Missing the boat: when is it too late to start hedging?

With the steady decline of the U.S. dollar (USD) since the summer of 2003, the gradual rise in short term interest rates and the painful rise of commodities prices, many treasurers are revisiting their hedging strategies and policies. Is it too late to start hedging against these moves or, as the saying goes: "Are they a day late and a dollar short?"

Now, it would not have taken a Warren Buffett or George Soros to figure out that one day interest rates might rise and that the U.S. dollar was heading for a decline because of the ever-widening U.S. trade deficit. So for the most part, it's not that treasurers missed an opportunity to hedge, but often exposures are not understood until it is too late, which may result in an unpleasant surprise to report at the end of the quarter.

Let's start with the common gauge for interest rate exposure and the measurement of the fix-float mix for corporate liability management. It follows a good rule of keeping it simple, with a single percentage describing the relative exposure to changing interest rates--with 100 percent being completely fixed and not exposed to rising rates, and zero percent being completely floating and perhaps enjoying the benefits of low interest expense.

Companies can set hedging and issuance guidelines around this number that can be clearly and easily communicated. It's also nice because you can chose to use swaps to get you to your target mix if your comparative advantage for issuance does not suit your fix-float goal.

The problems with just using this number as your only measure is that it does not capture the duration of your liabilities and it looks just at the liability side, as most corporate treasuries do not have financial assets that bear fixed or floating coupons. For non-USD issuers, there is also noise from the underlying foreign exchange (Fx) exposures unless everything is swapped back to USD fixed or floating via cross-currency swaps.

To illustrate this point, say a company decided to change its fix-float mix from 50/50 in 2003 to 100 percent at the start of 2004. The company did not have a risk management policy that allowed for interest rate swaps, since it was typically able to issue fixed via the capital markets. However, if its long-term rating declined or the supply of fixed-rate corporate debt flooded the market, the company may be better forced to borrow at floating rates. The company now has to make operational changes to be able to enter into swaps, like establishing swap credit lines and legal agreements with dealers, setting up systems and dealing with FAS 133, all with rates moving against it.

Debt management can get complicated, but for the most part you should at least be able to tally your exposure. Foreign exchange risk is not that simple to assess and may lead to more surprises in un-hedged risk than not. Not only might you be dealing in many different currencies across a decentralized treasury, but getting subsidiaries or different departments to even provide you with the data, let alone accurate data, can be very challenging. Treasury departments are relying on sales or human resources departments for accurate forecasts and trying to eliminate natural offsets. Sometimes the exposure, like commodities, is handled completely outside of treasury--within procurement--and treasury would not have the in-house expertise to understand the risk or put on the commodity hedges.

Similar to the fix-float mix, for Fx exposure management, many companies will simply rely on the internal budget rates to either achieve or not achieve, as a measure of performance. For example, sales in Sterling (GBP) for 2004 might have been budgeted against an internal Fx rate of USD 1.70. With GBP rising above USD1.90, the company looked like it did a great job beating the budget rate, but it could have achieved it without hedging.

Some companies may leave their internal budget rate static for an extended period, but have a benchmarking process established for treasury and the risk management committee. Benchmarking measures your overall hedge performance as it helps determine the value of your decision not to hedge.

For example, you might have a policy to hedge up to 100 percent of your six-month Fx exposure, with the flexibility to only cover 75 percent. If you chose to hedge 80 percent instead of the full 100 percent, then you would track performance of the 20 percent open exposure against the price (average, last, at market or some other measure) of the cost to put on an actual hedge at that time. A good risk management policy would allow for some deviation against the benchmark rate for times when markets are uncertain or changing rapidly in one direction.

Treasury departments don't trade but hedge, so spending the time to understand your enterprise-wide exposures is the first step before you can even put on your first hedge. Barring that, it should never be too late to start hedging, and it can never be too early to define your risk management policy and reporting tools to measure your hedging performance.

Jiro Okochi is CEO and Co-Founder of Reval, a Web-based derivatives risk management solutions provider, specializing in FAS 133/IAS 39 reporting, that is based in New York City. He can be reached at [e-mail].