Treasury teams need to take a more holistic approach to managing FX risk.
In Asia Pacific, currency volatility is par for the course. And broadly speaking, when FX volatility is high, the immediate reaction from corporates is to hedge any visible exposure by buying forwards, non-deliverable forwards or options.
However, with so many currencies in Asia, the task can quickly become daunting, or the cost prohibitive. Phillipe Jaccard, Head of Liquidity Management at ANZ notes that corporates need to take a more comprehensive approach.
Preventing the sickness
Hedging is essentially buying financial products at a premium. Hedging too little can carry a heavy price (aside from the premium), but hedging too much can also cause losses.
“It’s like a heavy drinker and a chain smoker, with a bad diet, deciding to take on expensive health insurance upon realising their lifestyle is unhealthy,” says Jaccard. “That insurance may secure the best room in the hospital but it won’t prevent the sickness.”
Instead, Jaccard notes that mitigating FX volatility should be a process managed internally using an adequate currency exposure management framework. “It is best to start with the profit and loss (P&L) and splitting in- and out- cash flows by currencies to derive a net position within the company’s normal annual business cycle, which could be seasonal in the fashion and sports industries, for example,” he says.
The business cycle is defined by the time it takes to absorb currency volatility up and down the supply chain. For example, luxury watches may not have to pass on any negative movement, whereas commodity goods traders may have to pass on the change immediately.
Once a net P&L position for the appropriate time horizon is derived, a similar process needs to determine the structural exposure in the balance sheet – splitting assets and liabilities by currencies to derive a net equity position.
“If all assets and liabilities are valued in the same currency, there may be very little FX exposure left other than the P&L,” says Jaccard. “However, a company using heavy capital goods with an international replacement value may need to hedge the FX mismatch if the debt is in the domestic currency.”
Once the P&L and balance sheet exposures are well understood, Jaccard says corporates should consider redenominating supply chain contracts to minimise any currency mismatch, and also, to do the same for assets and liabilities.
“Perhaps a US dollar loan could reduce the exposure if the company’s assets are mostly denominated in US dollars,” he says. “This is a time where a gutsy treasurer could increase the mismatch to capitalise on a weakness but they better get the CEO aligned!”
Lastly, the treasurer needs to ensure the shareholders’ expectations are aligned. Treasury should know the answers to questions like do they expect a dividend in the next 12 months? How do they value FX exposure? Do they already hedge the risk? Do they consolidate the full balance sheet or just collect the dividend?
“This is usually established in a Treasury Board policy and approved at a shareholders’ meeting,” says Jaccard. “It defines how much risk is acceptable, how the dividend will be paid, and in what currency.”
With these questions answered, treasury can start considering buying FX insurance products. When doing so there are a few considerations that need to be made.
“The buying process can be centralised in a treasury centre, aggregating notional positions across the company,” says Jaccard. “That would leverage the expertise of professionals, and secure access to the best prices in financial centres such as Singapore or Hong Kong.
This might come at a price though if the underlying cash flows no longer match the hedging gains and losses booked in different jurisdictions. “This could cause unpleasant tax surprises: gains on a hedge may be treated as profit in one jurisdiction without the countervailing loss being netted out because it’s booked in another country, for example,” concludes Jaccard.