FXMPG2 Delves into Algos, Dynamic Hedging, CSAs and Options vs. Forwards
The FXMPG2 September meeting at the offices of host and sponsor Societe Generale produced a terrific day-and-a-half of in-depth discussions. Here’s a look at a few of the key takeaways that emerged as members connected with each other and with our hosts.
The Ins and Outs of Algo Trading. One member impressed and enlightened members with a comprehensive update of his company’s use of algos for hedging FX exposure.
- Key Takeaway: Bigger Savings with Bigger Trades. The presentation demonstrated that the savings gained by using algos vs a risk-transfer trade on $200 million notional far outpaced savings on a $50 million trade. The presenting company therefore has a $100 million minimum for EUR trades.
- Key Takeaway: Algos Take More Work. The difference in savings matters in part because the passive algos favored by the member can take up to 30 minutes to execute a $200 million trade (meaning the user is exposed to market risk) and require monitoring. One member said, “It sounds like a lot of work to me,” and asked if the extra time spent on algos negated the benefits. The presenter said the choice whether to spend 5-10 minutes of your time on an algo versus 1 minute for risk transfer comes down to how much you value the savings. He said $2-$3 million in savings is worth it to him.
Dynamic Hedging: The Case for Options—Literally and Figuratively. Supported by rigorous analysis, presenters from the bank laid out the case for ditching a completely static hedge program and having a hedge toolkit that includes options.
- Key Takeaway: Price maker or price taker? Market position, price elasticity and margins matter in risk management. Premium brands like Cartier (to take a French example) have an ability to pass through significant FX moves to consumers and they have the higher margins to unlock budget for options premiums. Lower margin brands operate in a much more competitive landscape; they often prefer the certainty of outcome that comes with a forwards-based strategy.
- Key Takeaway: More dynamic, please! Benefits of not being totally static. In a hedge program, the hedge ratio, tenor and instrument choice are the levers that allow flexibility (or not). In their presentation, the presenters noted that they refer mainly to instrument choice when they talk about static vs. dynamic hedging. A static hedge program is consistently applied regardless of market conditions. A dynamic systematic program is a rules-based framework using mainly forwards and collars and where the hedge ratio is determined by market-based triggers like volatility and forward premiums. This kind of program can result in considerable savings in hedge cost (or more risk reduction for the same cost) over time, while still having the guardrails of a well-defined framework. A dynamic opportunistic program allows decision making on a case-by-case basis based on currency, exposure, timing and market levels and can include options and option combinations.