Treasury Today Country Profiles in association with Citi

Managing the unknown

Man standing in a dark cave

In 2015, currency volatility couldn’t be kept out of the headlines. Today, a big question for many corporates is when, and where, the next shock will come from and, perhaps more importantly, am I prepared? In this article, experts from the world of banking, consultancy and corporate treasury share their views on how to best manage currency risk in a volatile world.

It has been a year in which the management of currency volatility has been firmly in the forefront of treasurers’ minds as a number of events caused sharp movements and shocks to global currency markets. These ranged from the Swiss central bank’s sudden unpegging of the Swiss franc from the euro; one of the most dramatic central bank announcements of recent times, and an event that created a selling tsunami in the market that brought a number of FX brokers to their knees. Other notable instances include China’s shock devaluation of the RMB in August, an event which served to exacerbate the already volatile currencies of many emerging economies such as Brazil, Malaysia, Turkey, Russia and Indonesia. Today, the threat of a currency war is real and its potential implications for corporates and their earnings could be profound.

We are already seeing this in the financial statements of many companies. Data compiled by the Frontier Strategy Group, for instance, highlights that $51bn was lost by the 211 European and North American companies surveyed due to negative currency impacts in the first half of 2015. Whilst these losses are the direct impact of currency volatility there are other impacts that, arguably, remain hidden including the potential risk of a ratings downgrade and the increased cost of access to capital.

Many predict that this volatility is here to stay, at least for the time being. The reason being that the two main causes of volatility, the divide in policy between the US Federal Reserve and the world’s other major central banks and the continued weakness of commodity prices that is creating a general malaise in the global economy, look set to continue. And whilst this trend is a ‘known’ (to borrow on old expression used by a former US Defence Secretary) that corporates can look to manage, it is the ‘known unknown’, namely that corporates cannot easily predict what direction currencies will move and when, that makes hedging such a challenging activity to get right.

Understanding the risk

Whilst currency risk is an ever present challenge, the recent bouts of volatility, and the losses suffered as a result have certainly caused treasurers to become more attentive to its management in the past year. The difficultly, however, is that currency risk is a complex subject that cannot be approached with a broad brush. The first step that treasurers should take, therefore, is to make an attempt to understand the different types of currency risk and from where these exposures arise. A research note published earlier this year by PwC succinctly highlight the three key exposures:

  • Economic exposures.

    These arise from selecting markets and choosing office and factory locations plus the currency profile of your competitors.

  • Transaction exposures.

    These arise from generating revenues and incurring costs in various currencies.

  • Translation exposures.

    These arise from the revaluation of foreign currency balances (cash, receivables and payables) in accordance with accounting rules.

With this knowledge in tow the next step is understanding how these various exposures manifest themselves. Unfortunately, as with most aspects of managing currency risk, this is rarely, if ever, a straightforward task. As Yann Umbricht, Partner and Treasury UK Leader at PwC explains: “You only begin to see that risk management processes are not working effectively when there is a crisis and unexpected FX gains or losses begin to appear in the profit and loss account. The challenge then is understanding why and where your risk management process has failed.” According to Umbricht the reasons for this are typically multi-faceted and are not often obvious.

Whilst currency risk is an ever present challenge, the recent bouts of volatility, and the losses suffered as a result have certainly caused treasurers to become more attentive to its management in the past year.

Managing currency risk is complex because the end-to-end process flows far beyond the office of treasury. “The exposure begins from the strategic decision to buy or sell in a particular market,” explains Umbricht. “It then flows all the way through to accounting where the impacts of these decisions are seen. Treasury sits somewhere in the middle of this.” It is Umbricht’s view that the only way to effectively manage the risk is for all these departments to work together to clarify what the organisation is trying to achieve and then build a robust and agile risk management framework that defines who will do what and when.

Bringing it home

A corporate’s FX management policy should, if completed correctly, outline what exposures to manage – be they economic, transaction or translation related – and how. And there is no single right answer – it really depends on each individual corporate’s exposures and how these impact cash flows. Following analysis, some corporates may wish to hedge every exposure, some may wish to hedge part, while others none. According to Mike Robertson, Global Head of Transactional FX at Bank of America Merrill Lynch (BofAML), whether a treasurer chooses to hedge an exposure in part or fully, is still doing something. “The question corporates should therefore ask themselves is what is the best approach to manage their exposures and why. This analysis should lead to a risk management framework to work within.”

Chart 1: Total currency volatility
Chart 1: Total currency volatility

Source: Frontier Strategy Group

With this framework in place the final piece of the complex jigsaw is ensuring that the decisions are being made from accurate forecasts built with accurate data. Of course, the issue of accurate cash flow forecasting opens another Pandora’s Box of challenges for corporates, but without this it would be almost impossible to effectively hedge currency risk. This again places the onus outside of the treasury office and onto other departments. Treasurers, therefore have a vital role to play in ensuring that these departments understand what they need and how to ensure the data they are inputting is robust.

Building a robust framework and ensuring that the data it has is correct is something that the Honeywell treasury has strived to achieve over recent years. Over half of Honeywell’s sales are outside its home market, the US, meaning that changes in FX can have a meaningful impact on the company’s reported financial results. “We therefore place a lot of focus on managing FX and have built a solid framework, using both people and systems, to gather and analyse information around FX and our exposures.” To do this, Jim Colby, Assistant Treasurer at Honeywell and his treasury team have worked closely with other Honeywell business units and senior management to ensure exposures are reported correctly. “Systems are important and are the means by which we input the data, aggregate our exposures and understand the impact they have on our company. But it is perhaps even more vital to educate people within the business to understand the various risks.”

To hedge or not to hedge?

With this information at hand, the company will then need to decide whether to hedge or not. Naturally corporates should not hedge just for the sake of it and, whilst losses during extremely volatile times may be painful in the short term, the treasurer should not panic as currency movements over the long term are often offset by price changes, thus reducing the real risk.

Once the decision what to hedge has been taken, the next call to be made concerns what particular product is to be used. Again there are many factors that play into this decision including: what is being hedged, why, and for how long. Other factors, including senior management’s understanding of hedging products, may also influence this decision.

Despite the recent bout of volatility the products that corporates use to hedge have not changed a great deal. The four most commonly used FX derivatives remain futures, options, forwards and swaps. Yet, in recent months there has been debate within the profession around the usage of these products for hedging particular transactions. Take for example FX forwards, the most commonly used corporate hedging instrument. Whilst the efficacy of these instruments for the purpose of hedging the major currencies remains unquestioned, some corporates have closely examined the effectiveness of forwards in the hedging of EM currencies. This is primarily due to the fact that, quite often, the risk premium on these products is very expensive. Corporates may therefore wish to consider various options contracts instead which are known to have a lower premium than forwards.

Indeed, this is something that the Honeywell treasury team and Colby have recently been investigating. “Currently we work exclusively with forward contacts because these deliver the greatest amount of certainty which, we want in our results,” says Colby. “Yet, in recent months we have been exploring the use of options to hedge certain currencies.” For Colby the benefit of using options is that treasury can ensure some degree of certainty whilst also preserving the upside on its underlying exposures. “Some currencies have been on a continuous downward trend, as have been many EM currencies, this therefore could be a logical step to take.”

Of course, vanilla instruments can be layered with complexity to create exotic derivatives, but it is largely recommended that corporates keep their hedging strategies simple. “This is down to the levels of understanding that senior management has,” explains PwC’s Umbricht. “If you go to the board with a complex instrument, even if it is the perfect hedge, if the board can’t understand it they will probably not agree to its use. Choosing a simple hedge can also significantly reduce the complexity associated with hedge accounting.” Also, if the hedge goes wrong then there can be significant repercussions on the business and it is unlikely that a treasurer would want their name attached to that.

However, a hedging instrument can only go so far. “Natural hedging is always preferred because financial hedging has a finite life, each hedge has a maturity date and after this you are exposed again,” says Colby. “That is why I think finding ways to develop natural offsets to your currency exposures is a more permanent solution to mitigate currency risk.” Yet, with many things related to driving change to implement natural offsets is not a treasury issue alone. “Natural hedges are ultimately a business decision,” says Colby. “Treasury can find these and help the business understand them but there needs to be coordination and cooperation across the business to push these through and make lasting change.”

Overcoming the regulatory pressures

As if treasurers do not already have enough to contend with, given the recent volatility, hedging strategies are also being impacted by regulatory pressures. For Honeywell’s Colby, this has manifested itself in two ways: “It is tough to meet the reporting requirements that have come from European Market Infrastructure Regulation (EMIR) and Dodd-Frank. For instance, we need to report all our European inter-affiliate activities with the European authorities within 24 hours of trading.” To be able to comply, Honeywell has had to invest significant amounts into sophisticated technology.

Aside from this, Colby also sees the Basel III regulations having an impact on the pricing of derivatives. “The increased bank capital and leverage requirements have made certain products more expensive,” he says. “Especially longer dated derivatives. As a reaction to this it wouldn’t surprise me to see corporates roll shorter-dated hedges in order to reduce the cost.” There is still value to be found in the market, however, because of variations in the way that Basel III has been implemented across the globe. “We use FXall as our multi-dealer FX platform and this enables us to send our deal request out to a wide market and obtain the best deal.”

Banks it seem are also recognising the issue and are innovating in order help their clients. Bank of America Merrill Lynch for example has recently launched a product, CashPro® Flow, which guarantees the rate for a set time period, yet this isn’t classified as a derivative and can only be used for transactional volumes. “The treasury risk in the trade and payment space is largely predicable and thematic,” says Suzanne Janse van Rensburg, EMEA Head of Liquidity for GTS at Bank of America Merrill Lynch. “This product therefore allows corporates to reduce the FX background noise and focus on the real FX exposures.” It is Janse van Rensburg’s belief that this is a space where banks will continue to innovate in order to ensure that corporates have the tools and services they need to support them in an uncertain world.

With experts saying that currency volatility is not likely to be going away anytime soon, and regulation adding further pressure on the resources of both corporates and banks, innovation may be key to ensuring that corporates can continue to navigate this landscape effectively. But, as Honeywell has proved, when it comes to hedging FX, corporates would be well-advised to keep it simple and do the basics correctly – report, understand and act. This is the key to protecting corporate cash flow – however volatile the markets become.

Naturally exposed

Rather than paying to use hedging instruments, many corporates will analyse their cash flows and try to spot natural hedges within their business. Yet, Jan Vermeer, Director at Belgium based consultancy firm Treasury Services, believes that, when analysed closely, what is perceived to be a natural hedge is often not effective.

“The mistake that corporates make is that they attempt to apply cash management techniques to risk management,” says Vermeer. “For example, if $100 comes into the business and $100 leaves then this is net $0 and it would seem the exposure is naturally hedged.” But Vermeer highlights that while this is true, a corporate is also assuming that the risk sensitivities of the two cash flows are equal, which is very often not the case.

Vermeer believes that the reason for this is because transactional FX exposures exist in two categories: committed exposures such as outstanding invoices and receipts and anticipated exposures predicted in forecasting. “These two exposures have different sensitivities,” explains Vermeer. “Committed exposures for instance are not sensitive to changes in prices due to exchange rate movements. Yet, many corporates I speak to who naturally hedge assume that the sensitivities are equal. And with more corporates moving to natural hedges because of the increasing cost of derivatives, in many cases they are actually neglecting their risks and this can result in increased volatility in earnings.”

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