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Layering Hedges and Extending the Hedge Horizon Through Rolling Hedge Programs
John Bird, Atlas Risk Advisory LLC
• Increasingly, companies are pursuing continuous rolling hedge programs and shifting away from annual static, set-and-forget hedge strategies.
• We examine the historical results of three different types of hedge programs: an unhedged program, a static “set-and-forget” hedge strategy, and rolling strategies with various hedge initiation periods.
• By contrasting rolling hedge programs against “no hedge” and static hedge strategies, we find that rolling strategies result in more stable hedge results over time with lower period to period deviations.
• Moreover, we find that the longer the hedge horizon, the less volatile the effective hedge rates.
• The reduction of hedge volatility supports our qualitative assessment that hedging early (with longer tenors) and hedging often (by layering hedges) will enhance a company’s risk management results.
In years past, it was common for companies to set budget rates and execute most of the hedges for the entire year at the beginning of the fiscal calendar. Upon completion of these hedges, companies would largely consider themselves “finished” with the majority of their hedge activity. In our advisory work with multinational corporations, however, we have noted a shift in hedging practices. Increasingly, companies are refining exposures and layering in hedges throughout the year to build up coverage from exposed assets, liabilities and cash flows. And as coverage increases for the existing forecasts, new forecasts are formed, and hedges are extended forward into future periods. One aspect of the shift toward rolling strategies has been an extension of the maximum hedge horizon. This longer-tenored, layering and rolling practice has turned the exposure creation and risk management process into a continuous exercise that is sharply different from the annual, set-and-forget strategy previously mentioned.
There are several reasons why companies are changing hedge practices. Periodic revaluations of exposures and derivatives as required by FAS 133/ASC 815 accounting rules have led companies to review their hedges more often, with a refinement of hedged amounts over time leading to less hedge ineffectiveness. Another main driver is the weak business environment that has made it more difficult to determine exact exposure forecasts, especially for longer-dated exposures. Faced with uncertainties, companies have realized a need to adjust hedges and become more active in managing their risks throughout the fiscal year. Finally, Wall Street’s intense focus on the stability of earnings growth has caused treasurers to look beyond hedge performance within a particular fiscal year. Layering and extending hedges across fiscal years provides more stability in effective rates during and across fiscal years.
Qualitatively, we would say that rolling and layering hedge strategies are attractive because these strategies require companies to review exposures and refine hedge coverage across time. Doing so can help avoid timing and coverage mismatch due to exposure forecasts that are often less certain at the outset of the year. The longer horizon helps the process by anchoring hedge rates across longer time periods, adding to the reduction in hedge rate volatility.
Witnessing a change in hedge execution practices across firms and industries led us to examine the historical results of three broad types of hedge programs: an unhedged program, a static “set-and-forget” hedge strategy, and rolling strategies. With the rolling strategy, we also examine the impact of different hedge horizons. By contrasting rolling hedge programs against “no hedge” and static hedge strategies, we find that the rolling and layering hedge methodology results in more stable financial results over time with lower period to period deviations in hedge rates. With regard to hedge horizon, we find that the longer the hedge horizon, the less volatile the results. Reduced volatility, in combination with favorable economic results, supports our qualitative assessment that hedging early (with longer tenors) and hedging often (by layering hedges) will enhance a company’s risk management effort.
We study three main types of hedge programs using quarterly historical market data from 2000. In total, six hedge methodologies are tested—unhedged, a static hedge program, and four rolling programs of various tenor. They are outlined below:
• No hedge—exposures are converted at period-end spot rates
• Static hedges—hedges are initiated for the four quarters of the coming year during the final quarter of the ‘previous’ year.
• Rolling hedges—several quarters prior to the start of the budget year, hedges are executed to cover a percentage of the quarterly exposures and added in the subsequent quarters.
• Four rolling periods are examined: with initial hedges placed 4 quarters prior to the start of the year, 6 quarters prior, 8 quarters prior, and 12 quarters prior.
Details regarding how each program is executed are described in the next section. We use FX forwards as our hedge vehicle, and assume the underlying exposure is long EUR with a USD base currency and that the exposure notional is constant in every period. As we consider the various strategies, we assume that the risk management effort is focused broadly on economic outcomes.