Four Steps to Managing Foreign Exchange Risk in Volatile Times

Managing foreign exchange risk has become vital on the back of the recent global economic turmoil. This article outlines four steps that can help assess and address the risks associated with foreign exchange volatility.

In the not so distant past, global currency markets were relatively stable, perhaps giving a false sense of certainty to treasury departments managing foreign exchange (FX) risks. Currencies went up a little and down a little. Aside from a few isolated economic disasters that led to sudden depressed values for a particular currency, including Mexico’s bank nationalisations in the 1980s and Argentina’s inflationary woes in the early 1990s, many FX trading days were downright uneventful. However, the volatility the currency markets experienced in 2008 changed the way companies now need to view their FX risk profiles.

Currency-related volatility poses challenges to treasury groups in many companies because of material profit and loss considerations, especially when currency fluctuations move unexpectedly in the double digits. Plus, treasury departments now need to anticipate risk and decide when to act over time. While no one knows where the currency markets are going to trade tomorrow, much less longer term, your company can mitigate its risk exposure.

Step 1: Understand Which FX Risk Exposures Matter Most

Managing FX risk begins with a firm understanding of your business priorities as well as company policies and philosophies around FX-related matters. For instance, many companies place their primary focus on protecting the value of booked or known cash flows. In other companies, the primary focus may be on assuring that the budgeted FX rate is protected against currency fluctuations. Or, a company may be more concerned about how FX volatility affects earnings from foreign subsidiaries. Some companies place a premium on protecting net investment values in foreign subsidiaries, while others choose to focus on protecting or expanding their competitive positions in certain markets. In these instances, market share may take precedence over predictable revenue or cash flows.

Step 2: Identify and Understand the Types of Exposures

Your treasury team should familiarise itself with how changes in FX rates can alter booked or known cash flow. For example, cross-border payables, receivables, and dividends are all affected by volatility in the FX marketplace, as is the value of international investments and income. Additionally, you should be on the alert for events that may increase economic, political, and/or country risk. For example, if an upcoming election threatens political stability in a country to which you export goods, you may want to hedge that country’s currency in case the political unrest affects its economy.

Step 3: Determine the Appropriate Level of Risk

Think carefully about your company’s appetite for risk as you determine appropriate risk tolerances. One company may require hedging all currency-related risk in excess of US$1m. Meanwhile, another company’s minimum may be US$100,000.

The process of assessing your company’s appetite for FX risk can help identify ways to mitigate that risk by working across subsidiaries. One way to do that is to find opportunities to net offsetting positions internally. Understanding the net exposure can help you stagger the timing of payments or receipts and allow you to avoid unnecessary currency trades.

Consider this scenario. A US company (UsCo) has a German subsidiary (GermanCo) and a Swiss subsidiary (SwissCo). If GermanCo is receiving a UK pound payment stream over the next three months and SwissCo has a similar amount of UK pound payables in six months, UsCo may have an internal netting opportunity. An on-balance-sheet approach would be to have GermanCo place its UK pound receipts in a pound-denominated account until SwissCo needs to initiate its UK pound payables. At that time, GermanCo sells its UK pounds to SwissCo. Without netting, GermanCo would have sold its pounds into the market when they were received and SwissCo would have purchased pounds from the market when its payables were due. The currency market has developed a number of instruments to replicate this strategy with off-balance-sheet derivative transactions.

In most companies, internal netting can only be used for a portion of overall FX-related exposures. They must then look to the market to hedge or offset risks that cannot be netted.

Step 4: Create an Action Plan

Once you determine which FX exposures you plan to target through hedging, there are several questions to be answered:

• Who will execute the hedges?
• When will you initiate the hedges?
• What instruments will you use?
• What counterparty risk is acceptable?
• What is the internal management approval and oversight process?
• How frequently should you monitor these positions and exposures?
• How will you organise your internal controls (i.e. levels of approval)?
• Is the FX budget rate achievable? The FX budget rate should only fluctuate between set amounts. For example, a budget of 20 basis points (BPS) for AUD to USD is $0.69 to $0.89. Anything more will require a different FX hedge.

Once you establish a process, review your results regularly. Although it may be unwise to modify investment actions to suit the strategy of the day, most companies find it helpful to periodically assess and modify their strategies based on ongoing analysis of currency trends.

The goals of a solid FX management strategy should be twofold: to secure more predictable and stable financial performance and to ensure no FX-related surprises on the balance sheet that would require explanations to shareholders. Checking your risk management policy against economic forecasts and other trends will help expose any potential vulnerabilities you may need to address, ensure cash management remains as stable as possible, and establish a framework for the future.

The New ‘Normal’ for Currency Markets

In late 2008, currency markets followed the volatile trajectories of other markets as the global economy took a pounding. In a matter of just two days, currencies including the Mexican peso and the Icelandic krona lost more than 20% of their values against the US dollar. The Icelandic krona snapped back more than 28% over the following two days before embarking on a more gradual 30-day decline. Ultimately, the krona lost almost half of its value during the fourth quarter of 2008. Even a more historically stable currency pair like the US dollar and the Canadian dollar was not immune to extreme volatility. Over a one-month period, the Canadian dollar lost 25% against the US dollar before staging a 12% comeback a week later. In this new era, we no longer view movement of 10-20% as outliers. This type of volatility over short periods of time has become commonplace

Article by Larry Kirschner . He has more than 30 years experience with investment and commercial banks at the senior management level.