Staying Ahead of the Curve: Mitigating Risk and Uncertainty with Hedge Strategies

When it comes to mitigating risk and responding to market volatility, CFOs,Treasurers, and other finance professionals are expected to lead companies through the storm. However, reactionary solutions are not the only option. 

We talked with our technical accounting expert, Bill Witt, Director at Morgan Franklin Consulting, about how deploying hedge strategies can help finance leaders meet market volatility with a proactive approach and stay ahead of the curve. Here are the major takeaways about mitigating risk and finding solid ground amidst uncertainty. 

Taking a Proactive, Not Reactive, Approach

While market expansion can create substantial growth opportunities, sudden changes in the economic climate can quickly turn anticipated growth into costly repercussions, which we are now seeing today. Many middle market companies that took on additional debt to finance rapid expansion such as acquisitions are now at the mercy of escalated interest rates. Strategies that were supposed to deliver tremendous opportunity are now costing companies valuable cash flow to sustain. This is because the current IPO market activity is relatively flat when compared to Q1 of 2022. Lower valuations and lackluster market performance of companies that have already completed an IPO have made these transactions less desirable, especially as higher interest rates and turmoil in the banking industry have limited viable debt issuance opportunities.

Finance execs know that market volatility is nothing new and far beyond their control. If that’s the case, then what measures should companies take to weather the storm and mitigate the impact? 

The key here is to look to the future and to create a proactive, rather than a reactive mindset. According to Bill, that’s exactly when hedge strategies might come into play.

Assessing and Mitigating Exposure

Hedge strategies ultimately come down to protecting against downside risk by either lessening or avoiding exposure to market volatility. While constructing a hedge strategy involves a deep understanding of how risks and investments evolve over time, Bill states that the first step companies can take is looking at their long-term commitments and assessing the level of exposure to unfavorable market swings, then utilizing the right tools to protect against those fluctuations. 

Here’s an example: let’s say a medical device manufacturing company based in the United States is looking to buy a 3D printing system from a European vendor that will take two years to produce and deliver. The purchase is in Euros and as a result, the company is now exposed to any fluctuations between the two currencies. Payment is due upon delivery in two years.

This is where finance teams can turn to hedge strategies as tools, or a way to “cushion” against volatility.

Examples of Hedge Strategies

Deploying a successful hedge strategy comes down to evaluating the variability levels and their effects on your operating results. That means that there may be more than one great solution for any given situation. Using the example fact pattern above, let’s take a look at a few different approaches. 

The medical device company’s CFO expects that the volatility in the USD to EUR could lead to an unfavorable rate swing that decreases the purchasing power of USD. Seeking to lock in today’s exchange rate, the manufacturer’s CFO could protect against downside risk by locking down today’s rate  utilizing a forward contract with a counterparty. In this approach, both parties would agree upon a specified contract amount, exchange rate, and future settlement date in two years for a currency exchange. For example, the contract agrees that the counterparty would receive the rate of 1.22 US dollar for each Euro at the settlement date two years into the future. The medical device company now has a contract that allows them to purchase a stated amount of euros at a fixed price in two years. This strategy ensures that the medical device company is protected against the exchange rate soaring past the 1.22 USD to EUR level during the two year period until settlement.

Let’s change the fact pattern slightly to say that the contract required an upfront payment which the medical device company financed utilizing variable rate debt that requires quarterly interest rate payments. If the CFO of the medical device company is concerned that interest rate volatility over the next two years will result in higher interest rates, there is a hedge strategy that can be adopted to limit the downside risk associated with rising interest rates. In this scenario, the medical device company  enters into an interest rate swap arrangement with a counterparty that allows it to pay the fixed interest rate of 5%, while the counterparty pays the variable rate. The medical device company is now protected against rising interest rates during the life of the two year debt facility. 

A variation on this example which is sometimes less expensive is an interest rate cap, or an “insurance policy” on a floating rate. Essentially, by purchasing a cap, the medical device company  is agreeing to pay a maximum interest rate of 5% on the loan during the term. If the market (variable) interest rates exceed 5%, then the counterparty will compensate the medical device company for the difference between the market rate and the capped rate of 5%. However, the catch is this: the longer the term of the cap the higher the fixed rate required by the counterparty. 

Yet another variation on this example is an interest rate collar, which is an instrument that sets a maximum and a minimum interest rate. The following scenarios are possible:

  1. If the interest rate is below the ceiling but above the floor, the company pays the actual debt rate.
  2. If the current interest rate is above the ceiling, the company pays the debt at its actual rate but gets compensated by the counterparty for the difference between the actual market rate and ceiling rate.
  3. If the current interest rate is below the floor, the company pays the floor rate and compensates the counterparty for the difference between the actual market rate and the floor rate.

The objective is to protect against potential volatility by limiting the impact of unfavorable rate changes. The advantage to an interest rate collar is the ability to guard against rate volatility in both directions. 

Potential Gain vs. Future Whiplash

Hedging strategies are by no means conducted in a strict format. In fact, many times, experienced finance teams will take a dynamic approach and implement strategies to various degrees in order to mitigate different areas of risk. 

Despite the differences in each option, they all push the same question: how can I lessen the blow if things should unexpectedly turn south? 

One concern that arises when considering hedging strategies is the limit on the potential gain or potentially locking in the wrong rate. Bill states that successfully approaching hedges requires a paradigm shift—it’s all about the gaining of control. What feels like dismissing an opportunity is actually setting yourself up for a solid position amidst a potential storm. Sometimes the decision to wait for a perfect time to close on a debt or equity transaction can be costly in terms of real cash and opportunity cost.

When Should Companies Evaluate Their Liquidity Strategies 

When asked about the optimal time to consider hedge strategies, Bill states that the time to manage against downside risk is now. Oftentimes, companies tend to consider hedging during the annual forecast process in the late third and early fourth quarters but when looking for opportunities to bolster their company against market volatility, it’s all about taking a proactive approach and making the appropriate accounting elections. 

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