To hedge, or not to hedge

Volatility and uncertainty in today’s global markets drive investors to be prudent in their risk management strategies. In emerging markets, where financing systems are not so well developed, currency risk remains a big challenge for investors and developers. 

Rob Dornton-Duff, who leads Chatham Financial’s global infrastructure and project finance advisory business, explains that infrastructure projects are not normally structured to provide sufficient headroom to absorb market risks – including currency risk – based on available cashflows to service debt. 

He suggests that a typical debt service coverage ratio of 1.2 could see a payment default if the debt and revenue are mismatched, say due to a foreign exchange rate movement in a 20 percent range. “And 20 percent isn’t severe by the volatility standard for any currency. We cannot assume the headroom is available to absorb such market risks,” he points out.   

For example, the worst performing currency in 2015, the Argentinian peso, lost 34.6 percent against the dollar.
David Russell, chief executive of Singapore-based renewables developer Equis, reckons hedging currency risk is a bespoke decision, one that needs to be considered in the context of a firm’s investor base. Regarding the Asian markets in which Equis invests, the firm considers the availability of currency hedges and also the costs and benefits associated with them, which will impact the structure and tenor of its contracts. 

Equis considers hedging as a risk mitigation tool. It begins with an understanding of each investor’s objectives, the project’s cashflow profile, any natural hedges around the denomination of the project’s cash outflows and any debt financing, and concludes with individual market dynamics and the availability of hedge products for the currency under consideration. 

Russell says that for good projects, foreign currency should never act as an impediment to project realisation. “As a long-term investor, any residual foreign currency risk which cannot be hedged may be mitigated by taking a long-term view to currency volatility,” said Russell. 

However, in extreme cases, the pricing of derivatives may impact on the viability of infrastructure projects, or even a whole infrastructure programme, Dornton-Duff argues. 

For liquid currencies like the US dollar, the euro and the Japanese yen, investors can go for natural hedges. But for less liquid markets, especially in the emerging regions, hedging with derivatives and currency swaps may sometimes be the only available option. If that is the case, cost becomes an immediate consideration.

“A question we often get asked is: ‘What says if the hedging is too expensive?’” recalls Dornton-Duff. He points out the first consideration is to assess a project’s tolerance to FX risk. Assuming the project has none or not very much, investors need to then ask what is the cheapest way to mitigate that risk. The cost of hedging is a direct input to the cost of financing, which in turn impacts on valuation. “It’s a major item in that calculation,” he stresses.

Dornton-Duff points to Colombia as an example of a market with a less liquid currency. “There is neither enough liquidity in the local debt market to fund the infrastructure programme the government wants to put in place, nor enough liquidity in the currency swaps market to create artificial local funding by derivatives. That’s where the market runs out of options.”

So what can be done in those cases? A discussion paper on Currency Risk in Project Finance, by Canada’s International Institute for Sustainable Development, argues that multilateral agencies and development banks have a role to play in this respect. 

Specifically, the paper calls for these institutions to help develop local capital markets and support local currency financing for infrastructure projects. It also calls for a paradigm shift in these agencies’ practices, but admits this may be challenging. Then again, there are no easy solutions when it comes to currency hedging.