Risk Management

More currency chaos ahead

Published: Jan 2023

Regular reviews of FX risk management strategy will be a vital factor in successfully navigating currency market uncertainty.

Winter, snowy landscape with beautiful orange sunrise

Kyriba’s currency impact report for Q222 underlined the FX risk management challenge facing corporates, noting that the collective quantified negative impact reported by North American and European companies totalled US$37.3bn between April and June – a 126% increase from the previous quarter. This challenge is likely to become even greater next year according to a recent research note from ING, in which the bank’s global head of markets suggested that FX trends will become less clear in 2023 and that volatility will continue to rise.

In terms of specific currencies, it has been pretty much all about the mighty dollar this year as it reached its highest level against the pound since the mid-1980s and neared parity with the euro for the first time in 20 years. What is particularly interesting from an FX perspective is the differing stories of inflation from each side of the Atlantic, and specifically that in the US it may have peaked since the country is largely shielded from Ukraine-related gas price spikes suggests Vedanta Hedging CEO, Abhishek Sachdev.

“This is what is driving volatility in GBP/USD,” he explains. “We have seen a sharp increase in the cost of hedging GBP/USD beyond the 12 month point.”

One of the most concerning observations comes from Michael Quinn, Group Trading Manager at Monex Europe, who refers to an underlying expectation that currency markets are being distorted by temporary factors such as the conflict in Ukraine and the hangover from supply side pandemic shocks.

“However, this expectation that markets will normalise was also there in the aftermath of the global financial crisis, but never actually materialised,” he says.

So how should companies go about mitigating FX risks? Amol Dhargalkar, Managing Partner and Chairman of Chatham Financial says the first step is to get a clear understanding of exposures and underlying risks, ideally through a value-at-risk type of analysis which will help companies determine where to focus their mitigation strategies.

“Companies also need clear and early communication, especially during budget season, around new markets they may be entering into,” he adds. “Those with existing hedging programmes may be entering 2023 with some rates already hedged at a better rate than the current market environment, which will buy them time, but eventually they will be exposed to the new rate environment.”

He recommends that companies who currently hedge continue to do so on the basis that if you stop hedging it can be very difficult to determine the appropriate time to re-enter the market and that there is no guarantee rates will ever return to previous levels.

“Companies may choose to be a little more opportunistic in the execution of hedges to try and ‘buy the dip’, but even this can lead to dangerous chasing of prices that may never materialise,” says Dhargalkar.

Sachdev recommends hedging more frequently for shorter durations and avoiding complex (for example, leveraged) option structures unless absolutely necessary. “It is more important than ever to keep hedging costs as low as possible, since these can quickly add up if a company is hedging a few times a year instead of buying all of their cover for one year at a time,” he says.

Whether they hedge or not, corporates would be well advised to address issues such as a lack of reliable FX-related data and forecasts, manual and error prone processes, and poor or non-existent FX results analytics for both cash flow and balance sheet FX risks.

“Companies first need to get visibility into accurate FX data, which means understanding the transactional currency details of both the income statement and the balance sheet,” says Scott Bilter, Principal of Atlas FX. “Where the transactional currency differs from the functional currency of any entity where this activity takes place, there will be an FX risk that needs to be monitored or hedged.”

During calmer times pre-pandemic some corporates moved towards more exotic hedging products observes Eric Huttman, CEO of Milltech FX.

“In recent months we have noticed many reverting back towards the more straightforward linear products such as forwards, which are more liquid and easier for corporates to unwind should the market move against them,” he says. “In our experience, corporates are also hedging a high amount of their exposure and instead of locking in rates for twelve months or more for FX forwards they are shortening the length of their hedging contracts.”

The average tenor of the hedges put in place by the 251 CFOs, treasurers and senior finance decision-makers in mid-sized corporates surveyed on behalf of Milltech FX between June and July 2022 was five months, indicating that they are balancing concerns around profit erosion with the need to be nimble in the face of fragile supply chains, weakening consumer demand, and rising inflation.

In the context of the last year or more the dollar is still quite strong across the board. However, we have come off the highs quite a bit in the last two months so protection is worth considering reckons Thomas Anderson, Managing Director for Moneycorp Americas.

“The market is telling us that there will be a lot of volatility through the first quarter of next year, so preparing ahead of time is prudent,” he says.

Agreeing on a budgeted exchange rate for the year will help when placing trades observes Joe Jones, Head of Sales at Cornerstone FS. “This should be done in consultation with an FX specialist and take into account volume and timing of expected requirements, current rate(s), and an educated assumption on future rates,” he adds.

Attempting to call the absolute top of a market in any kind of consistent fashion is impossible, yet leaving a business completely exposed in these market conditions is unsustainable suggests Quinn.

“The final quarter of the year has seen perceived risks subside and a cautious optimism has crept back in to markets,” he says. “Companies have had time to adjust both cost and sale prices to account for the changing economic landscape, while governments have introduced a variety of programmes to support their domestic economies.”

Yet the precise impact of monetary policy changes can only ever be estimated. After over a decade of low interest rates and an increase in monetary supply, it is still eminently possible that central banks have over-tightened and that we could slip in to a global recession next year.

Ivan Asensio, Head of FX Risk Advisory at Silicon Valley Bank suggests the drivers for currency direction will shift away from interest rate hikes and monetary policy next year and on to economic growth. “The key question is whether central banks successfully fight inflation whilst engineering a soft landing, or we are headed for a hard landing recessionary landscape,” he says. “The latter will further aggravate volatility, dampen asset prices, and may result in a rise in the dollar as a result of risk aversion.”

Dhargalkar says companies should plan their strategy assuming the strong dollar will continue. Historically FX rates do tend to revert to the mean, but the timetable to do that is unknown and it is not always clear when we have entered a ‘new normal’.

“A lot of the drivers of dollar strength – rising interest rates, war in Ukraine, European energy costs – are not expected to be relieved any time soon,” he says. “For most companies, the danger of being unhedged and the dollar strengthening further is a worse situation than hedging now and the dollar ultimately weakening.”

According to Gary Slawther, a professional interim treasurer who works with companies with a wide spread of geographies, industries and exposures, corporates need to take a holistic view of FX risk management and recognise the importance of cash management.

“Companies that have traditionally hedged are still hedging,” he says. “Now that interest rates have increased, a lot of treasurers who might not have hedged over the last decade or so are coming under pressure from their boards to change tack, but of course the cost of hedging has also risen.”

Over the last 12-18 months we have seen spot rates rise above forward rates for the first time in many years. However, Slawther says that in his experience most CFOs are not giving in to pressure to change their FX risk management strategy on the basis that no one can predict how rates will change.

“When to comes to FX, if you are right half the time you are doing very well indeed,” he says. “My advice is to have faith in your currency management programme – in some years it will be painful, but in others you will look like a genius.”

One of the most fundamental things a company can do to protect itself against risk is to always have liquidity and this is something CFOs are increasingly telling their boards, making sure their working capital is structurally cash generative and that procurement and sales teams are not offering unrealistic payment terms.

“I have worked for five different CEOs over the last 18 months and they are all focused on improving liquidity, which is great news for treasury because this is an area where our skills and competencies come to the fore,” says Slawther.

This trend also emphasises the importance of treasurers knowing and understanding their business because this will improve their understanding of where the risks and opportunities lie and recognise the traps that can lead to lost liquidity, he adds. “This is a time of great opportunity for the commercial treasurer.”

Case study

Inform logo

International publishing company Informa has balance sheet exposures and translation of profits rather than significant FX transaction exposure given that around 80% of its EBITDA is in US dollars or US dollar pegged and that it reports on a consolidated PLC basis explains Group Treasurer, Richard Garry.

“We usually seek to finance out net investment in our principal overseas subsidiaries by borrowing in those subsidiaries’ functional currencies, primarily USD,” he says.

This policy has the effect of partially protecting the group’s consolidated balance sheet from movements in those currencies to the extent that the associated net assets are hedged by the net foreign currency borrowings. Informa monitors the effectiveness of its hedging strategy monthly and reviews any foreign exchange volatility that is coming through the income statement to take additional action where necessary, adds Garry.

“On that basis, this year’s volatility has been no more challenging than any other year as our regular processes have been effective,” he says. “We also conduct an in-depth review of our strategy annually – utilising external expertise to ensure we are taking an independent, robust and up to date view – and again, that did not bring to light any changes required tactically or strategically.”

The business has undergone significant change this year as it divested one of its divisions and this change, combined with the strength of the US dollar, also prompted a review of foreign exchange policy. But that review did not suggest any policy changes were necessary.

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