Hedging Policy in Corporate Treasuries

Do we really need a Hedging Policy?

Let’s make one thing clear: a Hedging Policy is not the same as the Transfer Pricing Policy, it is not the same as a FX Procedure for executing FX hedges, and it is not the rulebook for the hedge accounting treatment of derivatives.

When I have this conversation with clients who have not adopted a Hedging Policy (yet), invariably the next question I get is “so why do we need a Hedging Policy then?”

Today, the micro-economic environment we operate in is deeply interconnected, and events in any part of the world can have swift repercussions on our business: companies are exposed, either directly or indirectly, to a multitude of financial risks, be it FX or Interest Rates, or the price of certain commodities and so on. Establishing a robust hedging policy, that describes how a company identifies, measures and manages its financial risks, is not just beneficial: it's a critical safeguard and attests to the maturity level of the company’s enterprise-wide risk management framework. 

Mandatory? Not really...

Very often I am reminded that a Hedging Policy is not a mandatory requirement. Not only is this statement correct, but with a notable exception regulated by the SEC in relation to hedging of own securities (outside of the scope of this article) I cannot see such obligation being explicitly introduced any time soon. But the fact that nobody mandates us to do something prudent, beneficial and forward looking is not a good enough reason to put the item at the bottom of the pile. 

Technically speaking, indirectly the very same IFRS9 appears to be establishing a requirement for setting a Hedging Policy. The hedging policy forms a core part of the documentation required under IFRS 9. It details the entity's approach to risk management, including how it identifies, evaluates, and mitigates financial risks. The hedging policy typically specifies the types of hedging relationships that are acceptable, the methods for assessing hedge effectiveness, and the internal guidelines for hedge ratio determination.

The hedge ratio must be justified as part of the hedge effectiveness assessment. Without a formal policy outlining how such decisions are made, it becomes challenging to consistently apply and justify the hedge ratios used in practice.

This could complicate the compliance with IFRS 9, as auditors and regulators might require evidence that the hedge ratios used are systematically derived and aligned with the entity's overall risk management strategy

But are there really any dangers in navigating by sight?

“What can go wrong if my company doesn't bother to adopt a well-thought-out Hedging Policy? “

Nothing, if there are no significant direct and indirect financial risks to worry about. I think it's a rare situation in today's markets, but in all honesty that would be the right answer.

Quite a lot, otherwise.

I have taken some time to go through the lessons learnt from recent, and also less recent, episodes where mis-management of market risk, either because it had not been looked after or because dealing in derivatives was not sufficiently well managed/monitored internally, inflicted significant damages to the accounts and to the financial stability of an otherwise healthy company.

Such stories are not always easy to find in the press: during my multi-decade-long experience in the banking/financial sector, I had the opportunity to come across a number of interesting situations and I have taken the liberty of collating the following list of comments, heard in response to queries around the root cause of such incidents:

• “No one could have predicted such extreme move in price of xxx, it was truly a one-in-a-decade move”;
• 
  
• “We were convinced that we were internally hedged”;
• 
  
• “Our business is solid; we have been innocent victims of market speculators”;
• 
  
• “Our views, as supported by that of many of our relationship banks, were that the price of xxx would not go up, and therefore we decided to remain unhedged”;
• 
  
• “Our CEO believes that hedging introduces unnecessary complexity”; [incidentally, I recommend a very interesting reading “Me, myself and I: CEO narcissism and selective hedging” (Bajo, Jankesgård, Marinelli – 2021). It shows how the self confidence of a CEO influences hedging decisions]
• 
  
• “Nobody could understand what the Treasurer was doing: he kept reassuring that all was going well”;
• 
  
• “The activity in derivatives has never been a matter of relevance for the CEO/ The Board”;
• 
  
• “We were reassured that the mark-to-market of the derivatives was just an accounting thing”;
• 
  
• “The presentation that we were given by the bank did not explicitly clarify the possibility that we could remain locked into this derivative trade for many years”;
• 
  
• “We were told that this new product could allow us trade at a much better-than-the market rate, and if needed it could easily be re-structured”;
• 
  
• “We used to have a Hedging Policy, but it was no longer adhered to since our business model had changed few years ago”;
• 
  
• “The FX hedging was done correctly: it was just that we did not have sufficient funds to cover the margin calls”;
• 
  
• “The responsibility for monitoring the compliance of our derivative activity with our Hedging Policy was with someone who left the organization and was never replaced”;
• 
  
• “This is something the Treasurer should be kept accountable for: he was the man in charge. Clearly, he messed things up”.
• 
  

I could continue with the list but I prefer to stop here, since by now it should be clear that the root cause should instead be found in the lack of a well-crafted, and rigorously implemented, piece of document that describes the way the company must identify, measure and manage its market risks.

My collection of remarkable quotes is already too long for adding any more: as Corporate Treasurer, as Risk Manager, CFO, CEO, Board Member, you have an individual responsibility to ensure that the right conversation happens in your organization.