How to Effectively Hedge Risk in Volatile Markets
Volatility across currency, interest rate and commodity markets – plus regulatory and accounting standards updates – have market participants wondering what they can do to stabilize their operations. Here’s how to respond with hedging – no matter how the market turns.
A hedge program is designed to drive predictability in financial statements and protect margin and earnings from unexpected changes. However, market events and updates often pause organizations who think it’s too late, too risky or too complex to get started.
This is far from the truth. Ignoring hedging won’t make the risk go away. On the contrary, strategic advantages are created when companies hedge to meet clearly defined objectives.
To understand how, let’s first take a look at top issues corporates and financial institutions are facing this year.
Top Market Pressures in 2023
#1. SOFR Transition
Market participants have been navigating reference rate reform for over a year. At this point, new transactions are no longer based on current benchmark interest rates. The pressure is on for organizations to evaluate and convert the underlying reference rate on their derivatives and debt. The market is only going to get even noisier as the final deadline (June 2023) gets closer.
That said, market participants are starting to realize that there is divergence in the market across how counterparty banks calculate their Dodd-Frank mid-market adjusted term SOFR rates. This is requiring more detailed analysis to understand how a bank determines a SOFR mid-market rate, whereas market participants are used to just focusing on the bank charges and credit spreads. Reduced liquidity in USD-LIBOR is exacerbating the dislocation between SOFR and LIBOR and adding to the credit spread uncertainty.
#2. Inflationary Pressures & the Interest Rate Environment
To combat inflationary pressures, the FOMC has increased rates in the March and May meetings – and has signaled ongoing rate hikes through the rest of 2022. The fed funds rate is expected to reach 2% by the end of the year.
This interest rate environment has inspired market participants to lock in lower rates today before they get even higher throughout the year.
#3. Geo-Political Uncertainty
Geopolitical uncertainty (especially Ukraine, Russia and Belarus) is impacting all asset classes: interest rates, foreign exchange and commodities. This volatility and uncertainty across the board, coupled with the first two regulatory pressures, has further complicated organizations’ risk management programs.
#4. Hiring & Retaining Talent Challenges
While market events continue to hit, companies are also struggling to hire and retain the right talent with relevant experience and knowledge on the above issues. While some of this is natural and unavoidable (we’re all learning as we go), many professionals feel uncomfortable dealing with these types of issues.
At the same time, some professionals believe derivatives are used for speculative purposes and aren’t warm to hedging because of that. Others are uncomfortable dealing with all of these market events and updates all at once. It comes down to one thing: people are feeling overwhelmed.
In light of this, what can organizations do to overcome these challenges – and anything new that comes up in the future?
How to Respond to Market Events & Updates with Hedging
If you don’t already have a hedge program, it’s never too late to start one. A hedging program can protect you against “regular” FX, IR or commodity price risk. While your regular risk management strategies can’t protect you fully from “black swan” market events, a solid hedge program will give you the ability to keep operations steady and redirect resources to respond to events, trusting that your hedge program is protecting you against everything else in running a business.
With that said, here are some tips to get started with a hedge program. Like last week, last year and five years ago, the steps are the same. If you already have a hedge program in place, please reach out to see what you can do to further optimize and stabilize.
#1. Establish Objectives
Get specific with your objectives. For example, an objective that says “to mitigate FX risk” is not clear enough. What does success or failure really look like? What are you trying to do? For example, you might want to smooth the impact of currency into your financials.
The clearer your objectives, the more strategic advantages you’ll be able to realize.
#2. Identify & Quantify Exposures
You will have different objectives for different types of exposures. That’s why it’s critical to get that clear objective established first. Investigate the start of the exposure and its end.
Sources are dependent on type of risk (FX, IR, commodity). You’ll need a process (and supporting technology) for collecting exposures at different stages: anticipated, recognized, impacting earnings, settled.
#3. Establish Credit Lines & Trade Compliance
How much credit do you need? How will it be secured? Make sure that you have a good working relationship and legal framework (ISDA) with your counterparties and that you set up a good process for trading and competitive bidding.
#4. Define Hedging Strategies & Execute Trades
Once you’ve analyzed your exposures and identified the risks you want to hedge, you must define which derivatives will be used to hedge which exposures. Then, once you have trade relationships are in place, you can execute on your trades at a cadence that makes sense with your goals and strategy.
#5. Account for Derivatives
Derivative accounting can be overwhelming, so be sure to get your accounting team involved in the hedging process early. Accounting is guided by ASC 815, and our team of experts can help you better understand this guidance and execute on the accounting.
Hedge accounting should not be left to spreadsheets. CapellaFX is not only a trade repository but also accumulates your exposure data (existing and anticipated), applies hedge decisions, designates and documents exposures, drives your hedge accounting and provides effectiveness tests. Most importantly, it is user-friendly for both Treasury and Accounting and doesn’t require a derivative specialist to use or implement.
#6. Create Key Controls & Monitor
Every sound hedge program must include key accounting, trading and reporting controls.
- Accounting: Identify all derivatives, make sure they are recorded as assets or liabilities at period end, and ensure that amounts are stored correctly on the balance sheet.
- Trading: Make sure the trader and confirmer are not the same person and that the confirmation is done in a timely manner.
- Reporting: Is the program meeting objectives? Is it being executed with the policy?
No matter what’s happening in the market, a clearly defined hedge program will help you stabilize operations and realize strategic advantages. And don’t worry, you don’t have to face this alone. Hedge Trackers can help you with every step. We have the people and software tools to assist your team. Contact us to see how we can work together.