A question of appetite

17 August 2015

by William Mah, Risk Assurance Services Partner, PwC Malaysia

As I write this, a Grexit is still on the cards, China’s economy is expected to cool and the Federal Reserve is contemplating raising interest rates. Closer to home, the Ringgit is trading at around 3.90 per USD and has depreciated significantly against a basket of currencies. Crude oil and commodity prices continue to be volatile.

The significant volatility in the financial markets will be a continuing challenge for Malaysian businesses.

Recently, the MARTRADE CEO was quoted as recommending Malaysian exporters to hedge the ringgit, which is said to be at its best level for exports, against the US dollar. In fact, hedging is often offered as a panacea to manage volatility. There are many hedging products, strategies and solutions offered by a myriad of banks and professionals out there.

To hedge or not to hedge?

So, should we or should we not hedge? If we do, what instrument(s) should we use? What’s the right amount to hedge? How far out into the future should we hedge? How long should we maintain the hedges?

Under pressure, managers often want hard and fast answers to these questions. The fact is: there are no right answers.

“Many financial disasters can be traced to people who thought they were hedging “says Aaron C Brown, well known financial author. Perhaps a case in point, according to the Economist, is that of Delta Airlines, which is expected to lose $1.2 billion in 2015 on fuel hedging done before the current slump in prices.

So perhaps it’s worthwhile discussing what hedging is and isn’t.

Google defines hedging as to "protect oneself against loss on (a bet or investment) by making balancing or compensating transactions.” In the context of managing financial risks, I would venture to say that this definition is unhelpful and can be misleading.

Hedging does not guarantee absolute protection. In fact, it actually involves taking a view on the future, which may not be too different from speculating.

Suppose, as a hedge, I enter into a forward-looking contract to fix the price of oil purchases next month at USD70 per barrel. My implicit view would be that oil prices will increase in the future beyond USD70. If oil prices were to drop below USD70, I would be better off not entering into the hedge, as I would be able to buy oil at spot price below USD70.

Of course, I could have entered into another type of hedge which allows me to have my cake and eat it too, i.e. buying an option. This involves me acquiring the right to buy the oil at USD70 per barrel with the choice not to buy if the market price goes below USD70. This option contract comes with a premium, which is more expensive when the market is more volatile. (Ironically, most corporates only consider hedging when the market is volatile, i.e. when the premium is also the highest!) This time, my implicit view is that the price increase would be higher than the premium I am paying for the option. Otherwise I should not hedge with the option.

Whether a hedge is “good” or “bad”, can only be decided upon hindsight, something which managers do not have when they make hedging decisions.

How then should the manager approach hedging?

I would suggest going right back to basics. The object of any hedge is risk (or minimising it). Therefore, let’s take a look at this issue through the lens of risk.

What risks should a company take?

Stakeholders expect companies to take business risks to generate returns. The higher the risks, the higher the expected returns.

What risks should be hedged? Some will advise to hedge fully, others partially. Some will advise that investors embrace their risk exposure in full, even to profit from it. Very often the answer is: it all depends. Which raises the Million Dollar question - depends on what? Perhaps it's a question of how much risk your stakeholders have the stomach for.

For instance, if a company is in the widget business and not the foreign exchange business, it would seem odd for that company be exposed to foreign exchange rate changes — especially if tools are readily available to eliminate this risk.

Appetite for risks

Companies should decide how much appetite they have for risks. At its simplest, risk appetite can be defined as the amount of risk, that an organisation is willing to take on, in pursuit of its strategic objectives.

A good understanding of the risk appetite of stakeholders will allow managers to align their business and risk strategies. For example, the manager in a company that has the appetite for foreign currency risks will not hedge all its foreign currency exposures.

Can we afford not to hedge?

Companies should ask themselves whether they can afford not to hedge, by understanding how much capacity they have for risk. This does not have to be a complicated exercise using sophisticated mathematical models. A simple what-if scenario analysis can be performed to identify the impact of the particular (unhedged) risk on the cash flows, profits or debt of the company.

Under a stressed scenario (e.g. the ringgit depreciates to RM4 to USD1), can the company still meet its debt covenants, and maintain its rating and dividend policy? Will analysts downgrade its stock? What is the impact on its share price? If the impact is not acceptable, then the particular risk should be hedged.

Can we afford to hedge?

Amid the debate of whether to hedge, one should not lose sight of the costs of entering into hedging arrangements. Many treasurers and risk managers underestimate the true cost of hedging, typically focusing only on the direct transactional costs, such as broker fees. These components are often a small portion of the total hedge costs, leaving out larger, indirect costs. This could result in the cost of hedging outweighing the benefits.

One indirect cost is holding margin capital. As a result of the financial crisis and new capital rules for banks, companies entering into hedging trades with banks are required to post collateral or cash. This requirement could tie up significant amounts of working capital which might be better deployed for other business ventures, an opportunity cost that may be overlooked.

Another indirect cost is lost upside. When the probability that prices will move favourably is higher than the probability that they’ll move unfavourably, hedging to lock in current prices can cost more in forgone upside than the value of the downside protection.

Hedge accounting

One important aspect of hedging that I have not touched upon is accounting. Half of the respondents to our PwC Asia Corporate Treasury Survey 2014 did not apply hedge accounting, citing reasons such as the complexity and restrictive nature of current accounting standards, the administrative burden and the lack of appropriate technology to deal with hedge accounting requirements. If hedge accounting is not applied, hedging may actually create more volatility to earnings.

There is good news, however, as the accounting rules on hedging have been relaxed in the new accounting standard, which is effective from 1 January 2018.

In summary, hedging can be a useful tool to manage uncertainties. When done well, its benefits may go beyond merely avoiding financial distress to help preserve and even create value for stakeholders. Done poorly, it may destroy more value than what was originally at risk.

So should you, as they say, hedge your bets in this volatile environment? You don't have to be a gambler to answer that one - but you do have to link any decision back to your overall risk appetite.

 

William Mah is a Partner in PwC Malaysia's risk assurance services practice, where he advises clients on financial risk management. This column will continue to explore the theme of building trust and business resilience.

This article was first published in The Edge Weekly.

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