Turning Black Swans White – Dynamic Corporate FX Hedging Strategies

To forecasters who thought they correctly predicted the results of the Brexit referendum,the famous  economist John Galbraith had some wise words: "There are two kinds of forecasters: those who don't know,and those who don't know they don't know."

In the morning of 24 June,it became clear that nearly 52% of the British public had voted to leave the European Union. The result,which was almost unimaginable to the rest of the world,delivered short-term seismic gyrations to the financial markets.

Initially,higher risk assets saw precipitous falls. Credit indices gapped out 10-25%,the pound sterling tumbled 12% against the US dollar,while the South African rand slumped by as much as 13% against the US dollar at one point. A flight to safe-haven assets also saw reserve currency government bond yields re-establish all-time lows,with a notable underperformance from peripheral European yields. The market,however,did not get truly disorderly nor did it witness the Armageddon predicted by financial analysts once the UK voted against expectations to leave the EU. In fact,most emerging market currencies such as the South African rand,Brazilian real and Indian rupee have all rebounded while the FTSE 100 index has recovered to a one-year high following the vote.

Financial markets recognized that the true economic implications of Brexit would only be felt in a matter of years,not days. They also realized that asset price implications were far from clear in the immediate aftermath and would be driven by factors as yet unknown,including the reaction of regulators and central banks to these perceived economic impacts.

So-called "black swan" events such as Brexit and their long-term tail impact are by their nature unpredictable. Short-term moves are often exacerbated by positioning within the financial community and a lack of genuine liquidity in financial assets. Longer term,market moves will be driven by consistent demand and supply factors. These may either reverse short-term moves or consolidate them. It is also worth bearing in mind that the view of events and the commercial opportunities they present might be different to corporates than the financial markets. This can lead to opportunity from market volatility as well as the requirement for customized hedging strategies.

If nothing else,Brexit,highlights the need for corporates to have a long-term risk management strategy in place. This risk management strategy should take into account the genuine requirements and opportunities of the company and incorporate natural hedges as well as risk management tools to specifically manage the cash flow requirements and translation risks the company is exposed to,both from a short- and long-term horizon. This article draws upon case studies to explain how Chinese corporates should better prepare themselves for future black swan events,especially given interests in strategic geographies driven by the "One Belt,One Road" initiative.

Avoid Being the Turkey

The idea of black swan events was coined by a Lebanese-American former trader,risk analyst and New York University Professor Nassim Nicholas Taleb,in his influential book published in 2007. The black swan theory explains the disproportionate role of rare,high-profile,hard-to-predict,but historic events that are beyond rational expectations or scientific modeling.

The main objective is not to predict black swan events,but to build robustness against negative ones and be able to exploit positive ones. In other words,statistical normal distributions are not successful in calculating risk. Taleb states that a black swan event depends on the observer. For example,what may be a black swan surprise for a turkey is not a black swan surprise to its butcher; hence the objective should be to "avoid being the turkey" by identifying areas of vulnerability in order to "turn the black swans white."

Examining this in the context of our unpredictable financial markets,these events can be broadly translated into either natural disasters,surprise economic developments or geopolitical tensions that occasionally (although seemingly more frequently) disturb the market. Usually,such black swan events in financial markets are meant to refer to significantly unexpected moves across asset classes. Asset prices formerly thought to be uncorrelated move in tandem and liquidity evaporates.

These black swan events are often extreme events characterized by massive outflows from all risky assets,creating a systemic financial crisis at a regional level or on a global scale. As witnessed immediately after the Brexit vote,all risk assets tended to perform poorly and there was a general flight to quality by investors. Similarly,as markets recovered there was a high degree of correlation between asset classes.

The Brexit Case

There are a number of potential events which could occur to significantly alter the underlying market structure due to Brexit. Clients might wish to address these depending on their exposures.

The central case for the post-Brexit market is that UK central bank rates will be cut and longer term rates will be moved downwards via quantitative easing. Use of the "Funding for Lending" scheme will further contract bank lending spreads. Fiscal action will also be taken at a later date involving additional spending by the government in an attempt to counteract increases to unemployment and a drop in growth. This will place further pressure on the pound and weaken it against most other currencies.

To leverage this central scenario,a client would shift any borrowings in sterling to a floating rate basis via the use of interest rate swaps. Clients whose borrowings are in sterling but whose revenues are in another currency would remove any foreign exchange forwards in place to hedge at present,while those whose revenues are in the UK,but costs are in another currency,would take out those same foreign exchange forwards to lock in current rates. Fiscal spending might allow profitable project investment into the UK,in which case costs would be shifted to sterling loans but projected profits to be repatriated would best be hedged,perhaps through collars set at a minimal breakeven level.

That said,the central case might not transpire,or might transpire before evolving into something else. Among the scenarios which could be considered as low probability,high consequence events are: UK political actions going too far in attempting to alleviate the symptoms of the central case (Case 1),a UK currency crisis (Case 2),or a UK-centered banking crisis (Case 3). There is also the possibility that either the UK sets aside the EU referendum result or enters into a quick agreement to join the European Economic Area (Case 4).  

Case 1: UK attempts to address the problems caused by the central case go too far,leading to high inflation and a sudden reversal of policy. Prior to the Brexit vote,the UK's spare capacity was low. One can imagine that an economic downturn along with the UK's negotiating position might lead to a reversal of immigration flows. Couple this effect with a weaker pound and fiscal stimulus,and the capacity of the economy might be exceeded in short order. Inflation rises sharply and long-term interest rates rise to compensate.

For clients borrowing at floating rates as per the central case,the sudden rise in longer term yields could be guarded against via the use of out of the money interest rate swaptions,where the client buys the right to enter a swap at a higher level than current rates. These would be especially effective in counteracting a steepening of the yield curve. In this case,the currency might not rise significantly until the central bank makes a firm commitment to raising rates,which would require a sudden change in thinking.

Case 2:  A UK Currency Crisis. The UK has had several currency events since World War II and it runs a current account deficit of over 7%. A drop in interest rates,a market perception that the government lacks fiscal restraint,and a weakening of overseas growth that curtails exports and investment returns from non-UK sources could create a combination of a falling pound and rising imported inflation. As the standard response to a currency crisis is for the central bank to raise rates,rates might rise sharply at short tenors rather than long,even while the currency weakens.

Hedging this event might require multiple instruments. In order for a borrower in sterling to hedge against the rise in interest rates in this case where the central bank is leading the move,interest rate caps would be an appropriate instrument as they would counteract the exposure to short-term rates rising at some unexpected time in the life of the loan. For clients who had revenues in pound sterling but costs