Currency risk exists in one form or another for most overseas traders. Hedging may reduce or remove that risk. When and how should treasurers approach it?
For businesses trading overseas, tackling currency volatility is par for the course. In recent times the Mexican peso crisis, the Asian currency crisis, the 1998 Russian financial crisis, the Argentine peso crisis, and the 2008 global financial crisis have all contributed to that volatility – and it’s not about to go away any time soon.
Currency risk types
If a financial transaction is denominated in a currency other than that of the base currency of the company there will be currency risk. That risk may exist in a number of forms. Transaction exposure exists around specific receivables and payables denominated in a foreign currency. Economic (or operating) exposure is more general and can, for example, affect demand or cost of goods or the movement in value of future cash flows from fixed assets which can subsequently affect the market value of a business. Translation exposure arises where changes in the exchange rate between the currencies in which a company reports (its consolidated accounts) and those in which the company’s assets and liabilities are denominated (usually its overseas operations), impact on a company’s balance sheet. Contingent exposure arises where a firm is waiting for acceptance or rejection of an overseas contract bid, leaving it uncertain as to whether it has a currency exposure or not.
Measuring currency risk
The level of currency risk a business may be exposed to can be measured using either the variance or standard deviation methods. Variance simply requires noting the points of fluctuation within a spot rate and the spread of those points; it is something a treasurer can do in a spreadsheet. Standard deviation is more involved and requires the observation of how far on average an exchange rate will deviate from the mean exchange rate over a given period when plotted on a ‘probability distribution’ (eg the minimum and maximum statistically possible values).
Analysing the possibility of an event happening at the extremes of possibility (tail risk) – and the potential losses that may be incurred – can be done by corporate or bank-based risk managers using Value at Risk (VaR) modelling. Measuring VaR typically deploys either historical, parametric (variance and covariance) or Monte Carlo simulation techniques (the latter being based on a computer algorithm for calculating the range of outcomes and the probabilities they will occur within a stated scenario). Since the 2008 global financial crisis VaR has taken some flak for being less reliable when identifying very rare but large and extreme swings in the market (so-called ‘tail risk’).
To hedge or not
In a world of uncertainty, hedging is most commonly seen as a means of using the underlying asset of one financial product (a derivative) to offset potential losses of another. It is not the only option open: in their 2011 publication, ‘International Financial Management’, Professors Cheol Eun and Bruce Resnick said that mitigation of transaction exposure can be effected either through money markets, foreign exchange derivatives (such as forward contracts, futures contracts, options and swaps), or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting.
Economic exposures tend to be handled through operational considerations (such as where to site production facilities). And because translation exposure is an accounting and reporting issue, although hedging with FX derivatives is possible, the generally accepted accounting principles (GAAP) of each jurisdiction (or International Financial Reporting Standards) will dictate how FX-based gains or losses in the parent company’s consolidated financial statements can be accounted for (mainly to avoid misleading stakeholders).
Gambling away the profits
The increasing dependence by more and more businesses upon international trade has pushed the management of currency exposures to the fore, but for too many it is a risk left unmanaged. “Many businesses are engaging in currency risk management and have some form of policy in place, but there is also a shocking number that don’t,” notes Guido Schulz, Global Head of Strategic Management, AFEX. “These businesses are just playing it by ear; in some cases they get lucky and in some cases they are gambling away their revenue.” The reason for this incautious approach, he believes, is in part due to an ‘old-school’ mind-set, relying a little too much on intuition, but he feels that without the guidance of formal policy, some have adopted a “casino mentality”, watching the markets obsessively and thinking they can beat them.
Some may even see FX hedging as a potential for “lost opportunity”. With this viewpoint, a treasurer may lock in a set of staggered forward contracts for the year but if that currency suddenly strengthens they regret the decision, fretting over how much better they could have done.
Most treasurers tend to be conservative and enjoy security but Schulz says sometimes there is the temptation to reach for “higher hanging fruit that is even sweeter”. This can drive that casino mentality which, as many pro traders will acknowledge, could have dire consequences when the market turns against them (cf, Kerviel, Leeson et al). “There is a draw created by the dynamism of the markets but you have to suppress the urge to play it by putting a policy in place,” he says. “We advise clients to make foreign exchange a non-event for themselves.” He admits that it takes discipline, “but once that risk management strategy is in place you have to stop worrying about the market.”
Despite the obvious excitement pro-trading may create, the way in which a business tackles currency risk is not a decision to be taken by the treasurer, says Philippe Gelis, CEO of peer-to-peer trading platform provider, Kantox. “In my view, in any company, the decision regarding what is hedged and how should be based on a policy agreement made between the members of the senior management team; the treasurer will be the one to implement policy but top management should be involved in what they do and how they do it, from day one.”
According to UK-based Interim Treasurer, Jo Dealey, “many organisations don’t have a hedging policy in place, arguing that they have been alright until now. But how much is it okay to lose? The treasury and management teams need to be protected and the Board needs to know what they are letting themselves in for because getting it wrong can make or break a company.” It is, she adds, the responsibility of the treasurer, along with the FD or CFO, to have a clear understanding of the company’s currency exposures, what the implications are in the context of the balance sheet, banking covenants, share price and so on – and what measures can be taken to defend against volatility.
A hedging policy should firstly note all exposures and the risk this may present (possibly using one of the measurement tools such as VaR or the less demanding variance model). It should then lay down the agreed rules for what is being hedged, why this is being done, by whom, what actions are acceptable, under what conditions and how often all this should be reviewed. An additional operational element, prescribing specific actions to be taken and instruments to use, must have a certain degree of flexibility, Dealey advises. This enables the company to respond quickly to market changes and challenges. Where large, long-term hedges are deployed, she also advises companies to review them regularly, assessing if they still meet the needs of the exposure.
Regardless of content, there has to be hedging policy buy-in from all stakeholders, she continues. “If an organisation enters into a contract without really understanding what the implications are, it can cause heavy losses or even bankrupt a company. If it goes badly wrong, heads will roll.”
All risk management contains a strong element of forecasting and for currency risk Gelis strongly advises businesses to base significant hedging decisions on a quantitative model that assumes a worst-case scenario for exchange-rate activity. Indeed, Dealey believes it is vital for anyone looking into hedging to be able to carry out their own ‘what if’ modelling, particularly on larger contracts that are likely to require something more complex than a simple forward. Analysis, she says, does not have to be based on complex algorithms and although there are proprietary systems to assist, spreadsheets are a perfectly functional tool in many cases. It is also reasonable for a treasurer to ask a relationship bank to help do some of the modelling.
Proof of product
When it comes to product selection Dealey urges a degree of caution. “Banks will try to sell you a solution that might initially seem very attractive, but closer inspection might reveal it to be one that could potentially lock the company into something unfavourable.” For this reason, she says treasurers need to be absolutely sure of what they are looking at. Of course, a good relationship bank should not be encouraging clients to take unsuitable products, but it is always advisable to talk to a few banks to compare and contrast offerings, at the very least to get a feel for pricing.
However, even this comes with a caveat. “If it’s a very large trade, you don’t want every bank to know about it; once the market gets wind of a large deal they will all be on to you at once,” warns Dealey. “I suggest consulting two or three at the most.” Furthermore, if the small selection of banks believe they have each given their client good advice they will all be expecting the trade. This may create an awkward balancing act for the treasurer in terms of share of wallet. “The most important thing is to make sure you have the best cover, whilst also being fair to your relationship banks” says Dealey. This may mean carving up the deal so the banks each have an opportunity to participate and the company gets the best price on each deal.
For a company with a regular hedging programme – an ongoing trade where an estimated cash flow is hedged, for example – if the treasurer has the luxury of not having to lock in to a single point in time, it may be possible to spread that hedge by a certain percentage per month, so it is not taking on market price risk at the locked in date. The actual percentage of a proportional hedge will depend on the exposure, the company’s appetite for risk and the certainty of the cash flow behind it, Dealey notes. It is also possible to mix and match the hedging instruments used for a certain exposure; it does not have to be the same product covering the downside, as long as it is covered according to policy and preferably doesn’t expire or lock-in at the wrong phase of the market (arguably difficult to predict).
Keep it simple
Whilst the currency markets are used by many traders to create significant wealth, it is not the role of treasurer, as discussed above, to tackle the complexities that inevitably arise when seeking fortune. “There is a possibility that a company can get itself tied up in the hedging itself without fully understanding what is going on behind it,” warns Brenda Kelly, Chief Market Strategist, IG. “For a company not au fait with the currency markets, or if it is in any way uncertain about it, a simple forward contract would be the better way to start because it takes the surprise out of the hedging scenario.” Forwards are an easy instrument to understand and easy to handle from an accounting perspective. This view is shared by Gelis. “Keep it simple and try to use only products you fully understand,” he comments. Echoing Dealey’s comment above he adds that “some complex products look attractive but may hide risk; we know that banks are very good at marketing and will often try to sell products that are more profitable for them”.
However, in some cases it may be possible, notes Kelly, to use “natural hedges”. A company side-steps the potentially expensive and time-consuming derivatives market by using revenue it obtains in a particular foreign currency to offset expenses it incurs in that currency; this would be standard practice in most jurisdictions where currency controls are in place and cash is effectively ‘trapped’.
Where there is clearly a higher degree of uncertainty about the current price of the currency, the length of time until settlement and the volatility of the market, Kelly believes it might be better to consider trading an ‘option’, which offers the choice but not the obligation to buy or sell at a particular point in time. A euro-sterling cross, for example, would clearly not attract the same level of volatility as an emerging market currency cross, she notes, so here it might be better to use a simple forward contract, only adopting an option strategy when it comes to emerging market trade.
Hedging an emerging market currency cross will always be a lot more expensive but in all cases Kelly advises the need to assess the value of the hedge. “The idea of hedging FX risk is to ward off any volatility in the market and to provide a clearer view of any costs that may be incurred in regards to an investment or trade,” she explains. “But sometimes it is not worthwhile hedging either where the level of underlying volatility does not warrant it, or where the costs can be so much more in terms of using a derivative compared with the cost associated with any volatility in the FX market.” There is no predefined use-case, she notes “so it is worth crunching the numbers to ascertain whether the hedge itself is undoing the profitability of what you are trying to hedge”.
Accounting for hedges
Hedging can create accounting complexities which must also be understood. Where a supplier is selling in a currency that its buyer’s treasury is not comfortable with (and therefore feels the need to hedge that cost), if the supplier subsequently changes to a more amenable currency, the contract is effectively denominated in a foreign currency (known as a host contract) which creates an underlying exposure for the supplier. In such a case, Dealey says it is “absolutely essential” for the treasurer to know how the supplier intends to price in the new currency.
If the price is fixed, will the supplier be able to afford to sell at the new currency rate or would it damage the supply chain if the exchange rate moves too far in the wrong direction? Alternatively, if the supplier’s price changes according to a pre-defined trigger in the currency market place, somewhere in the contract there must be an embedded foreign currency derivative which will also be triggered. Under International Financial Reporting Standards (IFRS), this has to be separated from the host contract and be accounted for separately. The rules of hedge accounting are complex (see Treasury Today, Back to Basics, March 2014)
No excitement needed
As long as a company has a good idea of what its currency exposures are, Schulz argues that it makes sense to hedge. “Even if the market seems benign it just needs something extraordinary to happen to upset the market. Hedging is really a matter of insuring against the unforeseen rather than trying to figure out what that event might look like.” Clearly playing the markets or fretting over missed opportunities helps no one. But sometimes, as both Dealey and Kelly note, hedging can cost more than it saves. Either way, the need for treasurers to work to an agreed company policy is essential, and making their predictable currency exposures “non-events” should be at the heart of every currency risk management decision.