Dynamic hedging or how to adjust pricing over time to reduce costs of hedging

Faced with volatile markets and fluctuating currencies, with high interest rates, who hasn't dreamed of being able to save the swap points that deteriorate the forward price? As Sun Tzu said, the success of any operation lies in its preparation. And preparation is the implementation of tools adapted to the strategy that can guarantee the agility of reaction. For FX management, a process that remains too manual, even in MNC's, adding the missing IT piece is the key to efficiency. By adopting a dynamic management, one can gain competitive advantages over competitors in pricing and price protection, especially for the most exotic currencies.

Why make your FX management (more) dynamic?

To have a truly dynamic FX management, you first need an appropriate and automated IT tool. Indeed, it is impossible to set up such an efficient manual system even for a single exposure. This is why few treasurers’ resort to such a strategy. The idea of tools such as CMA (i.e., Currency Management Automation solution), a necessary complement to T(R)MS's, is to make hedging processes more fluid, efficient, fast, secure and to create opportunities, if possible, as with the "dynamic" strategies we intend to describe. Whatever your approach to currency risk (i.e., layering, static or micro-hedging or multi-strategies), the key is to automate the process of hedging the financial world 24/7 and protect positions no matter what. Volatility is indeed one of the after-effects of the recent covid or more recently of the (risk of) wars. Taking advantage of a monitoring tool allows you not to hedge while controlling your risk and your position and finally being able to act just in case. The "just in case" approach is vital in these times. The so-called dynamic management will only cover the pre-trade and trade part of the process.

CMA solution, the perfect complement to a TMS for FX hedging purposes

CMA are a perfect complement to any TMS, as it covers functionalities, these TMS’s do not cover or at best not cover at 100%. We could compare this to a car. You told to your CFO you bought a new car (i.e., a TMS) and claim it is the best solution to solve your treasury issues. However, after a while you realize the car is not perfect and do not cover all your needs. Therefore, you decide to add options, (i.e., CMA) to complement the engine and get better performances in line with your expectations and to cover 100% of your needs. The problem with whatever TMS these days is their SaaS multi-tenant approach which make them rather generic, sort of “prêt-à-porter” solutions not fully perfect and fit. It explains why they may require additional tools to cover the whole spectrum of functionalities around FX all treasurers need. To give you examples, TMS’s in general present lacks strong FX rate feeders. A good CMA should allow treasury teams, among many other things, to set up an efficient data-driven solution to manage all the aspects of pricing with FX rates, including pricing risk.

Dynamic pricing

To set up an efficient FX risk management process in place, the treasurer needs to manage pricing risk. In terms of pricing efficiency and speed of delivering data. Treasurers must understand pricing to design an effective automated FX management process. When you have a dynamic FX price fixing, you can adjust it. Pricing risk is the risk that —between the moment an FX-driven price is set and the moment it is updated— shifts in FX markets can impact either a firm’s competitive position or its profit margins. To mitigate risks, the treasury team must increase the frequency of pricing updates. For companies keeping pricing during the whole season, budget period or campaign, the re-fixing of pricing is less an issue. However, time is the most important issue for all companies when underlying risks are identified by business operations and reported to treasury. The faster and more straight the data is conducted to the in-house bank, the smaller the delta will be.

Dynamic hedging, what it is and it is not

When we talk about “Dynamic Hedging”, some people refer to the strategy of hedging in those periods when existing currency positions are expected to be adversely affected and remaining un-hedged in other periods when currency positions are expected to be favorably affected. It is also a strategy that involves rebalancing hedge positions as market conditions change; a strategy that seeks to ensure the value of a portfolio using a synthetic put option. However, here we prefer to opt for another acceptance in treasury. For CMA solutions, it may mean that the company in order not to be penalized by huge differential of interest and negative swap points (depending on if you sell or buy the exotic currency) decide to opt for a more dynamic approach with daily limit refixing to get benefit of time passing (and therefore reduce costs of hedging) while fixing purchase order (i.e., security boundaries). It means that each day we are within the boundaries and in the range, no hedging is made. Every day it is refixed and adjusted if needed to take benefit from time reduction (i.e., less swap point impacts) and potentially enjoy a better hedging rate. In FX hedging time can have a cost and it is what we need to control without necessarily hedging at inception. Providing you have an automated tool in place, you can guarantee the risk is under control and potentially get benefit of time passing.

Value creation through better FX management

Dynamic hedging is key to get benefit from time and fight against swap points penalties. These days, the cost of hedging is already increasing over time (for many different reasons but mainly accounting and regulatory reasons) and huge differential of interest may penalize companies and prevent doing some businesses. Failure to take advantage of this type of opportunity is a serious shortcoming in terms of pricing strategies, at a time when —according to consultants — pricing is becoming a key strategic element in today’s competitive landscape. It is even more essential for low margin and high-volume businesses. Arbitrary time-driven rules (well-defined) should give way to a data-driven approach that consists of setting boundaries around an FX reference rate, such that prices are updated only if the market moves beyond the upper and lower bounds of those boundaries. The system then serves a new reference rate and dynamically adjusts the upper and lower bands around it. These approaches enable treasurers to take advantage of favorable moves in currency markets while protecting budgeted profit margins, independent of when movements (if any) occur. The determination of boundaries far or close to the reference rate set reflects the treasurers’ tolerance/appetite to FX risk. The beauty of automated systems is the capacity to select the currency pairs to be dynamically monitored, the boundaries, the amount, the timeframe, etc… and it can be adjusted based on circumstances. In a fast-changing world, highly competitive, the refining of FX rates for hedging may give the corporation a competitive advantage on peers. Don’t miss opportunities to better and more efficiently manage FX risks.

François Masquelier, CEO of Simply Treasury – March 2022

Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).