Volatility in Foreign Currency Leaving More Exposed Than Ever, Chatham Financial Study Finds
As fewer companies hedge top financial risks and volatility increases, more companies are exposed to risk
November 1, 2016 (Kennett Square, PA, USA) – According to a recent study from Chatham Financial, many businesses fail to fully protect themselves against the most significant financial risks they face. Chatham Financial’s 2016 State of Financial Risk Management Study found that only 55 percent of firms with exposure to currency risk actively manage this risk through the use of financial hedges. The percentage of firms hedging their commodity and interest rate risk exposures is even lower, with just 49 percent and 37 percent, respectively, utilizing derivatives to manage these risks.
The study, which analyzes the 2015 financial risk management practices of more than 1,500 publicly listed corporations in the U.S., found that fewer companies are hedging currency, interest rate, and commodity risks than they were three years ago. The amount of companies employing hedges to manage their interest rate risks fell from 37 percent in 2012 to 32 percent in 2015. The number of overall companies utilizing currency and commodity hedges fell three percent each from 2012, and now sits at 37 and 20 percent, respectively.
Uncertainty in Global Markets
The decrease in usage of financial risk management tools has emerged during a period of heightened volatility in global markets, especially in currencies. “Given the tremendous levels of volatility in currency markets over the past several years, it’s surprising to see that fewer companies are electing to hedge against exposures in this asset class,” said Amol Dhargalkar, managing director of Chatham Financial’s Global Corporate Sector.
Slow growth in Europe, Canada, China, and Japan and recessionary environments in Brazil, South Africa, and Russia have had an impact on the ability of firms to forecast swings in FX rates. As a result, some firms – especially newer entrants to the global markets – are putting off hedging for the time being.
“This practice will likely continue until these firms feel comfortable in their ability to predict business patterns and forecasts,” added Dhargalkar. “Unfortunately, this can result in the business being exposed to enormous downside risk as currencies fluctuate, be it from singular ‘shock’ events or longer-term trends.”
The decline in interest rate hedging activity, however, is to be expected. “The zero interest rate policies of many major central banks, coupled with negative rates in Japan and across Europe, have resulted in a decline of hedging activity in this sector,” said Dhargalkar.
Smaller Firms Face Brunt of Unhedged Exposures
Predictably, the study found that larger companies tended to have greater exposure to risks. For example, 75 percent of large firms (those with annual revenues of $5-$20 billion) reported having FX exposure, with just 58 percent of smaller firms (revenues of $500 million to $1 billion) stating so. However, smaller firms are equally less likely to hedge exposures to all forms of risk. While 69 percent of large companies hedged their FX risks in 2015, just 39 percent of small companies did so.
“Hedging programs require sophisticated teams and dedicated resources, which just isn’t an option for many smaller firms,” said Dhargalkar. “Larger firms are naturally better positioned to plan and execute a robust internal hedging practice.”
Still, the exposure faced by smaller firms can be especially dangerous in a volatile climate, as these firms tend to have fewer natural hedges against risks elsewhere in the business. “While some firms are perfectly well-founded in taking a strategic ‘wait and see approach’ to hedging, many of those who don’t hedge do so simply because of their inability to manage these rigorous processes internally,” said Dhargalkar. “Third party practitioners such as Chatham Financial can work with these firms to provide financial risk management planning and execution that doesn’t require an outlay of additional dedicated internal resources.”
The study also quantified the widespread use of hedge accounting treatment, which is used by companies to reduce the profit and loss impact of derivatives usage. A strong majority of firms are utilizing hedge accounting to manage at least one form of risk. Seventy six percent of firms hedging forecasted revenue and expenses are utilizing hedge accounting strategies. Additionally, 80 percent of firms that hedge risks are applying hedge accounting to interest rate derivatives, and only 45 percent are doing so for their commodity derivatives.
While corporations overwhelmingly utilize hedge accounting, the complexity of hedge accounting remains a deterrent to many, specifically with respect to commodity programs. To apply hedge accounting to commodity programs, a company must consider the all-in price risk. This is inclusive of the commodity itself as well as other basis adjustments. This makes it difficult to apply for hedge accounting when the derivative itself is based off of a particular index but the hedged transactions are based off of the all-in price to which the company is exposed.
Given the recent changes in financial markets – from negative interest rates, to the Brexit vote, to 10-year lows for oil – more and more companies are taking a fresh look at their hedging programs, reviewing everything from strategic objectives to work flow and program costs. With the increasing impact of regulation (such as Dodd-Frank in the U.S. and EMIR in Europe) and impending changes in hedge accounting standards, forward-thinking treasury teams are staying ahead of these changes by evaluating and rethinking their current practices.
The 2016 State of Financial Risk Management Study was conducted through a deep-dive analysis of the 2015 annual 10-K fillings of 1,589 publicly listed corporations with revenues ranging from $500 million to $20 billion. The study analyzed how companies manage risk exposure by asset class as well as the type of hedging program utilized and the application of hedge accounting by type of risk. This data was combined with insight gleaned from Chatham Financial’s client base of more than 2,500 companies to provide a comprehensive look at the financial risk management issues facing organizations today and how they are being managed. Data were compared to the results of Chatham’s 2013 State of Financial Risk Management Study, which analyzed 10-K reports filed by companies in 2012.
Companies were surveyed from the following industries: manufacturing; professional and business services; trade, transportation and utilities; financial activities, information, natural resources and mining; leisure and hospitality, construction, and education and health services.
The full report is available here: https://info.chathamfinancial.com/Benchmark2016.html. For more information on financial risk management and the types of solutions provided by Chatham Financial, please visit: https://www.chathamfinancial.com/.
About Chatham Financial
Chatham Financial is a full-service financial risk management advisory services and technology solutions firm, serving clients in the areas of interest rate, foreign currency and commodity hedging, hedge accounting, regulatory compliance, and debt and derivatives valuations. Founded in 1991, Chatham serves over 2,500 companies annually bringing expertise, services and technology solutions to our clients through a global team and debt and derivatives professionals, CPAs, analysts and technology developers. Read more at ChathamFinancial.com.
On behalf of Chatham Financial