Opinion: Many challenges with currency hedging

By Roger J Kerr Local USD exporters are already entering long-term (2 to 5 years) currency hedging contracts for up to 50% of their forecast USD receipts of spot rates around 0.5200 and 0.5300. Many would like to use NZD call options as the method of hedging as this does not lock them into a fixed exchange rate and allows them participation in rates in the 0.4000's if that eventuates. Unfortunately, the extreme volatility in the NZD/USD exchange rate renders the option premiums prohibitively expensive (5 cents cost for 12-months protection). Forward contracts and "collar" options are acceptable, if not ideal, alternative methods of hedging. Hedging currency risk is not as straight forward as many think. New Zealand investment fund managers who hedge the NZD/USD risk 100% on overseas bond portfolios and between 50% and 100% on international equity portfolios have experienced massive negative cash-flows in recent times. They use 3-month rolling forward exchange contracts to hedge the currency risk and when a 0.5500 contract is replacing a previous 0.7000 contract, the NZD cash outflow to the bank for the difference is massive. In the case of the NZ Super Fund the cash shortfalls have run into the hundreds of millions. This has forced them and other fund managers to sell shares and bonds (potentially at the market bottom) to generate the cash to settle the maturing FX contracts. Understanding all possible cashflow outcomes and their consequences is an important part of foreign exchange risk management and it appears some have underestimated this. After months of freefall from 0.8000 to 0.5200, the expectation is that the NZD/USD will now stabilise in the 0.5000's with all markets moving into a period of in-action and stability after the extremes of 2008.    --------------- *Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com