OPTIMIZATION
As with investors, corporations can use an “optimization” model to create an “efficient frontier” of hedging strategies to manage their currency risk. This measures the cost of the hedge against the degree of risk hedged. Thus, the most efficient hedging strategy is that which is the cheapest for the most risk hedged. This is a very efficient and useful tool for hedging currency risk in a more sophisticated way than just buying a vanilla hedge and “hoping” it is the appropriate strategy. Hedging optimizers frequently compare the following strategies to find the optimal one for the given currency view and exposure:
100% hedged using vanilla forwards
100% unhedged
Option risk reversal
Option call spread
Option low-delta call
While such an approach to managing risk is extremely helpful in providing the cheapest hedging structure for a given risk profile, it is not perfect and relies on a discretionary exchange rate view. Further research needs to be done in turning a corporation’s risk profile into a mathematical answer rather than a discretionary view. A starting point for this may be found in the type of equity market profile the corporation wants to create — value, income, defensive and so forth. From this, it may be possible to suggest an optimal profit stream the corporation should generate according to this profile and from this in turn we may be able to extrapolate a more exact hedging strategy to maintain that profit stream than simply a discretionary view might give. As it is, optimization, using a corporate risk optimizer (CROP), can be undertaken for transaction, translation or economic currency risk as long as one knows the risks entailed and gives a specific currency view within that. For example, if a corporation is looking for the best and most efficient hedging strategy in emerging market currencies, a CROP model can integrate the specific characteristics of those currencies together with the size of the expo- sure and hedging objectives (efficient frontier, performance maximization, risk minimization).Performance can be measured as P&L, an effective hedging rate or a distance to a given budget rate. The risk embedded in the hedge is expressed as a VaR number that will be consistent with the performance measure. While most CROP models do not provide a hedging process for basket currency hedging, they are very useful for finding the most efficient hedge for individual currency exposures. A CROP model is thus a tool for optimizing hedging strategies for currency-denominated cash flows.
Users of a CROP model are able to define the nature of their specific exposure and hedging objectives. The model also allows for scenario building, whether it be a neutral market view, the incorporation of budget/benchmark rates or the jump risk associated with emerging market currencies. If the objective is risk reduction, an efficient frontier can be created to find the most efficient hedge, which incorporates the cheapest hedge which offsets the most risk. Both performance and VaR are measured as effective rates.
Emerging markets are an example where corporate hedging used to adopt a binary approach — that is, to hedge or not to hedge. Options are a perfect tool for hedging, taking account of long periods when emerging market currencies do nothing and also capturing dramatic moves when they occur. They are cheaper and leave the corporation less exposed to an adverse exchange rate move. Furthermore, a CROP model can give the optimal hedging strategy using options or forwards for a given currency view and a given currency exposure.
The way this works is as follows:
Determine a possible exchange rate scenario over a specified time period, say six months.
Run a random distribution within the scenario specified.
Calculate the effective hedge rate for each hedging instrument used and the risk in local currency points.
Solve to find the hedging strategy with the lowest possible effective hedge rate for various accepted levels of uncertainty.
It should of course be noted that it is not possible to choose a single optimal hedging strategy without defining the risk one is allowed or willing to take. In scenarios reflecting a perception of volatility or jump risk, options will always produce a better or similar effective hedge rate at lower uncertainty than the unhedged position. Where the local currency has a relatively high yield and low volatility, options will almost always produce a better effective hedging rate than forward hedging.
July 5th, 2009