SVB Makes the Argument for FX Hedging

A new post by Silicon Valley Bank, part of First Citizens, argues that firms that are “FX agnostic”, and therefore inactive on currency risk management, are talking on financial risk they do not expect to be compensated for, and makes the argument that “currency-agnostic is not the same as currency-neutral, or even currency hedged”.

The post, authored by Ivan Asencio, head of FX risk advisory at SVB, asks that if being fully unhedged is undesirable as it exposes the corporation to risk without expected reward, then is being fully hedged, a currency-neutral position, the answer? Its answer – sometimes it is, but not always.

SVB observes that one of the leading reasons why institutions do not hedge is anxiety about the opportunity cost. Fully hedging an incoming cash flow with a forward contract delivers certainty and peace of mind but forfeits FX gains should the market subsequently shift in the company’s direction between the time the contract is signed until the cash is received. It adds that by construction, forwards oblige execution at the ex-ante agreed-upon rate, regardless of whether it is more or less advantageous at contract expiry.
“We believe a 50% forward hedge is a more appropriate launch-off point, versus an unhedged position, as it strikes an attractive balance between certainty and flexibility for potential upside,” the post states. “Also, a 50% hedge ratio aligns with the expected probability distribution for FX moves. Following 50-plus years of observing currencies, since the collapse of Bretton Woods shifted FX towards a floating system, we have learned that currency movements resemble a random walk. In other words, the best predictor of tomorrow’s FX rate is today’s FX rate.”

To support this “stylistic fact that is supported by empirical evidence”, the post highlights that dating back to 1976, the DXY Index has gone up 49.84% of days and gone down 50.16%.

The post stresses that while a 50% hedge ratio can serve as a baseline, it is not a “rigid rule”. Notably, forecast visibility, risk tolerance, a view on a currency and business needs can impact it, and see the ratio adjusted.

The post argues that corporate decision-makers tend to be agnostic on currencies. It adds, however, that “as currency direction is fundamentally uncertain, a 50% hedge ratio represents a disciplined middle ground and more appropriate starting point. It reduces FX risk, while avoiding the implicit speculation embedded in remaining fully unhedged.

“The 50% baseline creates a transparent rule that is intuitive and easy to grasp by internal stakeholders, the board of directors, and external investors, the post concludes.