Hedging Forecasted Cash Flows

CitiFX | Client Solutions May 2014 Hedging Forecasted Cash Flows A rules based approach to G10 and EM Hedging Matthieu Brunet CitiFX Client Solutio...
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CitiFX | Client Solutions

May 2014

Hedging Forecasted Cash Flows A rules based approach to G10 and EM Hedging

Matthieu Brunet CitiFX Client Solutions

[email protected] +44 20 7986 9174

Sources of Currency Risk

Transaction

Translation

Forecasted Transactions

Yield

Foreign Liabilities

Currency Clauses

Cash

Divestments Net Investments

Tax

Bid-to-award

M&A Payables Receivables

Dividends Pensions

Capex

1

Earnings

Inter-Co Loans

Forecasted Cash Flow Hedging

2

In G10, focus on carry and valuation The dynamic layered hedging program is a two-step process 

Hedging strategy – Select hedging weights looking at valuation – Select the hedging instruments looking at valuation and carry Valuation

3

Instrument Matrix

In EM, focus on levels of risk (EWS Heat Map)

Below average risk

Above average risk

Hedge signal** Money supply

Industrial prod.

Exports

CDS spread

Equities

Eco surprises

Global risk

REER

99%

92%

58%

88%

81%

37%

98%

81%

40%

39%

80%

96%

100%

98%

61%

88%

44%

69%

61%

76%

94%

8%

34%

25D

74%

68%

46%

74%

48%

81%

2%

68%

66%

86%

52%

34%

11%

-

Fwd

25%

99%

65%

78%

4%

16%

-

Fwd

65%

96%

89%

90%

4%

40%

90%

97%

54%

26%

100%

99%

72%

29%

29%

2.1% ▲

ATMF

25D

93%

69%

62%

84%

70%

40%

0%

72%

71%

51%

48%

34%

57.9%

3.7% ▲

ATMF

25D

57%

65%

79%

74%

24%

5%

72%

64%

85%

57%

78%

26%

13%

Brazil

55.5%

-0.2% ▼

-

Fwd

63%

73%

61%

84%

Chile

55.1%

-3.3% ▼

-

Fwd

53%

67%

66%

31%

79%

42%

70%

56%

83%

12%

32%

11%

93%

90%

54%

8%

91%

62%

44%

Colombia

54.2%

-0.6% ▼

-

Fwd

89%

57%

48%

3%

84%

95%

41%

33%

21%

71%

78%

25%

10%

Croatia

53.9%

-5.7% ▼

-

Fwd

36%

39%

Russia

53.8%

1.2% ▲

25D

ATMF

51%

68%

77%

30%

44%

98%

14%

90%

84%

34%

49%

62%

52%

74%

19%

66%

86%

84%

26%

Serbia

53.5%

-1.5% ▼

-

Fwd

86%

4%

64%

88%

25%

56%

56%

8%

89%

54%

27%

Romania

51.4%

3.5% ▲

25D

ATMF

52%

46%

23%

40%

78%

77%

19%

66%

33%

29%

54%

Mexico

49.1%

-2.2% ▼

-

Kazakhstan

49.1%

2.6% ▲

-

Fwd

70%

48%

67%

55%

26%

39%

45%

14%

76%

45%

30%

Fwd

37%

46%

74%

29%

80%

17%

29%

72%

72%

32%

Uganda

47.3%

-4.8% ▼

-

Fwd

96%

66%

43%

29%

15%

13%

38%

30%

99%

Egypt

47.2%

2.3% ▲

-

Fwd

64%

41%

63%

87%

0%

61%

0%

92%

6%

37%

73%

Thailand Bulgaria

46.8%

2.0% ▲

-

Fwd

17%

59%

95%

73%

51%

14%

18%

39%

87%

25%

16%

46.8%

1.3% ▲

-

Fwd

99%

54%

32%

84%

47%

61%

39%

0%

33%

50%

Risk index

Poland

45.6%

0.3% ▲

-

Fwd

84%

55%

36%

54%

59%

52%

15%

6%

31%

69%

28%

60%

btw. 50-55%

Peru

43.9%

-9.2% ▼

-

Fwd

71%

45%

80%

43%

47%

7%

24%

77%

44%

32%

23%

Israel

43.3%

6.0% ▲

-

Fwd

30%

38%

47%

85%

49%

8%

12%

16%

34%

27%

76%

South Korea

43.0%

-1.7% ▼

-

Fwd

19%

27%

54%

44%

62%

61%

30%

2%

49%

69%

28%

71%

Risk index

Hungary

42.9%

-3.0% ▼

-

Fwd

10%

25%

25%

59%

63%

76%

35%

80%

61%

12%

25%

43%

below 50%

Pakistan

42.6%

0.2% ▲

-

Fwd

70%

84%

42%

30%

0%

31%

34%

96%

7%

29%

45%

Nigeria

42.1%

-3.4% ▼

-

Fwd

28%

51%

46%

75%

4%

21%

6%

60%

27%

93%

Singapore

41.3%

2.6% ▲

-

Fwd

2%

33%

13%

50%

53%

93%

6%

71%

68%

30%

37%

China

41.0%

-2.3% ▼

-

Fwd

30%

48%

23%

82%

6%

20%

3%

15%

75%

98%

27%

65%

Philippines

40.2%

1.2% ▲

-

Fwd

23%

92%

63%

20%

57%

22%

12%

23%

80%

45%

27%

20%

Kenya

36.9%

-1.7% ▼

-

Fwd

100%

46%

43%

83%

34%

45%

2%

Malaysia

36.7%

-1.9% ▼

-

Fwd

13%

60%

30%

53%

45%

48%

23%

Saudi Arabia

33.7%

-3.3% ▼

-

Fwd

5%

55%

41%

53%

45%

0%

Taiwan

33.1%

5.2% ▲

-

Fwd

7%

43%

51%

62%

20%

29%

5%

Czech Republic

31.3%

0.7% ▲

-

Fwd

70%

15%

31%

47%

33%

41%

5%

MoM

External Long EM Short EM financing

April 2014

Index*

Ukraine

76.2%

2.1% ▲

-

Fwd

Turkey

59.0%

-2.9% ▼

-

Fwd

Indonesia

59.0%

1.2% ▲

ATMF

Venezuela

58.6%

-0.6% ▼

Argentina

58.5%

4.0% ▲

South Africa

58.2%

India

Loan-toShortImplied deposit term debt FX vol

* - The EWS risk indices are calculated as average rolling percent ranks of 12 indicators of economic and financial stress. The indices vary between 0% (low risk) and 100% (high risk).

4

53%

74%

68%

17% 22%

61%

0%

54%

1%

above 65%

Risk index

28% 23%

Risk index

30%

34%

28%

56%

50%

30%

30%

40%

58%

20%

32%

23%

Source: Citi; Sample: 30 April 2014

btw. 55-65%

What about portfolio risk? The portfolio VaR is EUR 384k whereas the sum of the individual VaR’s is EUR 641k.  Concentration Risk: Although 50% of the notional exposures are G10 based, 60% of the portfolio risk is in the EM currencies.  The currencies with best hedging cost to risk ratios are USD and JPY (earning carry) and GBP and SEK (paying carry).

Underlying Exposure plus Forwards Portfolio

Currency JPY CHF USD GBP SEK HUF PLN TWD RUB TRY TOTAL

Exposures EUR Equiv. 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 10,000,000

Sum of Individual VaRs Total Portfolio VaR Diversification Benefit Diversification Benefit (%) Portfolio Volatilty

5

Individual 3M VaR - EUR @ 95% C.L. 91,182 31,069 63,007 56,379 62,646 62,173 46,967 56,274 63,490 107,598 640,783

EUR Equivalent 640,783 383,605 -257,178 -40% 4.7%

Component 3M VaR - EUR @ 95% C.L. 54,747 3,025 34,243 29,791 33,414 28,912 23,341 35,089 49,423 91,620 383,605

Contribution to Risk 14.3% 0.8% 8.9% 7.8% 8.7% 7.5% 6.1% 9.1% 12.9% 23.9% 100%

Marginal 3M VaR - EUR @ 95% C.L. -46,760 -1,771 -30,262 -26,567 -29,427 -24,666 -21,043 -32,323 -47,055 -86,220

Hedging (Costs) / Benefits Using Forwards EUR Equiv 467 768 12 -637 -1,534 -4,344 -5,543 4,164 -15,585 -19,013 -41,244

Earning Carry

Paying Carry

Marginal VaR Impact per EUR1 earned -100 -2 -2,525

Marginal VaR Impact per EUR1 spent

-42 -19 -6 -4 -8 -3 -5

Individual Volatilities 11.1% 3.8% 7.7% 6.9% 7.6% 7.6% 5.7% 6.8% 7.7% 13.1%

Portfolio Risk – Efficient Frontier The following chart compares a 50% hedged portfolio with the portfolios on the efficient frontier

VaR vs. Hedging (Costs)/Benefits

Fully Hedged 0 P1

P2

(50,000)

P3

P4 (100,000)

P5 P6

(150,000)

P7

VaR

P8

50% Hedged Portfolio

(200,000)

P9 (250,000) P10 (300,000)

P11

(350,000) Unhedged

(400,000)

(450,000) (50,000)

(40,000)

(30,000)

(20,000)

Hedging (Costs)/Benefits

6

(10,000)

0

10,000

Back Testing Results Cash flow hedging in G10 and EM

G10 cash flow hedging: short EUR/USD case study  The table presents summary statistics from the hedges examined including the dynamic program  18-month hedging tenor, Q-on-Q changes – WERM +/- 10% – Carry +/- 1% – Historical data set: Q2 1993 - Q1 2013  The average achieved rate of 1.2080 is significantly better than all of the other programs evaluated.  The standard deviation is on par with the other layered programs.

Average Best-case Worst-case VaR (95%) Standard deviation

7

Back Testing Results

Unhedged

Rolling Forward

Layered Forward

Rolling Option

Layered Option

Rolling Collar

Layered Collar

1.2220

1.2232

1.2243

1.2183

1.2212

1.2185

1.2224

Rolling Particip. Forward 1.2216

9.7%

9.3%

3.5%

9.0%

8.6%

9.4%

4.1%

9.0%

6.0%

6.1%

(-4%)

(-64%)

(-7%)

(-12%)

(-3%)

(-57%)

(-7%)

(-38%)

(-37%)

-12.6%

-4.6%

-13.9%

-7.4%

-12.6%

-4.7%

-12.6%

-4.7%

-10.1%

(-6%)

(-65%)

(4%)

(-45%)

(-6%)

(-65%)

(-6%)

(-65%)

(-25%)

-8.3%

-3.8%

-7.3%

-4.7%

-8.0%

-3.4%

-7.6%

-3.3%

-4.0%

(-3%)

(-55%)

(-14%)

(-45%)

(-6%)

(-60%)

(-11%)

(-61%)

(-53%)

5.0%

2.2%

4.8%

3.3%

4.7%

2.3%

4.4%

2.5%

2.7%

(-2%)

(-58%)

(-7%)

(-36%)

(-8%)

(-56%)

(-15%)

(-52%)

(-48%)

-13.4% -8.5% 5.1%

Layered Particip. Forward 1.2235

Dynamic 1.2080

EM cash flow hedging: short EUR/BRL case study  This study looks at layered hedging and the effect of using EWS as a decision tool for EUR/BRL. – The underlying exposure is short EUR / long BRL – The analysis is from December 2005 until January 2014. – The analysis assumes a 100% hedge ratio is achieved for the rolling & layered hedging strategies – The hedging program is based on monthly implementation points with equal weights per month  The Early Warning Signal layered hedging program works as a standard layered program, but with hedges only placed if a hedge signal is produced.  The average rate achieved for the 6m EWS Layered compared to 6m rolling forwards and Layered Forwards has been improved by 6 big figures and 3 big figures on average per month since 2005.  Using EWS layered hedging produces a lower volatility compared to both the unhedged case and the rolling program.

12/2005 to 12/2013

Unhedged

6m Rolling

6m Layered

6m EWS Layered

Avg. Effective Rate

2.6229

2.6821

2.6525

2.6201

Best Case

8.8%

8.8%

3.0%

6.5%

Worst Case

8

(16.8%)

(16.9%)

(4.8%)

(12.1%)

VaR (95%)

(8.5%)

(7.7%)

(3.0%)

(5.2%)

St. dev. (1m)

4.4%

4.4%

1.5%

3.3%

Back Testing Results

EWS

Hedge

< 50%

Unhedged

50% - 55%

25D

55% - 65%

ATMF

above 65%

Forward

Signal Sum m ary 25D

17.5%

ATMF

21.6%

Forw ard

3.1%

Total Hedge

42.3%

Unhedged

57.7%

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