With corporate hedging considered cheap and easy over the past few years, are today's corporates prepared for spikes in volatility and increases in hedging costs? In this video blog Udi Sela, Vice President of the Numerix Client Solutions Group and Numerix CMO Jim Jockle sit down to explore the meaning and implications surrounding the recently published Risk Magazine article,“Expert Warns of Corporates’ Complacency over FX Hedging Costs.”
In his analysis, Udi discusses the reasons to assume that there will be increased volatility in the markets in the months to come and what this means for corporates. He also breaks down what corporates should start thinking about—including the need to rethink current hedging strategies and warning indictors to watch out for.
Udi Sela (Guest): Thank you very much. Good to be here.
Jockle: Udi I want to talk to you about an article that came out in Risk Magazine this past week. And the article is titled “Expert Warns of Corporates’ Complacency over FX Hedging Costs”. And I guess basically due to lack of volatility in the FX derivative market, we’ve seen prices dramatically tighten over the last year. But, what is interesting in this quote from an individual who has not identified himself, other than a Senior Treasury Official at a global technology company, the quote is, “what the corporate world sees now is absolutely fantastic.
Hedging is cheap, transparent and fast. What is worrying is that we see total complacency among companies,” he says. “Many treasuries are not ready for the possibility of price increase. In fact, they don’t believe they ever will. And that is a dangerous belief.” So Udi, perhaps you can give us a little bit of guidance of what’s going on in the market right now that is really, kind of, according to this individual has driven complacency, especially in regards to hedging being cheap, transparent and fast.
Sela: Yes of course. So you may be able to recall that a few months ago we had a webinar about the historically low levels of volatility. Across different markets, from the VIX, through equity markets to foreign exchange. You know it was at the level of 10% (the VIX) to foreign exchange volatilities that were trading at 5-6 level. And I think basically the senior (quoted in the article) basically is inclined to the fact that corporates got used to very low volatility, and hence sense no need to hedge because you know “I’m just wasting premiums or whatever I pay while the market is not moving”. And guess what? Since at probably the end of August, or early September, the markets started moving across all asset classes.
So if we saw VIX at the level of 10%, last week we saw VIX almost at 30, so that’s a huge jump. And, if we look at some emerging markets, typically Brazil, the Brazilian real went from something like 2.30 to 2.50 (Real per US Dollar). And we saw the short term volatility levels of USD/BRLjumping into levels of like 26%. Having said that, in most markets, actually the implied volatilities are still pretty low. So we’re looking at levels of 7.5 to 8 in the major currencies. So I think this is what this person implies. It’s still relatively cheap to hedge and given the Ebola disease, and given the end of the quantitative easing in the U.S. and so forth. The crisis in Greece now. Germany going into depression. There are reasons to assume that there will be increased volatility in the markets.
Jockle: And we’ve seen a lot of recent swing as it relates to Dollar/Yen, Euro/Dollar in the past couple of weeks. And that’s probably going to continue to play out as well. Especially as equities have been quite volatile given all the negative news around the globe. In terms of this pick up in volatility, and yes the VIX has blown out over the last four months at this point. Obviously this is probably good for sell side market participants, but what corporates should start thinking about is the potential effects. I mean obviously perhaps less efficient pricing and wider spreads.
Sela: Yeah so I think that you’re actually applying to an interesting point. Which is the impact of regulation on market volatility and price gapping. So what we’ve seen actually during the last days or weeks, is that very few banks now have an appetite or mandate to maintain (market) risk in-house and to hold large positions. Therefore when you need to make prices. For instance, people trying to get away from holding Greek government bonds as the yield jumped from 5.5% to about 7% because there were very few people that were willing to put bids, or in other words to buy these bonds and since the appetite for risk has really declined. And given the cost of capital liquidity is drying-up and this is what the price that we will have to pay for increased regulation. And indeed this is what the banks are now claiming. That they cannot maintain positions anymore it’s just too expensive. This is something that regulators will have to take into account.
Jockle: So what are the indicators? What should people be looking for? Is it credit spreads? Looking at CDS spreads on governments. Where is the warning indicators that should be on the top of individual’s minds?
Sela: The first thing that I always look at is the ten year bonds yield, the government bonds. So for instance just an example that at the height of the crisis this week, we saw the ten year U.S. treasury trade below 2 percent yield. So that was pretty remarkable. We saw the German bond trading, German bunds, at a yield of 76 basis points. Which is almost incredible. So if you stick to these and follow them you will see that eventually the equity markets and the foreign exchange markets actually follow and catch up.
And also interesting to say, is mentioning (trade) volumes this week, we actually saw that the CME, ICE, CBOE, all reported record volumes, records never seen. I think the CME if I’m not mistaken had a daily volume of over 36 million contracts traded. Never seen before. Last year the closest was maybe 10 million contracts less. Actually it was 39 million contracts, and the previous record was something like 26 (million), so it’s absolutely amazing. It’s probably also an indicator that more volumes go to the exchanges.
Jockle: Udi I want to thank you so much for your insight on this. I mean clearly, this is something that’s going to be much more top of mind especially as the markets continue this volatility trend that we’re seeing now and obviously people are going to have to start to rethink some of their strategies if this market continues the way it is. But I’m definitely going to be tapping you for more insights. As we see how the rest of the year plays out. So I want to thank you again for joining us for today’s video blog.
Sela: Thank you for having me today.
Jockle: And of course we want to talk about the topics you want to hear. Please feel free to follow us on twitter @nxanalytics and of course we post all of our videos and company updates on our LinkedIn page. You can follow us there as well as numerix.com. Udi we’ll see you next time.
Sela: Indeed. Thank you very much.