REDUCING HEDGING COSTS

The foreign exchange (FX) market is one of the highest-volume markets in the financial world; annualized FX trading equates to an astounding 13 times global GDP. Multinational corporations (MNCs) are, necessarily, major participants in this market. In order to hedge their FX risk, MNCs trade large volumes of FX-based derivatives. However, the playing field for these trades is often tilted in favor of their banking partners in OTC trading. FX derivatives constitute only 9% of all derivative volume (IR, FX, equity, commodity, credit), but 58.8% of all derivative profit. Reducing that advantage is an important part of any hedging program.

You can reduce pricing spreads with a few simple strategies. Specify your trades to be executed at the WM-Reuters fixing rate, established every day at 10am NYC/4pm London. Trade your OTC contracts on the same day as the CME and other FX exchanges - a EURUSD contract on the OTC should converge to the same value as an exchange-traded contract. To avoid front running and reduce spreads even further, establish an anonymous trading program, using a prime broker and a trading platform through FXall or 360T.

Currency Risk Management offers several analytic tools and capabilities to further reduce your hedging costs.

Trade Reduction Tool (TRT)

Companies with subsidiaries that are local-currency functional are particularly susceptible to higher costs, because their subsidiaries must use less-liquid (and therefore higher-spread) cross currency pairs when hedging their exposure. Additionally, multiple corporate entities hedging with crosses inevitably generate large numbers of trades, increasing credit exposure.

CRM's Trade Reduction Tool reduces hedging costs in two ways. First, by using an algorithm to decompose the cross trades into equivalent USD-based trades, they can be netted, reducing the total number of trades. In the example to the right, 18 cross-currency hedges from 3 different foreign subsidiaries have been reduced to only 10 USD-based trades.

Second, by using USD-based trades, the company will see lower spreads for those trades. The volume of trade where one leg is USD constitutes 87% of the entire $5.3Trillion/day FX market, and spreads in those pairs are narrow. Conversely, the trade volume of cross currencies constitute just 1.7% of the total FX market by volume. This lower volume results in significantly higher trading costs.

In this example, CRM's Trade Reduction Tool converts 18 expensive cross-currency trades into only 10 USD-based trades, greatly lowering trading costs.

 

Pricing

Use independent third-party sources to determine the spot and forward prices at the time of each trade. This exposes each bank’s true bid-ask spread. Spot rates are easy to verify using services such as TrueFX, but forward points are not as easy to pinpoint. Subscriptions to Bloomberg, SuperDerivatives, WM/Reuters FX Indices, and Interactive Brokers are not cheap, but they can pay for themselves by revealing where the market truly is. Avoiding a misquote of 10 basis points (bps) on the forward rate—which consists of the spot rate plus forward points—for a trade worth US$2.5 million per month would cover the cost of a typical subscription.

A treasurer may also want to specify that trade pricing be tied to the WM/Reuters fixing rate. Despite the recent scandal, WM/Reuters fixing rates are the most transparent and liquid in the foreign exchange market. Specifying that trades will be priced at the WM/Reuters spot rate allows a treasurer to bid out the trade’s forward points, preventing any possibility of a skewed spot quote.