Heightened hedging

Market volatility and a new-found confidence in mark-to-market accounting rules have led to a resurgence in hedging activity among Hong Kong corporate clients. How are dealers adapting to meet this demand? By Rachel Alembakis

Corporate hedging in Hong Kong has risen steadily in the past three years. And the increase in market volatility across asset classes since June this year has resulted in an acceleration of this hedging activity, according to investment banking and corporate treasury professionals in the territory.

A lot of hedging takes place via privately negotiated over-the-counter derivatives, and on-exchange futures and option statistics do not break out contracts used for hedging, so substantiating these claims is difficult. But industry experts say company accounting departments have become increasingly more comfortable with mark-to-market international accounting standard changes that took place in Hong Kong in 2005, and this is driving a rise in hedging activity.

"In the run-up to new accounting standards in Hong Kong, we could observe that customers were splitting themselves into two categories - those that beefed up the accounting departments, and a group of institutions that took more of a wait-and-see approach," says Daniel Mamadou, head of Deutsche Bank's debt capital markets and corporate coverage group in Hong Kong. "A lot of the second category ended up reducing their hedging activities."

The new rules were largely based on International Accounting Standard (IAS) 39. And they mandated that derivatives be booked at fair value based on a mark-to-market price in a company's income statements. However, as derivatives used by corporates for hedge positions did not always perfectly match-off underlying exposures, they could end up causing undue volatility in financial statements.

"Definitely in the beginning, it made a lot of corporates hesitate to enter into derivatives transactions because they had concerns as to whether that is available for hedge accounting, which otherwise may affect their P&L," says Alvin Li, head of derivatives structuring products at Citi in Hong Kong. "It's been with us for about two years now, and some corporates are feeling more comfortable with IAS 39. But on the other hand, it does explain how some approach the hedging exercise, using simple structures like vanilla swaps. You can easily demonstrate the effectiveness of those structures."

The move mirrors what dealers have witnessed in other markets such as Europe and the US. And for a long while, corporates turned to simple instruments such as vanilla interest rate swaps to hedge their exposures. "For those customers who are willing to take a step further to consider structured products, sometimes they may require us to break the structure down into its components for discussion with the auditors to make sure they are eligible for hedge accounting," says Li.

Investment banking officials say they have seen increased hedging in equities as well as in other asset classes such as currencies, interest rates and commodities. "We see a little bit of everything," says Deutsche Bank's Mamadou. "Clients that have accepted hedging is a necessity and they're happy to live with mark-to-market impact of their positions, these customers have engaged into multi-asset hedging transactions."

These corporates often use correlation products to allow them to hedge more than one asset class at the same time as well as new asset classes, such as property derivatives. "We are also seeing some trade in agriculture commodities, which can only be hedged up to three or six months. We're developing contracts to three years."

Mamadou says clients that are more wary of volatility due to mark-to-market fluctuations in their profit and loss statements still build hedge positions using simple instruments. "(They) really focus on building as efficient a hedging account policy as possible (and) are effectively limited to flow derivatives, very simple forwards, very simple OTC contracts and typically positions where they are net purchasers of volatility," Mamadou says. "They wouldn't be engaging in carry trades, as much as the first group, because, by definition, carry trades will not attract full hedging account treatment. They are limited in their options and those limitations are caused by the types of hedging policies they would adopt."

However, even some of Hong Kong's largest companies that tend to use simple derivatives for hedging, say the new rules are still inefficient. "We use relatively straightforward derivatives for hedging purposes that are easy to mark to market using third-party pricing and price it on Bloomberg as a check on what we're being told," says Andrew West, treasurer of Swire Pacific. "The biggest problem for us is the documentation required for auditors. It's a time-consuming exercise. For instance, and this is one thing that annoys me, even if we have matching terms to the underlying instrument we are hedging, you have to back test, which is mad because by definition it is a perfect cashflow hedge - it has to meet the 80/125 rule."

Swire Pacific, a diversified group with operations in property, aviation, beverages, marine services and trading and industrial, hedges interest rate and currency risks with mostly "plain vanilla" instruments, West says.

"Primarily we use cross currency swaps, interest rate swaps, FRAs, and FX forwards," he says. "As far as our approach to interest rate risk - we typically aim to have 50-60% in fixed-interest-rate-bearing instruments. That's a rough guideline. The key thing is that we flex interest rates to assess their impact on our P&L and cashflows, using interest rate swaps to address any material exposure. We use basic swaps and that's really it. The nature of our businesses is very stable long-term investments, and our asset liability modelling and long-term debt is based on that."

West adds that it is the group's policy not to enter into derivative transactions for speculative purposes. "Derivatives are used solely for management of an underlying risk," he says.

Keith Fung, general manager of corporate finance for Hong Kong airline Cathay Pacific, adds that IAS 39 reporting requirements still provide challenges. "IAS 39 does cause accounting problems for us," he says. "We did some hedging in the form of derivatives. In the past, you could do it in a transaction that involved a bundle of options, but now we have to separate them into different contracts. It doesn't change the hedge pricing, but it makes it, in terms of administration, more burdensome."

Cathay Pacific also hedges a basket of currencies and against interest rate volatility, but also, as an airliner, hedges against jet fuel increases, Fung says. Cathay Pacific does not have a set hedging price/volume policy, but rather acts purely when the prices of instruments available make it attractive for the company, but did not provide further details.

However, Hong Kong corporates appear to have become more pragmatic about accepting the volatility that comes with mark-to-market derivatives reporting. They are also asking more questions about how to quantify the balance sheet exposure in comparison to the risk protection of using derivatives instruments, says Lutfey Siddiqi, managing director of risk advisory and corporate FX, Asia Pacific, at Barclays Capital in Singapore.

Siddiqi says the old approach of dealers asking clients if, for example, they have a view on whether the yen will rise or fall and then asking if they wanted to use that view in taking a derivatives hedge position is no longer popular. "The challenge for traditional derivatives specialists is that the old-style method of putting forward pre-packaged trades to corporates based purely on directional market outlook is now obsolete." Siddiqi says. "Clients want to talk about process - how you would frame the exposure, quantify the risks in the absence of hedging. Now let's talk about the product. Then demonstrate to me a range of scenarios in terms of mark to market impact that I would be subject to."

As corporates have become more comfortable with their derivatives hedging under IAS39, dealers have increasingly targeted small to medium sized enterprises (SMEs) as well as large local and multinational companies (MNCs). To better target this SME segment, some banks have reorganised their businesses. For example, Deutsche Bank broke its corporate coverage group into three desks - multinationals, large local companies and mid-cap companies. Currently, Deutsche Bank calculates that its corporate hedging business is 20% MNC clients, and 40% each large local and mid-cap companies, he adds.

"For midcaps, the focus tends to be on activity just in Hong Kong, maybe China, and they have just one or two markets where they export," says Deutsche Bank's Mamadou. "It's a loose definition, though. I don't think there is really a difference in terms of the products, because we've seen midcaps that are conservative and large caps that are assertive and vice-versa."

Given the rapid growth of businesses in Asia in recent years, capturing a business client when they are an SME often results in more business once the company has expanded over a period of years into a large corporate. And as Siddiqi at Barclays Capital says: "The service levels that are being demanded by large-cap and medium cap companies are pretty similar; you can't afford not to give good service. The changes are that today's small company will become tomorrow's larger company."