Flexible currency hedging with the participating forward.
The year 2020 was marked by unexpected events that posed challenges for companies in terms of currency hedging. Lisa Mahi, FX Sales Corporate & Institutional Clients, explains why the participating forward is an attractive currency hedging solution in these volatile and uncertain times.
Unexpected events make currency hedging a challenge
The COVID-19 pandemic caught the world economy completely off guard in 2020. The Fed's decision to cut key interest rates from the 1.50–1.75% target range to 0–0.25% was nearly as surprising; what's more, the US central bank announced that it expects things to stay that way for the next few years. Hopes that the European Central Bank, at least, would hike the interest rate on its deposit facility in the first quarter of 2021 likewise evaporated quickly as a result.
A good hedging strategy is important for companies
The fact that systematic currency hedging is even more important for companies in these uncertain times was highlighted in August 2020, when the USD/CHF exchange rate unexpectedly fell to nearly 0.90. Because the USD/CHF currency pair remained in a narrow band between 0.96 and parity in the second quarter of 2019, Swiss companies that needed to sell the US dollar against the Swiss franc had reckoned with a rate of 0.99 or parity in protecting their budget.
Many companies therefore decided to keep their position unhedged – a strategy that subsequently caught them out. With the fall of the currency pair, some companies ended up having to sell USD against CHF below their budget rate and therefore suffered a loss versus their reference rate.
Currency hedging in volatile times
For companies, protecting their budget or profit margin is essential to avoid losses. But the hedging strategy they choose should be flexible. Fact is, at the end of the day companies can never be sure whether their projections will come true or not. Amid these volatile times, companies could therefore find it worthwhile to hedge their exposure with a participating forward.
Enjoy the benefits of the participating forward
Use of a participating forward ensures a company is 100% protected but only liable for 50%. If a currency pair moves in the company's favor it can benefit from the price gains on 50% of the nominal hedged.
Advantages and risks of the participating forward
- You are fully protected at a known worst-case rate at expiry.
- At the same time, you can benefit partially from favorable market moves.
- No premium has to be paid (zero-premium strategy).
- More than 80 currencies and precious metal pairs are available.
- The participation in favorable market moves is limited to the participation ratio.
- Settled amount depends on the market rate at each expiry.
- Closing or restructuring the participating forward can result in costs or gains, depending on market conditions.
How the participating forward works
If a company decides to hedge currency risks with a participating forward, it needs to define the currency pair, duration, nominal amount for each expiry, and participation ratio. The above factors will ultimately define the hedging rate.
On each expiry, two scenarios can occur (Example for a seller of a currency pair):
If the currency pair trades below the hedging rate, the nominal amount can be sold at the corresponding hedge rate.
If, by contrast, the currency pair trades at or above the hedging rate, the nominal amount multiplied by the participation ratio needs to be sold at the hedging rate.
Flexibility is key to currency hedging
In the event of high volatility, basic hedging instruments such as the participating forward or purchase of options are a better solution than a forward transaction, for example. Although the latter is still one of the preferred instruments for addressing currency fluctuations, it's not always the right solution in a volatile environment.
A company is well protected with a forward transaction too, but cannot benefit from it in the event of any movement in its favor. As a result, there is ultimately no flexibility in terms of the amount. And in uncertain times in particular, flexibility is key to a reliable hedging strategy.