Would you forego a holiday in the Seychelles because there’s no direct flight to Victoria airport? Probably not. So why would your company not hedge against fluctuations of a currency where there is no counterparties for direct hedging against EURO, when it’s easily available indirectly?
What’s the answer?
Hedging against major currencies using the standard derivatives on the market is a relatively straightforward proposition. But at first sight it can seem more complex to hedge against fluctuations in more “exotic” currencies. There might be little or no choice of hedging products or the offer may be very expensive. The solution is double-hedging.
When you can’t fly directly to your destination you have the option of a more roundabout indirect solution. The same is true for currencies: when you can’t trade them directly versus your domestic currency, you can still “take a connecting flight” to get to your destination.
In the foreign exchange market, taking a connecting flight simply means pass through another tenor currency to trade your chosen derivative in exotic currency.
Take the example of a French company that wants to hedge against fluctuations in the Hongkong dollar (HKD). If its counterparty ( usually a bank) cannot offer FX derivative product to hedge directly versus variations in the HKD/EUR exchange rate but only EUR/USD and USD/HKD hedging instruments, the company could consider a double-hedge using the US Dollar as the common currency.
By hedging the EURO against the US dollar and then the US dollar against the Hongkong Dollar, the company is hedging against fluctuations in the EUR/HKD exchange rate.
Efficiently managing risks specific to double-hedging
Although they are fairly simple to set up, double-hedges call for rigorous management, since the company is not only holding Cross Currecy Risk, but also execution and intermediation risks.
For management of cross exchange risk to be effective, the first priority is to get the size of the two hedging transactions right. An excessive position in either of the currency pairs could leave the company dangerously over-exposed to fluctuations in the currency market.
The next order of business is to synchronise set-up, operation and unwinding of your hedging positions to make sure you’re never exposed to just one or other of the currency pairs, but always to both simultaneously.
You can see the importance of choosing the right financial intermediaries to guarantee seamless order execution and to minimise intermediation risk and transaction costs.
FX hedges on an exotic currency are not more complicated than getting to holiday destinations that are off the beaten track – provided you’re willing to accept connecting flights.
But you need the right tools to arrange efficient double-hedges and keep a tight rein on cross-exchange risk.
It’s crucial to be able to accurately estimate and monitor the costs charged by each intermediary for each foreign exchange transaction, and to have the capability to arrange and view your cross-hedge from different angles (“net position and “non-netted” uncombined position, for example).
Accurate and informative reports are a valuable tool to track key metrics, such as your actual FX hedging rate, foreign exchange profit and losses by currency pair and by reconstituted currency pair. You can also test simulated or actual hedging rates for your combined position or for each element individually in a variety of market scenarios.
What’s more, a tool to automatically generate accounting entries throughout the life of the instrument, from set-up to unwinding, allows you to post gains and losses on your overall position in the same set of entries to produce clear, transparent disclosures giving a true and fair view of the company’s position.
These are all the reasons why a treasury management system specialising in financial risk management like titantreasury is so valuable if double-hedging is part of your strategy. Our robust and secure solution will simplify, speed up and optimise your FX risk management.