Why hedging can be effective in 2019

Hedging mechanisms can act as a buffer against price volatility and improve cost optimization, a strategy that when deployed effectively offers financial stability

As financial markets remain volatile and funding costs continue to rise, all businesses must ward against uncertainty, and CFOs and corporate treasurers should pay closer attention to the benefits of hedging, industry experts are urging.

At its most effective, a hedging strategy enables companies to better manage their balance sheets and improve their profitability.

Take Huafu Fashion, an A-share listed company who announced that their hedging strategy raised profits during 2018, registering 66 million yuan net profit for the year. According to sources at Huafu Fashion, the company bought cotton futures at a low spot price and locked in their raw material costs with the strike price.

Another successful hedging example using derivatives is China's automobile company Geely, which acquired 9.69% of Daimler's shares for US$9 billion in February 2018. Although Daimler's share price plunged over 30% in 2018, Geely effectively hedged their equity position with a collar strategy by longing a put option and shorting a call option at different strike prices at the same time. This strategy shielded Geely from disadvantageous share price changes.

Conversely, overlooking hedging mechanisms or a general lack of a of understanding of financial products can erode a company's income statement.

China's SOE Sinopec's ineffective hedging strategy in crude oil lost the company billions of US dollars in 2018. Sinopec was apparently involved in a zero-cost collar trade where the company sold a put option and bought a call option at the same time, according to well-informed sources.

A calamitous hedging strategy that also concerns the movement of fuel prices and highlights the dangers of misconceived strategies relates to Cathay Pacific. This Hong Kong based airliner took out a hedge against rising fuel prices several years ago, only for OPEC to unexpectedly release huge quantities of oil onto world markets in a bid to make US shale gas unprofitable. Subsequently, oil prices collapsed and Cathay was left sitting on above market fuel input costs, resulting in substantial financial underperformance.

The company was forced to embark on an internal restructuring strategy, including layoffs, partly as a result of this disastrous fuel price hedge, according to many industry insiders.

However, hedging has undoubted benefits when utilized effectively. For instance, another aspect of hedging is with regards to financing cost optimization. In the Asset Benchmark Research Treasury Review 2018, which received 1123 responses from Asian CFOs and treasurers, optimizing financing costs was ranked as the fourth most important treasury goal.

"The US dollar interest rate hike cycle has impacted corporate funding costs and liquidities. More corporates are willing to consider structured funding to reduce the cost," says Xuping Yang, head of global client sales for Asia at MUFG Bank in an interview with The Asset. "We have seen more corporates increase the hedging ratio of their total liability against the interest rate hike cycle."

According to Yang, some corporates worry about the hikes in US rates and its knock-on negative impact on the Chinese economy and renminbi depreciation. And a number of corporates have considered switching part of their liabilities from foreign currencies into renminbi as the "natural hedge" against currency depreciation.

In a bid to reduce costs, some Asian corporates are turning into euro funding to benefit from a lower interest rate. "Corporates with euro funding needs are more willingly to use synthetic loans by borrowing in US dollars and to then swap to euros simultaneously, taking the advantage of the euro negative interest," says Yang.

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Date

22 Jan 2019

Channel

Capital Markets

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