Treasury Today Country Profiles in association with Citi

Mitigating FX volatility

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In the last four years global corporations have lived through some of the most volatile times in the $5.3 trillion a day foreign exchange market. The volatility started with the global financial crisis, swiftly followed by the sovereign debt crisis in the Eurozone and, in more recent months, volatility in safe-haven currencies such as the Japanese yen and the Swiss franc. Talk of turning off the liquidity taps by the US Federal Reserve Bank also highlighted some structural weaknesses in emerging market economies such as India, which saw the rupee record some of its biggest falls against the US dollar in more than two decades.

Volatility is not just confined to emerging markets currencies. The G10 currencies have had their fair share of ups and downs too. The US debt-ceiling crisis saw the dollar depreciate against sterling and the euro and go-to safe havens — yen and the Swiss franc — were undermined by local shifts in policy. The Swiss introduced a currency floor in September 2011 and “Abenomics” — named after Japanese Prime Minister Shinzo Abe — resulted in expansionary monetary policies, which caused the yen to depreciate.

In Q2 2013, 233 companies reported negative currency headwinds, say FX exposure management and analytics provider FiREapps, see Chart 1 below. This was less than the same period a year earlier but an increase of 9% on Q1 2013 and a 10% increase over the 2012 average. FiREapps attributed the increased headwinds in Q2 to currency wars in Latin America and Japan and “surprise” impacts from countries like Australia (FX volatility increased ahead of recent political elections), which continued to significantly erode corporates’ EPS.

Chart 1: Number of companies reporting negative currency impact
Chart 1: Number of companies reporting negative currency impact

Source: FiREapps Q2 2013 Corporate Earnings Currency Impact Report

FiREapps estimates that for the last two years multinationals have consistently lost money to currency exposures, with second quarter 2013 losses totalling $4.01 billion (an average currency impact to earnings per share of $.03, which is three times higher than the standard industry benchmark). Total currency-related losses for the first half of 2013 reached $7.7 billion, say FiREapps. Quarterly loss estimates are based on analysis of earnings calls of 800 publicly-traded companies — a subset of the Fortune 2000—that have 15% or more of their revenues in at least two currencies.

Different levels of awareness

Yet, as FiREapps points out, currency impacts reported by companies are likely to be underestimates as those that faced strong “headwinds” are unlikely to point them out, and few companies may have quantified the impact. “The other thing you have to look at is the maturity level of the financial disclosure,” says Andy Gage, Vice President, Strategic Market Development, FiREapps. “If you look at the US versus European disclosure, the Securities Exchange Commission puts pressure on corporates to be much more transparent on how FX impacts their corporate performance. Europe is just behind that but they don’t get as much heat as US corporates, and in Asia it is a bit murkier.”

However, Gage believes the devaluation of the Indian rupee last spring has had a profound effect on how financial professionals view currency risk. “There were some huge exposures to the rupee and CFO’s do not want to see this happen again,” he says. Others say Indian rupee volatility will make little difference when it comes to Asian treasurers’ awareness of currency risk in general. “I don’t think it will make currency risk a higher priority, as Asian treasurers are not fully aware of all strategies to hedge their receivables and payables,“says Rahul Magan, Corporate Treasury Manager at EXL Services, an outsourcing and transformation firm. “Treasurers understanding of FX exposure is very limited in Asia.”

Chart 2: Size of reported negative currency impact
Chart 2: Size of reported negative currency impact

Source: FiREapps Q2 2013 Corporate Earnings Currency Impact Report

Asian treasurers’ limited understanding of FX volatility and risk can be attributed to a number of factors. FX is only one aspect of treasury operations, and for Asian companies that are experiencing rapid growth or who are largely domestic focused, FX risk may not be as high a priority as it is for Western companies who have already experienced major international expansion and have a greater awareness of the risks that can bring. “In Asia, understanding of FX exposure is evolving,” says Gage. “It is such a rapidly growing environment in a lot of these markets. One of the challenges about FX and treasury in general is when a company experiences rapid growth they are so focused on staying out in front by supporting operations and distribution that risk management often takes a back seat. By contrast, a US or European corporate puts risk management higher up the priority list. They understand the business and volatility in these markets, and have a more mature view of currency risk.”

To hedge or not to hedge

While MNCs typically have a risk management policy that is fairly regimented, local companies in developing markets who transact business in a limited number of currencies have more leeway in general, says Gautam Hazarika, Head of MNC Markets Sales, APAC ex-Japan, Royal Bank of Scotland. “There’s an element of the local mindset seeping in,” he explains. “If you are a local Indian company and you have a US dollar exposure what you think is going to happen to the rupee impacts hedging decisions.”

Blaik Wilson, Director, Solutions Consulting, Asia Pacific for risk and treasury management solutions provider, Reval, says treasurers in mature markets tend to be more cautious and passive in their hedging strategies. “They hedge for longer periods,” he says. “In Asia they tend to hedge more short term and are more subjective in their approach. Asian treasurers typically run really good margins, and if you have excess cash you can ride the currency a lot more but as margins get squeezed you need to hedge more.”

Those treasurers with a less coherent and disciplined strategy for mitigating FX risk are more likely to find themselves in reactive mode when currency markets become more volatile. “Arguably, the biggest mistake prospective hedgers make is to wait until volatility increases,” says Ira Kawaller of Kawaller & Co. Brooklyn, New York, which advises companies on their use of derivatives for managing financial risks. “More often than not, it’s not the higher volatility that precipitates the consideration of hedging strategies, but rather it’s the coincidence of higher volatility with an adverse change in the exchange rate moves. The time to develop a hedging programme is before the perception of higher volatility is reflected in derivatives’ pricing.”

Hedging in a competitive market environment can be difficult, says Kawaller. “There is a real concern if you guess wrong on a hedge and your competitors don’t, you could put yourself at a disadvantage. You do not want to be far out on a limb, diverging too much from the rest of industry.” Instead of thinking would one have made or saved money after the fact had you not hedged, Hazarika of RBS says corporates should look at hedging as an insurance policy that can buy them some certainty. “Maximising certainty of cash flows and reducing costs are the key objectives for most corporates,” he says.

“More often than not, it’s not the higher volatility that precipitates the consideration of hedging strategies, but rather it’s the coincidence of higher volatility with an adverse change in the exchange rate moves.”

Ira Kawaller of Kawaller & Co., Brooklyn, New York

Wilson of Reval goes a step further, saying the treasurer needs to give management a clear understanding of the consequences of not hedging, even if they lose on a hedge. “Treasurers in emerging markets need to educate management, and as the business expands into new geographical areas stricter guidelines on hedging are needed.”

Rolling with the punches

Magan of EXL Services points to the example of the Indian economy, which as it becomes more globalised, is experiencing a greater inflow of payables and receivables in foreign currencies including the Australian dollar, New Zealand dollar, Canadian dollar and G7 currencies. Globalisation has also meant there are increasing foreign currency loans (mostly in US dollars) on Indian companies’ books, particularly in the steel sector, which are subject to interest rate and revaluation risks. Magan says hedging strategies linked to derivatives such as plain vanilla forwards, options and interest rate swaps are highly effective tools for mitigating the impact of currency and interest rate volatility on companies’ balance sheets.

Given the current volatility in currencies such as the rupee, Magan says treasurers should hedge their receivables and payables using a layered hedging strategy, which takes into account the nature of their business. “Layering hedging over a rolling six month period means you could start off hedging 95% of your exposures in the first month, then 30%, and so on ( ratios can change subject to the exporting model ),” he explains. “It is always a declining percentage. That gives you more flexibility.”

In a rolling hedging programme, Magan says the treasurer needs to understand the spot level, the implied volatility, historical volatility and where the currency is moving. “Treasurers need to change their mindset to one of managing FX as a vital function,” he says. “FX is the most volatile market in the world. The mindset should not be I have covered my exposure, and then leave it at that. If you are able to use your skill set in the best way then you will be able to pass on any gains from hedging to your clients in the form of a discount and, ultimately, win more business from clients.”

Kawaller says more disciplined companies have hedging horizons that they divide into smaller sub-periods, setting parameters to change how much they hedge in say, six month time spans. “You might hedge 80% of your exposure in the first six months, then 60%, 40%, 20%. You need to have trigger points that foster hedge adjustments. For instance, if you see a deterioration of 2% or 5% in the exchange rate, you can adjust your hedging strategy to take into account changing market conditions and new market information.”

The challenge for most treasurers is that with hedging there is no clear-cut right answer, says Kawaller. “Regardless of how much information you collate you are still in a probabilistic world. That is why you need a roadmap of how you are going to respond. All the time you are making business judgements, which should be based on disciplined considerations of objective criteria.”

Typically, FX managers from leading multinationals have management objectives of less than $.01 EPS impact from balance sheet currency exposures, says Gage of FiREapps. “The best way to achieve that is not to be concerned about specific currencies but instead look at your total portfolio of exposure and manage it in the most cost effective way.” Yet one of the biggest challenges many treasurers face is gaining a clear picture of what their underlying currency exposures are. “Most treasurers struggle to quantify their exposure or loss. If you haven’t got the systems and processes set up it is not that easy to produce exposure data,” says Wilson of Reval.

The challenge of collating FX exposure data is multiplied if your treasury operations are wholly reliant on manual processes. However, by extracting data from ERP and accounting systems cloud-based software solutions such as FiREapps’ FX exposure platform can give treasurers visibility of their balance sheet currency exposure at a more granular level, which helps them to make more well-informed hedging decisions.

Embedded risks

But FX exposure management is not a hedging-only story, nor is it confined just to the balance sheet. In some emerging market currencies hedging may not even be an option, or the costs may be too prohibitive to make it worthwhile. “Treasurers need to make a decision: am I going to get enough return on my investment in a derivative product to warrant the potential cost of hedging?” says Gage of FiREapps. “If hedging doesn’t make sense you can set up inter-company lending and move cash to reduce your net exposure.”

“Even if you have centralised treasury operations you still need to have an approach that is mindful of the fact that the people that manage these processes are not going to think as coherently as someone managing that risk,”

Andy Gage, Vice President, FiREapps

Hazarika of RBS says treasurers should also focus on uncovering unapparent costs such as suppliers paid in local currency where the contract is linked to an underlying commodity. “When you look at the fine print of a contract, you might pay 100 rupees per item, but if the price of oil goes up by more than 5%, you might have to pay 105 rupees. Such details must be highlighted in the forecasting process so treasury can manage the risk“. Another avenue of managing costs is to change the invoicing currency for suppliers to their local currency rather than, for example, US dollars, so suppliers don’t include a premium into their existing US dollars contracts for managing FX exposures they face today, says Hazarika.

These “hidden” FX risks, which aren’t always reflected in the balance sheet, are much more difficult for the treasurer to identify. While treasury operations may be centralised the underlying business processes that create these type of FX exposure are decentralised. “Even if you have centralised treasury operations you still need to have an approach that is mindful of the fact that the people that manage these processes are not going to think as coherently as someone managing that risk,” says Gage of FiREapps. Wilson of Reval says treasurers need to understand their pricing drivers, and even examine the contracts themselves for embedded currency risk.

For the most part treasurers today are still very much focused on balance sheet currency exposure, which is more obvious as it typically flows out onto the P&L under income and other expenses. More strategic treasurers, however, are starting to turn their attention towards cash flow currency exposure by trying to influence how sales contracts are written and collaborating more closely with their sales teams to make them more aware of how contract decisions translate in currency risk terms, but this is still very much unchartered territory.

At the end of the day managing the different nuances of FX exposure, whether it is on the cash side or on the balance sheet, is about the tools the treasurer has in their toolbox and how they decide to use them. That will then determine the effectiveness of their hedging programme, alongside any metrics and policies they put in place for defining how hedging decisions are made.