The Intelligent Quarterly from the publishers of The Insurance Insider

Winter 2011 / 2012

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It is said that the global financial crisis has changed the way the world looks at risk, and the gyrations in the currency market have certainly brought foreign exchange (FX) risk management higher up the agenda for our clients.

Given the large movements in the currency markets over this period and a sharp increase in the cost of buying option protection, clients have often asked what they can do to better manage FX risk and what "products" they should use. Our answer is that you should start with a robust risk management framework and use this to make decisions about your hedging policy - in other words, how much to hedge and when to hedge it.

In discussions with clients, it's clear that there is no one-size-fits-all approach that can be applied. In order to speed up the decision making process, a number of particularly active clients have created specific FX/treasury committees, which can react to market events and take advantage of opportunities outside of their regular hedging review process. These committees often have authority to commit to hedges, within agreed parameters, without the need to seek further approvals. Click to enlarge

We have also seen the creation of hybrid policies, where clients combine rolling and layering strategies to give an additional layer of flexibility, allowing them to hedge within maximum and minimum cover bands. Most importantly, however, investors should seek professional advice before entering into any arrangement.

In framing the policy, it's necessary to quantify just how much risk is inherent in the business, and how much of this you want to hedge. Commonly, clients use value-at-risk analysis to work out a probability-weighted estimate of how much cash is at risk over a given horizon, and therefore how much hedging to undertake.

The appropriate solution will be driven by the need to balance the economic benefits of hedging against any potential accounting impact. The simplest solutions can achieve hedge accounting under IFRS or US GAAP, but more structured solutions (including options) provide much more flexibility and can still achieve hedge accounting either partially or in full. More bespoke solutions using structured products will be marked-to-market through the profit and loss account, but can provide an exact economic hedge.

Top treasury risks

At the end of last year, in conjunction with the Association of Corporate Treasurers, we asked our clients what their top three risks were at treasury level. Unsurprisingly, FX transactional risk, interest rate risk and liquidity/funding risk were the top three, according to the majority of those who responded.

Tellingly, about 90 percent of our clients said that they had changed, or were about to change treasury policies in the light of lessons learned in the crisis. Seventy-four percent of our clients are hedging forecasted transaction risk, and one key trend was an increase in the amount of hedging taking place, often to longer tenors.

Prior to the crisis the average hedge tenor was less than one year. Since the crisis this has moved to approximately 15 months.

Our survey suggests that only 30 percent of the respondents can take advantage of favourable market conditions to hedge, but that clients do look to enter into rolling or layered hedges. Only 39 percent of those surveyed hedge net investment in foreign subsidiaries and only one third of those actually hedge earnings translation.

The issue of net investment hedging is of special interest to insurance clients, as an insurance group is generally exposed to FX translation risk arising from investment in foreign subsidiaries, and it is important to consider the impact of net investment hedges on both group capital resources (GCR) and insurance group directive (IGD) surpluses. Should the net foreign investment be left unhedged, the insurance group would be subject to both GCR and IGD surplus volatility.

However, if the net foreign investment is fully hedged, then GCR volatility is minimised, although the IGD surplus may be more volatile than without any net foreign investment hedge. Partial hedging of the net foreign investment (or expected IGD surplus capital) could stabilise the IGD surplus, though this might lead to more volatility in the GCR requirement. The table right outlines the main risks to revenue and capital.

Outlook for 2012

For many of our clients the £/$ exchange rate is their single largest FX risk. Our view is that sterling is likely to share Europe's pain against the dollar over the next 12 months. Our base case is that the Eurozone situation will get worse before it gets better, increasing the risk premium on European currencies, supporting the US dollar and weighing on sterling. Click to enlarge

The EU accounts for over 50 percent of the UK's export market and UK banks are highly correlated with their European peers, which we believe makes sterling vulnerable in the near term.

On top of this, the UK growth outlook remains challenging and there have been hints that the recently announced £75bn of quantitative easing may not be enough to offset the weakness in the economy, and that the Bank of England may announce a further round in due course. We forecast that the European Central Bank will cut rates in December, which would see EUR/$ head lower, taking £/$ with it.

Over a longer horizon, we are more optimistic about sterling's prospects. Interest rate differentials should be supportive of the pound and risk appetite is likely to rise as conditions ease in Europe and as the US and China loosen monetary and fiscal policy. Meanwhile, a reduction in safe haven demand will see the US dollar weaken and the UK's trade balance will improve as global trade rebounds.

The global financial crisis shows little sign of abating and is a positive only for perceived "safe havens" - principally the dollar and the yen. Managing uncertainty in this environment is difficult, and it's important that companies should think about what risks they want (or will be paid) to bear, and what is the appropriate quantum of FX risk to hedge.

Proactive management of FX and associated risks has never been so important and this is one area where we can add tangible value to our clients' business. Given the recent turbulence, it's likely that the market will experience continued volatility. This volatility should provide opportunities for those who have a robust framework in place to manage their risks.

Graham Sheridan is director, UK Risk Solutions Group, Barclays Capital