RISK MANAGEMENT

Protecting Against the USD: Tips for Adjusting Hedge Coverage Over Time

One of the tricky aspects underlying the determination of how much to hedge is that, whenever market expectations become widely accepted by economic actors, those expectations get reflected in the prices of derivative contracts.

For example, when everyone is convinced that interest rates are poised to rise, the cost of hedging against rising interest rates incorporates these expected rate increases. The more dramatic the expected price change, the higher the cost to hedge that risk.

The decision to hedge needn’t be all-or-nothing. Rather, hedges can be phased in and out, as the perceptions of risk and hedging costs vary

A wholly distinct class of companies operate with exactly the opposite risk concerns—i.e., having an exposure to the risk of falling interest rates. These firms would be cash-rich companies—or more likely financial institutions—that earn interest revenues.

For such firms, consensus expectations of higher interest rates actually serve as a hedge inducement in that derivatives pricing allows these firms to lock in more attractive (i.e., higher) interest rates than those currently available, as reflected by spot market conditions. In effect, the market is paying these companies to hedge their exposures, as opposed to exacting a cost.

These opportunities arise when consensus expectations assess the proposed hedged risk to be a low-probability event. But just because the risk is deemed to be unlikely doesn’t mean that it should be ignored. Rather, this set-up may present a particularly opportune time to hedge.

The vast majority of non-financial treasury departments face the risk of higher, rather than lower interest rates, so this consideration may not be particularly meaningful.

The concept might be more applicable, however, in connection with raw material or commodity purchases and sales. With these products, non-financial businesses are more evenly divided between suppliers and demanders, where suppliers face the risk of lower prices, while demanders bear the risk of higher prices. 

Futures prices: Commodities

Whether derivatives favor one side of the market or the other can be inferred from the configuration of futures prices.

Futures contracts are readily available for a wide array of basic commodities, and they serve as the building blocks for virtually all over-the-counter derivatives instruments (e.g., swaps, caps, floors, collars, etc.).

Futures prices are readily accessible on the website of the CME Group (formerly the Chicago Mercantile Exchange), the exchange that hosts trading for the vast majority of US commodity contracts. By looking at the configuration of futures prices, one can readily determine whether you happen to be on the side that pays for hedging or the side that gets paid for hedging.

With the exception of the currency contracts (FX), most futures contract prices will typically be said to be in contango. This term simply means that prices for more distant valuation dates move higher and higher, as you extend out in time.

This pricing configuration thus tends to favor the suppliers (i.e., sellers) of these commodities, as it allows these firms to lock in more attractive prices for future sales than the firm can realize today. 

Futures prices: Currencies

Foreign exchange rates are another story. For the currencies of countries with developed capital markets, forward pricing is determined by covered interest arbitrage.

This causes the forward prices of foreign currencies (i.e., non-USD) to be at a premium to spot prices whenever US interest rates are higher than foreign interest rates, and vice versa, although but these conditions change over time. 

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