Falling foul of currency hedging

Falling foul of currency hedging? Options, real and financial, are probably part of the answer

A common mistake is hedging a two-way economic exposure to a financial price with an outright cash flow hedge of one outcome. Jan Cienski’s article in the Financial Times of January 28 (Polish companies fall foul of currency hedging, see www.ft.com) gives us another example.

The original budget airline, Laker, advised and financed by a well known bank, bought US aircraft, financed in US dollars. While its customer revenue was almost all from the UK, it did not hedge. The dollar rose. Laker could not service the increased debt, and collapsed.

Later, Lufthansa, also buying airframes from the US, did hedge. When the dollar weakened significantly, Lufthansa found its (unhedged) competitors were able to buy airframes at a big discount. Competitors then set market prices at levels at which Lufthansa could only compete at a loss.

Who knows what Laker was thinking in not hedging – maybe they did not want to miss out on upside if the dollar fell. Lufthansa thought they wanted certainty of their costs.

It turned out that Laker very definitely did not want the disadvantages of a dollar rise; Lufthansa did want to avoid any downside from dollar strengthening but also not to be disadvantaged if its competition had the benefit of dollar weakening.

Not hedging and hedging outright were both a problem. Add to this that for many firms the currency flows are themselves uncertain, so outright hedges could leave the company with the opposite exposures if the expected sales or purchases are not made.

So, where is the solution?

Options. The risks of not hedging or of using an outright hedge proved excessive in the Laker and Lufthansa cases and risk was realised with significant monetary impact. Options would have been “hedges”, without excessive risk.

Hedging with financial options is very under utilised. Partly because of a failure correctly to describe exposures. Partly because options can be seen as “expensive”. We can add also: partly because vanilla options add a small extra work in accounting under IFRS. But, overwhelmingly most likely, it was because no one explained the real situation to general management.

And the less thoughtful tend to assume (i) that an option that expires worthless was entirely a wasted expense and (ii) that if it expires in the money, well, we’d have been better off with an outright contract after all and avoiding the option cost.
So “no one uses options” is often a conclusive argument against using options.
But, actually, many do use options.

General Motors have said that they hedge about 50% of their expected currency flows in months 7 to 1 year out using options. VW’s last annual report said that, using varying proportions of options, it hedged varying proportions of expected flows for up to five years. VW’s cover period has gone up each year recently – to a level not usually found in consumer durables but more often associated with very long supply commitments from qualified sites, as with aero engines.

You can’t hedge for ever. You hedge financially to ride out fluctuations and/or, in case of long-term movements, to give you time to adjust your business – in extremis to ease the path of withdrawal from a business. Hedges can give you more time to exercise “real options” implicit in your business. For example, a common answer to long-term real exchange rate movements – strategic exposures – is to switch sourcing between currency zones if this real option is open to the business. The fewer the real options you expect to be open to you (or the higher their exercise cost or the less their effectiveness), the longer you hedge with (financial) options. The improbability of VW shutting plants in Germany is reflected in their long currency cover period.

The FT reports Waldemar Pawlak, Economy Minister, as saying that about 200 companies had alerted the government to problems. They had desired certainty. But now they are certainly less able to compete with others (in Poland and Hungary) who did not hedge and so have the upside of Euro strength to enjoy. Like Lufthansa, the Polish companies now realise they really wanted to hedge their competitive situation as well as hedging an expected cash flow. We must hope that someone has explained the use of options to them.

By John Grout