explained that he also gathers market information from a mix of local and global banks to help model factors such as central bank reserves, commodity prices and so on to help inform his firm’s views on currency markets.
The pandemic has stirred some debate around using options for hedging, particularly with banks forever promoting new products. Laplace said her team was looking into them, but have not decided yet. Sottoriva noted that they have asymmetrical characteristics, namely that volatility tends to swell their premiums and so most of the time SITA has stuck with using forwards instead.
“We don’t use options currently,” said Tulkens. “I can see their uses, but where we’ve really struggled, is how the accounting links to it”. He explained that the company quite often uses non-deliverable forwards in some emerging markets for hedging where FX forwards aren’t available, but warned that they can be relatively expensive and often only have relatively short tenors.
The limits of automation
Despite the disruptive impact of the pandemic some valuable lessons have emerged. The revenue shocks and associated volatility has brought into question the accepted wisdom that automation and artificial intelligence would take over a big chunk of treasury functions. “My view is that our company is not automated,” said Sottoriva. He said that FX hedging showed the limits of automation as cash forecasts are often inaccurate, which means that hedges have to be dynamically adjusted with manual interventions or they risk becoming directional bets.
“A crisis is a great opportunity for improvement,” said Laplace, explaining that it has generated more awareness around accurate forecasting and closer partnering with businesses divisions.
The pandemic is an apt reminder of the need for skilled treasurers able to step up in the face of severe disruption to ensure FX hedges remain an insurance policy rather than morphing into yet another risk.