Structured hedging products have taken a prominent place among SMEs and sometimes even larger corporates. At first sight they might look like a simple and easy to use FX derivatives coupled with nice features that help reduce margin requirements or upfront payments. However, more often than not, they also include costs and additional, undesirable risk exposures.
The use of structured hedging products have grown significantly, and are available in both developed and emerging markets.
Most often, such structured hedging products (often not explicitly named like this) are sold promising businesses a ‘premium-free’ solution that will protect businesses from currency or other risks. But as with many “free” things – these products are likely to contain hidden fees and charges and should be analyzed more closely.
Structured hedging products – what are they really?
Typically, structured hedging products combine at least two types of derivatives. The key benefit of such solutions is that instead of directly entering/trading multiple derivatives, a client can enter an already wrapped product designed for a specific maturity. Types of products and solutions vary by region and many of them change as financial market conditions evolve and change for a given market.
Where’s the catch?
Often businesses choose to hedge currency risk by buying a structured hedging product from a specialized broker or investment bank with a FX pair as an underlying asset class. Quite othen these structured derivatives are nothing else but a combination of multiple derivatives, each of them could be bought or sold in the markets directly. In such instances, the main service of a broker or a bank is convenience – the hedging product combines multiple derivatives into a single package with a zero cost to the buyer – often called premium-free product.
Financial derivatives trade at what is commonly known as bid and offer prices – prices at which broker/dealer offers to sell (client goes long) or buy (client sells short) a derivative. As with any market – the higher bid/offer price range (spread), the larger potential profit for the broker. Typically, brokers and banks design structured hedging products as a combination of multiple instruments and use short positions to make hedging products more affordable than normally. This also means that they are the sellers/buyers of these products at prices favourable to them. The end result is, that once the product is decomposed into its constituents, clients can end up paying rather high “convenience” price for packaging up these derivatives into a product.If you wouldn’t know how to decompose the structured product the broker has proposed, you wouldn’t know about the hidden fees you are actually paying. Also you should pay extra attention when analyzing the worst scenario outcomes as built in short options positions to make the products look cheaper can actually increase risk exposure in the most unfavourable scenarios for the company!
Thus, a structured hedging product might be ‘premium-free’ but certainly not. Furthermore, the ways that the product is designed to be ‘premium-free’ can often expose business to additional risks that it certainly is not looking for.
Does this mean such products should be given up entirely?
At DeRISK we are often asked to review such hedging products and we find that there always is an alternative, more transparent solution that ensures better liquidity and mitigates risk. However, simple operational efficiencies combined with favourable market dynamics sometimes are enough that it would be worth considering these products. However, it really depends on the sophistication and operational capacity of the client as well as the client’s business model for which such a product is applied.
Conclusion
Overall, vigilance is key when it comes to accepting offers that might sound too good to be true. If you are offered a product and you are not sure how a broker or a bank is constructing it themselves and how you can price it – it is wise to seek advice before trading such a product. At DeRISK, we can dissect what combination of financial instruments are being offered and sold as a structured product, analyze and project any potential scenarios and vet any potential hidden costs.
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