Philippe Dupuy (Grenoble Ecolede Managemen): Dynamic currency hedging is no riskier
A team of researchers surveyed risk managers from large corporations about foreign exchange rate risk management. They highlight severalfactors justifying dynamic hedging. They also show that dynamic hedging is no riskier than systematic hedging. Interview with Philippe Dupuy, from Grenoble Ecole de Management, one of the authors
You released a paper called "Risk managers on managing foreign exchange risk". Why this research topic? What are the aims of this academic work?
In financial risk management, academia relies on practitioners, who, in turn, may benefit from fundamental research, finding valuable benchmarks to enhance their processes. In our
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study, we surveyed 110 large companies, mostly French but also European, highly exposed to foreign currencies. We asked treasurers precise questions and observed their reactions as they hedged their foreign exchange risk, particularly using vanilla instruments on the euro-dollar exchange rate. This provided a detailed understanding of their hedging processes. This research sheds light on a lively debate among both academics and financial risk managers. It focuses on the merits and limitations of systematic management, where hedging is primarily based on preset levels, versus selective or dynamic management, which reacts to changes in market factors like implicit volatility or cost, measured here in forward points for instance. I'm going to kill the suspense straight away: the evaluation model that we have built after analysing the data tells us that the two strategies can coexist, depending on the company's objectives.
What do we learn about the sensitivity of treasurers to market conditions?​
We looked at the evolution of the hedge ratio as a function of the level of implicit volatility at three months - taking 4.33%, the average level of volatility over thirty years, and then 7.5%, the level observed when there is tension on the markets. We can see that the sample of firms is roughly equally divided: 47% of treasurers do not change their hedge ratio, while 53% adopt dynamic management. The same approach was applied using the forward points as a parameter, which varies up to crisis levels in our study. Here, sensitivity is more widely shared, with 59% of treasurers changing their hedge ratio. We have measured the degree of sensitivity of these 59% of treasurers to changes in the cost of hedging: the hedging ratio falls from around 70% at the lowest cost to around 45% at a very high cost (graph), allowing treasurers who adopt a dynamic strategy to maintain a relatively stable ratio of hedging costs to risk. We also show that companies that adopt dynamic management do not have a higher level of risk, as measured by the beta of the firms’ stocks relative to the market indices, than those that do not. This is an important lesson for practitioners and their advisers, as well as supervisory authorities and legislators, when dealing with the use of derivatives in the foreign exchange market.​​​
Source: Dupuy, Haushalter, Meunier
Source: Kepler Cheuvreux
Treasurers can make decisions based on market conditions, but also on their tolerance of gains and losses...
One of the aims of the study was to establish a satisfaction function for gains and losses on the unhedged part of firms’ exposure. One of the contributions of the academic approach is to show that this function can be asymmetrical and non-linear. This has led to the identification of four types of company, the largest group being those whose maximum satisfaction is achieved when the risk is totally eliminated by a very high hedge ratio, even ifthis means paying a high hedging price if necessary. For the others, satisfaction is only negative in the event of a loss, and the hedge can therefore be lowered when the spot exchange rate of the currencies evolves favourably for the company.​​
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Are the methods different when dealing with the currencies of developing countries?
Our model allows us to carry out the same analyses with emerging markets currencies, and in this case we have focused on the EUR/BRL cross. Our first andmost general finding is that there is a difference in the way foreign exchange risk is managed, depending on whether we are dealing with G10 or non-G10 currencies. For example,for currencies such as the BRL, whenvolatility is low, the average hedging rate is 44.5%, significantly lower than the rate of almost 60% that prevails for the G10 currencies. In addition, just over a quarter of companies simply do not hedge the risk associated with theemerging marketscurrencies, whatever the market conditions.These companies, moreover, are adept ofsystematic management when dealing with G10 currencies.
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1. This interview was first published in La lettre du Trésorier and performed by Arnaud Brunet from AFTE.
2. The other co-authors of this study are David Haushalter, of the Smeal College of Business, Pennsylvania (USA) and Luc Meunier, of the Essca School of Management(France). The paperis visible at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4613807
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