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Using FX and interest rate derivative markets to manage risk.

The derivatives markets are undoubtedly the most traded of any financial market. The volume in foreign exchange (FX) alone is 40 to 50 times the size of the U.S. stock market on any given day. And the impact of FX and interest rate movements has vital implications for economic growth, inflation and, accordingly, corporate profitability across all industries.

The current global environment is particularly interesting. For the first time in nearly a decade we are seeing interest rates rise in the U.S. Both the U.S. and U.K. have had significant political regime changes, and other European countries will go through election phases this year. Finally, the global trade landscape is shifting based on policy proposals coming out of the U.S., which may have huge implications for FX. All of these factors create a heightened sense of risk and the potential for significant volatility.

Changes in FX and interest rates can benefit some economic constituents tremendously and be devastating to others. For example, a strong dollar benefits the consumer through lower inflation but hurts exporting companies who sell in foreign currencies. Interest rates present an even simpler example, as higher rates benefit lenders but increase the cost for borrowers. From a macroeconomic perspective, central banks have to strike a balance between raising rates to stem inflation and lowering rates to stimulate growth. Clearly, winners and losers are created when the FX and interest rate markets move.

From Macroeconomic to Microeconomic

Companies see the impact of these markets in several ways, some short term in nature and others long term. A company that borrows floating-rate debt would see a relatively immediate impact in interest expense and cash flow if interest rates rise. On the other hand, a company with fixed-rate debt would not typically recognize the effect of higher rates until the debt needs to be refinanced, at which point the new debt will carry a higher interest rate. Therefore, the impact of higher rates eventually impacts this company as well.

Foreign exchange exposure also results in short-term and long-term implications. Companies that buy or sell product outside of the U.S. often have to buy or sell other currencies. Consequently, foreign costs and revenues fluctuate with the value of the dollar. And since most companies that operate globally plan to do so into perpetuity, the exposure to FX is both immediate and ongoing.

Ultimately, these global risks cannot be eliminated, but they can be managed.

Assessing Risk and Setting Goals

To manage the risk, companies often need to hedge with derivatives. No single approach to hedging will make sense for all companies at all times. Each company should evaluate how FX and interest rates impact overall corporate risk. This process is not always as simple as looking at one risk factor and then trying to mitigate that risk. A best practice in assessing risk involves quantifying multiple factors and determining how these factors contribute to the total picture.

To evaluate FX risk, many companies use a value at risk (VAR) model to look at all of their currency exposures and the historical correlation of those exposures. Sometimes the "risk" of one currency offsets the "risk" of another such that the company has a natural hedge. This can provide insight into what exposures, and how much of an exposure, should be hedged.

Assessing risk should also involve comparing the underlying risk factor to the company's business. For example, an automotive company, like any company, is exposed to a higher cost of debt when interest rates rise. However, as interest rates tend to rise when the economy strengthens, and a strong economy correlates with higher car sales, auto companies may have a natural offset to the risk of higher rates. For cyclical industries, the adverse impact of higher interest rates is likely mitigated by increased business activity. Any interest rate hedging policy should take this into account.

In conjunction with assessing risk, a company should establish a robust hedging policy. As a hedge policy framework takes shape, it is imperative to set goals. Public companies may have a goal of reducing unexpected significant shocks to earnings. Other goals may include managing free cash flow or leverage ratios. Goals are not necessarily mutually exclusive, but neither do they necessarily yield the same conclusion.

With the proper goals in mind, the policy can state how and what to hedge.

From Policy to Practice

An effective hedging policy should set goal posts rather than precisely dictate hedging practice. Many companies, public and private, large and small, set a "fixed/float" range for their interest rate exposure. For example, a company policy might be to maintain 50% to 70% of their debt as fixed-rate debt. If

their current debt mix is 100% floating, the policy may stipulate that the company would "swap" between 50% and 70% to a fixed rate using certain types of interest rate derivatives, such as swaps or option-based products.

Market conditions present another reason to allow for flexibility. The price to buy or sell any foreign currency for a future date can vastly differ from the current market price. If a company contracts to purchase Mexican pesos at a discount for future delivery, the hedge not only reduces risk, but also reduces cost. On the other hand, a company attempting to hedge an investment in Brazil would face a very large hedge cost. Pricing considerations should not be the primary factor in hedge decisions, but they should be considered and the hedge policy should be granted leeway.

The approach to managing global market risk can be very involved. It requires an understanding of the underlying risks, evaluating how they interact with each other as well as the specific business, setting appropriate goals and policies, and, finally, implementing a process for execution strategies. With the right approach, companies can smoothly navigate the global derivative markets.

David Gopal is the managing director of Wells Fargo & Company's FX Risk Management Group, based in San Francisco. His team works with clients to design effective hedging strategies, utilizing foreign exchange options and cross-currency swaps. His group also specializes in foreign exchange-related accounting issues and quantitative analysis.

David will be presenting:

25570. Derivatives 101: Risk Mitigation and Liquidity in Markets

Learn about this session and more on pp. 42-47.
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Title Annotation:SELECTED TOPIC
Author:Gopal, David
Publication:Business Credit
Date:Apr 1, 2017
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