In operating a large corporate with diversified cash flows, companies generally will find themselves exposed to large elements of market risk. The larger and the more complex the company, the more likely that they will have exposure to macroeconomic and firm-specific variables that are beyond their control.
This falls into the purview of the CFO’s division – namely treasury and associated functions. Treasury controls the funds flow of the operation, and accordingly are responsible for smoothing cash flow volatility or matching assets to liabilities and revenues to expenses. They will interact with investment banks in order to solve these problems.
This operational hedging does not require broader strategic oversight and can be conducted in the absence of the investment bankers while the treasurer and possibly CFO interact with sales and trading staff, with the credit relationship quarterbacked by corporate banking.
If we assume that market movements are random, theoretically the expected value of cash flows is the same whether you hedge or you do not hedge (the expected value is actually negative with hedging owing to the friction costs of hedging, which will be discussed below) – however, there is a lot of earnings and cash flow noise that can distract investors from the underlying business.
For instance, Apple may have had an excellent year with record sales, but if the US dollar appreciated materially while most iPhone sales are global while costs are US based, investors could find it difficult to see past the headline earnings figure. Properly hedging market risks allows the investor community to focus on operations.
Generally speaking, a simple corporate – such as the local bakery, will not be sophisticated to enter into hedging transactions (nor have the credit capacity) with a salesperson from an investment bank. As the bakery expands, they will work closely with an investment bank to eventually come up with a hedging policy and form a risk management division.
For the largest, multinational corporates such as Swire Group, there will a complex treasury team with coverage for every risk exposure.
Market Risks for Corporates – Foreign Exchange Risk
The most obvious risk exposure is foreign exchange – and by far the most common.
The simplest example is a Canadian company with operations in the US while all of the factories are in Canada. As such, there will be a revenue (and possibly some expenses for salespeople and distribution) line item associated with US operations.
The treasurer could get rid of some of the FX exposure by hedging 75% of expected US EBITDA.
However, on the operational side, many FX risks may be less obvious than just having operations in a certain jurisdiction. At least from a Canadian example, for capital expenditure programs, a large amount of raw material and finished parts are not easily sourced domestically.
If steel or tractors have to be purchased from the US, the capex has US exposure. As the US is the financial center of the world, most commodities will trade in USD terms, so oil or copper – even if sourced domestically will still fluctuate with global prices.
There are hedges for operations and for financial instruments (debt and preferred equity). If there is debt issued in NOK (Norwegian Krone or “nokkies” as traders will call it) but the corporate is domiciled in the United Kingdom, interest rates and the final principal bullet payment may change expected cash outflows.
Beyond fluctuations to the bottom line, this underlies a more practical principle of matching assets to liabilities and revenues to expenses. There are a suite of trading products that can satisfy these needs – vanilla FX forwards, FX options and FX swaps with a series of forwards over time – as well as structured solutions involving the aforementioned.
Interest Rate Risk Hedging
This primarily has to do with funding – or having debt in the capital structure. For most corporates (smaller, commercial banking clients), debt is floating rate. This makes sense from the bank’s perspective, because this is not term debt or fixed debt – this is generally an operating line that fluctuates according to the company’s needs. As such, due to the on-demand nature of the loan, the bank has to be comfortable in always capturing the spread needed to clear their internal return hurdles.
However, for the company, floating rate debt does result in interest rate linked cash flow volatility, especially if the debt is more fixed in nature as part of funding acquisitions or not meant to be paid down. As such, they may ask the bank to swap the rate to fixed, which the bank will happily do for a fee. The most natural product for this is the floating-to-fixed interest rate swap – and possibly a cross-currency floating-to-fixed swap if debt is issued in a currency other than the operational currency.
Larger corporates generally incorporate a mix of fixed and floating rate debt as they can go straight to debt capital markets and issue bonds. Over a long enough period of time, however, all debt is floating as fixed coupon maturities that are to be refinanced are at the mercy of whatever rate is offered in the market at that time.
There is also a hedging solution for that, as corporates can enter into forward starting swaps or bond forwards/treasury locks with investment banks to “lock-in” an interest rate before they refinance.
Generally, in swapping to fixed, the yield curve is upwards sloping – so the fixed rate will be higher than the current floating rate as it incorporates a rising interest rate scenario. This is in a normal, good and rising economy. When the yield curve is inverted, times are probably bad and despite a lower fixed rate in theory it may be difficult to get banks to lend.
Commodity Price Risk
A third major risk factor is commodity price risk. This is obvious for companies that sell commodities as their primary business – for instance, an oil and gas producer’s primary output is oil and will see its cash flows fluctuate with the price of oil. A producer in the North Sea can get rid of a large amount of cash flow volatility by locking in to a price of Brent (the primary overseas crude oil benchmark).
However commodity hedging is actually widespread because of the use as an input.
An industry with major hedging activity is airlines – jet fuel constitutes a very large part of their cost structure. Fluctuating oil prices can have devastating effects on their equity. Accordingly, they will often hedge WTI (a barrel of oil).
Unlike FX and interest rates where there is more or less a binary outcome there needs to be an appropriate level of understanding the risk because aside from example 1 with the oil company hedging its direct output, the input is sometimes not a perfect match with the hedging instrument, giving rise to “basis risk“.
Going back to the oil example, if the producer was in the Permian and hedged out WTI (the North American crude benchmark) for the majority of its planned oil production – they would be in trouble as the transportation differential between WTI and their regional crude benchmark (which affects the realized price they actually get in selling a barrel) blew out owing to a lack of available takeaway options – leading to a supply glut.
Likewise, an airline that hedged using WTI to lock in their jet fuel prices may find that kerosene (jet fuel) and WTI have diverged owing to low demand for gasoline and gasoil (other refined products that derive from a barrel of crude) – so the imperfect hedge results in them paying their counterparty for the fall in WTI while their kerosene costs rise.
A corporate can also eliminate a natural hedge by hedging one component and neglecting another. So assuming a copper miner in Mongolia hedges out the copper price, they may not have considered that copper and the USD are negatively correlated (as are most commodities given the US Dollar’s status as a vehicle currency) – as such by hedging copper they are now facing naked USD risk.