Currency Hedging – when is the right moment?
Lauri Karp. Monday, November 23, 2009
This „Million Dollar Question“ is asked about currency hedging in almost every conversation with financial leaders. The high volatility of exchange rates in 2008 and 2009 affects every undertaking since almost all hedging instruments fluctuate between negative and positive market values from time to time.
In our Research paper of June 2009, we took our first step towards greater clarity by comparing the performance of a forward transaction with that of a currency option.
In each instance, we assumed securing at the start of the year and analysed the result at the year-end. However, many customers naturally wanted to know how decisions made in the course of a year would affect outcomes. Timing clearly plays a significant role in this. We now investigate three methods of determination of timing:
- The actual point in time and trends underlying forecasts determine the type of security (discretionary).
- Market prices determine the type of security (regulated).
- Circumstances or deadlines determine the type of security (event-driven).
Starting with 3 above (event-driven decisions), such currency dealings are decided more or less by „gut feeling“.
Most will be dealt with as cash transactions when a deal matures and the best market price accepted, or in effect „as the mood takes one“, whereby, depending on daily conditions, a hedge deal is made in the hope that the time was right and will remain so.
There are however more business-like methods: on the one hand discretionary, and on the other regulated decision-making processes.
With regulated deals, specific terms are laid down and, when these come into force, an agreed security, e.g. a currency hedge, is activated.
For example, a specified market price, the exchange rate on a due date or an acceptable range of volatility can be set, so that foreign currency purchases or sales can be triggered when these are reached.
In the case of discretionary deals, decisions will be made on the basis of appraisal at a particular point in time or after the elapse of a particular period. Hedging strategies will generally follow the forecasts of Banks or other professional market observers. Provided these forecasts are sensible and capable of being acted upon, this is surely the easiest form of currency hedging to explain to others.
Equally however, whatever method is chosen to determine the timing, decisions should never be reached out of ignorance or uncertainty.
In the next edition of Research we will analyse these three methods using market data and undertake a systematic comparison.
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