Risk Management

FX volatility

Published: Nov 2017

Philippe Jaccard

Philippe Jaccard, Head of Liquidity Management, ANZ:

When FX volatility is high, the immediate reaction is to hedge any visible exposure by buying forwards, non-deliverable forwards, or options. And with so many currencies in Asia, the task can quickly become daunting, or the cost prohibitive.

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. That insurance may secure the best room in the hospital but it won’t prevent the sickness.

Mitigating FX volatility should be a process managed internally using an adequate currency exposure management framework. Get on a diet! 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.

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. 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, consider redenominating supply chain contracts to minimise any currency mismatch. And 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. 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; 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. It defines how much risk is acceptable, how the dividend will be paid, and in what currency.

Once it has been all worked out, the treasurer can start considering buying FX insurance products. The buying process can be centralised in a treasury centre, aggregating notional positions across the company. That would leverage the expertise of professionals, and secure access to the best prices in financial centres such as Singapore or Hong Kong. However, this could also come at a price if 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.

Wolfgang Koester

Wolfgang Koester, CEO, FiREapps:

Automation! Automation! Automation! A trend that accelerated after the financial crisis of 2008, treasury professionals are now fully embracing automation. This movement came to Asia via Asia-based subsidiaries of large multinationals. Headquarters of North American and European companies needed to know what their global currency exposures were and they needed the accurate data quickly. To remedy this, they turned to financial technology solutions to help manage exposures for all their subsidiaries.

Today’s FX management programmes are less and less manual, and people are embracing modern technologies to run their formerly spreadsheet-based programmes. These technologies, especially the use of currency analytics to identify and manage currency exposures, provide access to accurate, complete and timely data and enable corporations to run an automated FX risk management programme, protecting them from volatile currency moves.

Now that treasury professionals in Asia have embraced automation to mitigate the impact of FX volatility, they need to figure how they can further leverage automated technologies to continue to streamline processes.

Automating FX is a key step in protecting earning and the improved operational efficiencies, deeper insights into currency trends, time savings and reduction in errors and risk enable companies to uphold the industry standard Management by Objective (MBO) of less than one cent EPS impact. Additionally, running an end-to-end automated FX programme, from data aggregation to analysis and trade execution, allows for corporations to pull data from multiple source systems, manage more currency pairs and reduce transaction costs of trading.

The need for technology that aggregates and analyses currency data is only going to continue to grow with the widespread adoption of international accounting standards. In the last ten years, treasury professionals that have chosen to leverage technology in order to better mitigate FX volatility have seen a 50% reduction in risk and have been able to increase their hedge ratios.

Treasury teams today are driven to leverage financial technology that provides insight into their exposures and enhanced analytics and reporting. Ultimately, for treasury professionals in Asia to mute the impact of FX volatility to their financial statements, they need to implement a technology-driven FX risk management programme that provides a better understanding of their currency risks and enables them to manage them fully.

Sandip Patil

Sandip Patil, Regional Head of Liquidity & Investments & Financial Institutions Group Sales Head, Treasury and Trade Solutions, Citi:

The last 18 months have been a rollercoaster ride for most treasury professionals in Asia in terms of navigating the FX markets. Starting from the Brexit referendum in June 2016 to the US presidential elections in November 2016 in the developed markets and closer to Asia, regulatory changes in Malaysia’s Foreign Exchange Administration rules in December 2016, these key events have certainly kept most treasury professionals in Asia extremely busy. The lack of depth in some of the local Asian swap markets, the limited hedging tools and the myriad of conditions that must be met in some jurisdictions before a hedge is permissible, all made the task of mitigating FX volatility a challenging one.

In Asia, companies with formal FX hedging policies typically mitigate their FX volatility by adopting a layered rolling hedge strategy. These hedges often do not extend beyond the 12 months’ horizon due to uncertainty in the forecasting and the costs involved in executing longer-term hedges. It is often a balancing act, especially when the cost of carry is high, and more so if a company operates in an environment where its pricing strategies are very much dependent on the actions of their close competitors. Whilst locking in their FX exposures may yield certainty in terms planning and budgeted rates, this may be detrimental especially when the market moves in the opposite direction of one’s hedges, leaving competitors with little or no hedges, the ability to price more aggressively to gain market share.

Spots, forwards and swaps are still the instruments of choice although savvier treasury professionals in Asia are slowly beginning to use FX options to enhance their overall hedge portfolio. Unlike their counterparts in the developed markets, treasury professionals in Asia are still reluctant to pay up on option premiums. In instances where hedging policies permit the usage of options, zero cost options are often preferred versus vanilla outright options. It is encouraging to note that some companies are beginning to adopt a more pro-active approach in managing their FX exposures arising from their strategic corporate decisions, such as a competitive bidding situation in an M&A by working closely with their trusted advisors on deal contingent hedges.

Companies with a sizeable footprint across Asia have realised the importance of centralised treasuries, not only from a liquidity management perspective but also from the FX exposure management lens. With centralised treasuries in Asia, companies can leverage off their platforms and processes to manage both their cash positions and FX exposures simultaneously. This is critical given the diverse market and regulatory landscape across Asia, ranging from regulated markets to liberal ones.

The setting up of intercompany netting programmes and in-house banks have enabled companies in Asia to benefit from a reduction and consolidation of FX deals and to reap cost savings arising from minimisation of external transactions and FX costs, in addition to the operational efficiencies and benefit of improved visibility and control of cash that result from such centralisation.

In 2016, some companies took a quantum leap with their FX transformation project where they collaborated with their key partner bank to deploy the next generation of tools to manage their FX risk and associated payments. As companies across Asia continue to focus on cost and operational efficiencies, centralised treasuries with streamlined programmes across both liquidity and FX management may be the way forward.

Next question:

“There is a lot of talk about payments innovation in Asia Pacific at the moment, but what solutions are corporates actually using?”

Please send your comments and responses to qa@treasurytoday.com

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