Contingent Hedging Introduction

Contingent Hedging Introduction

Selim Toker

30 years: Derivatives & risk management

In this video, Selim Toker talks about the hedging of market risks in an event-driven transaction, such as a piece of cross-border M&A. He uses the foreign exchange risk in the acquisition consideration as an example, but there are many other risks that could be hedged with products we are going to look at.

In this video, Selim Toker talks about the hedging of market risks in an event-driven transaction, such as a piece of cross-border M&A. He uses the foreign exchange risk in the acquisition consideration as an example, but there are many other risks that could be hedged with products we are going to look at.

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Contingent Hedging Introduction

11 mins 45 secs

Key learning objectives:

  • Understand how market risks impact event-driven transactions and the need for hedging these risks

  • Comprehend the key factors governing the pricing of Deal Contingent Transactions

  • Identify the available hedging instruments and their are the pros and cons

Overview:

In event-driven transactions, such as an M&A, market risks can impact the transaction, due to the time taken between agreement and completion. This video examines the instruments that are available to hedge these risks and the pros and cons of each instrument. We will also delve more deeply into deal contingent hedging transactions and the factors that govern their pricing.

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Summary

What are event driven transactions? 

Transactions such as M&A, or project finance, that are agreed at a point in time, but only complete after some time when certain conditions are met. In corporate M&A, then conditions will be in a Conditions Precedent Clause inside the signed Share Purchase Agreement (SPA). 

What risks could arise and how big could this impact be?

In a cross-border M&A for instance, the purchase price is usually in a different currency than the buyer’s books and if a price is agreed at signing in the foreign currency, then any strengthening of that foreign currency versus the balance sheet currency of the buyer will result in a more expensive transaction in domestic currency terms. FX can move significantly over the 6-12 month period that it typically takes to close an M&A. In 2020 Euro appreciated 8% versus sterling, and of course emerging market currencies can move multiples of this

What instruments can be used to hedge this FX risk?

  • FX forward  - At signing, a simple FX forward exchange is agreed for a future date to lock in the balance sheet currency amount. This is a simple transaction, minimises costs however, it does have disadvantages if the M&A does not succeed. As we are left with a naked hedge position and the cost could be as large as the unhedged risk if the market moves against us.

  • FX option - At signing, buying an at-the-money FX option locks in the currency amount. If the foreign currency appreciates, the option value will cover the increased cost in local currency terms. If the foreign currency depreciates, you will benefit from the lower purchase price in local currency terms and the option will expire worthless and if the M&A does not complete, the option may still have some value. However, we will have to pay a premium for the option, regardless of the success or failure of the M&A.

  • Deal Contingent Contract - The party enters into a FX forward agreement where the forward rate is taken along with the addition of a premium, known as the DC Premium (overlay that links to the underlying deal completion). If the deal succeeds, the risk is hedged and if the M&A does not succeed, then the DC forward contract is torn up, so the DC aligns to the M&A perfectly. This also solves issues around the tenor length and completion timeline. 

Who are the drivers of DC Pricing 

  • The underlying market risk being hedged - More volatile currencies will command a higher premium
  •  SPA conditions for deal completion - Prescriptive clauses such as antitrust approvals and the legal framework in the relevant jurisdiction
  • One-off or Idiosyncratic clauses - Shareholder votes or 3rd party consents are more difficult to gauge and may cause the pricing to increase
  • Hell or high water clause - The standards by which the parties are beholden to complete the conditions
  • Maximum length of the M&A ( long-stop date) - The longer the M&A takes to close, the more time the FX has to move against you, higher will be the DC cost

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Selim Toker

Selim Toker

After a 30-year career in Investment Banking, Selim Toker transitioned to the FinTech space and is currently the Chief Strategy Officer of incard, a digital banking and financial services platform targeting e-commerce and digital entrepreneurs. Prior to that Selim spent 17 years at UBS and 12 years at Nomura, focussed on derivatives advisory, structuring and marketing.

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