Strategic Hedging as a Requirement
Hedging may be part of a larger structured solution above the oversight of the treasurer and even the CFO. In these cases, a bespoke solution must be thought out that takes several considerations into account while servicing a specific goal of the firm. The CEO, investment bankers and other advisors (tax and legal) may be brought in.
Hedging for Cross Border Mergers & Acquisitions
When a Chinese company purchases a US company (good luck with a lot of that going on under the current administration), the acquirer and its funds will be RMB/CNY based. Should the USD appreciate materially while the share offer is in USD cash (for a NASDAQ listed semiconductor company), the offer is still binding and can be expensive to the point where it does not meet return hurdles for the acquirer (they would not have done the deal at that price).
There is an easy way to hedge this – a vanilla FX forward. However, the size may be so large that the trade may need to be syndicated across various banks. Also, the longer dated the closing date, the higher the price owing to a higher risk adjustment required for the investment banks.
Under such a regulatory environment where the consummation of mergers is not certain – the product that is the most appropriate may actually be an option strategy. Should the merger not go through, the acquirer will not be stuck with arbitrary FX risk while being able to capture upside should the exchange rate move favorably. Naturally, the premium on such a position would be high.
For sensitive inside information such as mergers and acquisitions, trading floor contacts may be brought over the wall to structure the transaction. It is important for investment banking professionals to choose the appropriate time to involve them as it handcuffs them from doing other business while they are “inside the tent”.
Hedging for Large Capex Program and Capital Budgeting
From time to time, companies may embark on a large scale organic growth program that may stress their balance sheet because of the debt they are layering on as well as the lack of free cash flow as operating cash flows are plowed back into cash flow from investments.
For example, a Middle East private infrastructure company may decide to construct a large petrochemicals plant as the Saudi government provides incentives to harness large, underutilized hydrocarbon resources and move up the value chain. While it will have transformative effects on cash flow and is far cheaper to build (costs estimated at 4x future EBITDA for the project versus buying a comparable plant at 7x EBITDA), there is not enough money on balance sheet so a large debt raise is effected.
Ideally, once the project is derisked and up and running, the company’s valuation will rocket. In the interim, Debt/EBITDA levels are getting close to the company’s internally mandated limits while they want to continue paying a dividend as per their distribution policy.
A hedge for market risks allows for market risks to be eliminated (although operating risk remains with the company – failure to execute cannot be hedged). So if the corporate is expected to generate distributable cash flow after capital expenditures that can meet dividend payments before FX costs or commodity costs (for steel), they can just get rid of that risk entirely.
Companies also will budget at the beginning of the year. Hedging is a useful way to ensure that budget is met assuming operations go as planned.
Hedging for Ratings Preservation
This can be related to the topic above too – when a company is at the cusp of an investment grade rating (or even an A rating if they so wish to preserve it), management may want to take measures to ensure that their cash flow is sufficient to keep BBB status.
Although rating agencies may look past temporary market fluctuations, the cash is objective. Net debt factors into multiple rating metrics.
Sometimes, rating agencies can be explicit – if Debt/EBITDA rises above 3x, this company is getting downgraded. If the company has budgeted for 2.8x but FX may push them over some percentage of the time under normal market volatility, designing a hedge makes sense. This can be paired with a ratings advisory group in an investment bank that knows triggers well and how to market the company to the agencies.
Framing the Risk in Designing a Hedging Program
As part of a broader strategic mandate, what is the investment bank’s job when there are many considerations that need to go into hedging?
Investment banks want to ensure that the hedge solves the actual problem – which is addressing the appropriate measure (do we care about Debt/EBITDA, purchase price, distributable cash flow) and does not leave residual risk (as discussed on the other articles – for example an airliner hedging WTI while their true exposure is jet fuel) while at the same time ensuring that the company is not overhedged as hedging is not free.
Calculating the appropriate quantum of risk will require operational modeling and sensitivities (a 10% move in copper results in a x% move in EBITDA).
Once the quantum of risk that needs to be extinguished has been identified, the merits of several solutions can be discussed – options, option strategies, forwards. There may also be some leeway allowed. For instance, the treasurer and CFO may be comfortable with minor fluctuations in cash flow owing to exchange rate changes but not more than $0.40 in EPS (earnings per share).
Fluctuations in currency are easy to map out and can be framed with a normal distribution. However, distortions due to tax and how these elements flow through into cost must be modeled out. Quant teams may look at Monte Carlo simulations or other methodologies to ascertain possible price paths.
Hedging Can Be Expensive While Not Offering a Longer Term Solution
Bespoke scenarios aside, as it pertains to operational hedging, a lot of companies that are comfortable with their cash flow and have a good amount of cushion in meeting financial obligations or preserving their credit ratings may eschew hedging altogether – choosing to only employ derivative solutions at investment banks for speculative purposes even if their risk management policies explicitly state that they do not enter into derivative contracts for speculative activities.
Hedging is not free as the banks act as middlemen for a spread. The more structured the solution, the higher the embedded cost in the trade (options are more costly than forwards). Also, the less creditworthy the corporate, the higher the costs to trade. A Microsoft may get a better quote than another bank for EURUSD while a B rated manufacturer in Ontario may get a 1.33 to purchase USD when USDCAD trades at 1.28 unless they put up ample collateral to satisfy the bank’s risk requirement.
For commodity companies there is an added layer of cost baked into illiquidity. Oil is a fungible and widely traded commodity which serves as the lifeblood of transportation. While gold and copper are also widely traded, they will not command the same volume of market participants and trading, resulting in wider spreads for traders to be comfortable operating.
Entering into a derivative transaction with a counterparty comes with two types of risk. The first type is market risk – should a bank enter into a transaction with a company to lock in the purchase of 90,000 barrels of oil per day at $70 and the price of oil plummets to $55/bbl, the bank faces a real obligation. They will have internal controls to make sure that their exposures on this front are managed.
However, also relevant to entering into derivative contracts with banks is when they experience right way risk – same contract but the price of oil rockets to $90/bbl. The bank has netted a $20/bbl profit – in theory. In reality, it still has to collect from the corporate it has transacted with. The more creditworthy the counterparty (BBB and above) the cheaper the hedging is. For companies such as Shell or ExxonMobil, they may be even more creditworthy than the banks they transact with.
Beyond a year, forward markets track expectations less closely – longer dated forward pricing is based on financial hedging activity and supply and demand economics that may not reflect the underlying item to be hedged. That said, if only one year forward is hedged, the next year the corporate will face the full force of a fluctuating market risk.