Trends in Foreign Exchange Risk Mitigation and Management

In the wake of the global financial crisis, understanding enterprise-wide currency risk exposure has become vital. Successful management of these risks, however, will strengthen many firms in the long term.

Out of all the economic destruction and chaos of the past two years, new perspectives on risk management have arisen. No mathematical models prepared us for the financial industry collapse, and no textbook responses were adequate to handle the consequences. Humbled by the hubris that exacerbated the crisis and equipped with invaluable experience, financial professionals are adapting to a radically changed world economy, and the risk management profession itself is changing in response.

Paradoxically seen as vital, but also treated with a high degree of scepticism, foreign exchange (FX) risk management is evolving rapidly. Interestingly, we are seeing a renewed focus on the basics. There is less reliance upon complex quantitative analysis and modeling extreme events, and more concentration upon the refinement of simple processes and tools. A shift is occurring away from complex, untested and often poorly understood approaches, towards simple, effective and comprehensive frameworks. There is a renewed focus on measuring and understanding exposures on an enterprise-wide level, and using proven tools in an effective manner to achieve desired risk management goals. In other words, fewer attempts to predict the unpredictable, and more concentration on strengthening companies so that they can withstand the winds of fate.

The Growth of Bespoke

While the mechanics of trading have become commoditised, bespoke risk management services are growing rapidly due to the nature of foreign exchange markets. The currency market is a highly specialised and complex arena, and specialised knowledge is required to navigate it. Currency movement is but one of the risks that companies face, and maintaining qualified, experienced personnel in currency management roles can severely stretch corporate resources. This has driven the growth of specialist firms dedicated to handling the specific requirements of day-to-day trading and the implementation of corporate hedging programmes. This outsourced structure allows leadership teams to focus on core business activities and maintain strategic perspective.

Exchange rate volatility hit astonishing levels over the past two years, making directional bets and unhedged currency exposures fatal for many organisations. In consequence, formalised trading and risk management policies have been implemented by many companies. These policies range from the simple to the highly complex, and are often implemented with the assistance of outside experts. Predefined hedge ratios are often important components of risk management policies, and are set with risk tolerances and liquidity requirements in mind. As a result, we have seen a distinct upsurge in the number of firms hedging mechanistically - when an exposure is identified, it is immediately hedged at the most favourable price level possible. This helps to reduce position risk, and reduces the potential for negative consequences when subjective judgments go wrong.

The world economy has splintered into a number of areas, and developing markets are growing much more quickly than mature economies. This means that companies are ever more focused upon working in areas with less developed financial infrastructure. While the rewards are great, the currency risks are substantial as well. Exotic currency hedges and payments have skyrocketed in popularity as businesses have seen the benefits of denominating contracts in local currencies. Non-deliverable forward markets are being used to hedge exposures to controlled currencies like the Chinese yuan, vastly improving year-on-year cash flow stability for importers. Quite often, businesses based in the UK can mitigate risks better than competitors based in developing countries. In essence, this situation places UK firms in the enviable position of being able to leverage the world’s deepest and most advanced financial infrastructure against global competition.

A Healthy Scepticism

While risk management has gained sceptics over the past two years, healthy scepticism has its benefits. The increasing confidence in quantitative models and complex risk management structures in the period that led up to the financial crash led to a series of catastrophic mistakes. The overconfidence bubble has burst, allowing practitioners to see things more clearly, and creating an opportunity for a redefinition of the profession. Currency risk managers are now focusing on providing clear and accurate information to leadership teams and on implementing strategies that have proven to be efficient and effective.

The new financial order which has emerged poses new risks, and offers great rewards to those organisations which can seize new opportunities while managing exposures effectively. The downturn has driven home the contribution that good currency risk management can make to business sustainability. In tandem with the general de-leveraging trend now occurring, this should lead to the strengthening of many companies over the longer term.

As the former England footballer Paul Gascoigne once said “I never predict anything, and I never will”. Without detracting from the wisdom of that statement, we predict that businesses will be better prepared for unpredictability in the future.

Article by Karl has over 10 years' experience in financial services, and has designed and implemented risk management and trading strategies for hundreds of companies, ranging from small businesses to large corporations. He is a member of the Professional Risk Manager's International Association (PRMIA) and the Global Association of Risk Professionals (GARP), and sits on the board of the Calgary chapter of the Treasury Management Association of Canada (TMAC). He is currently pursuing his Derivative Market Specialist Designation through the Canadian Securities Institute and his Professional Risk Manager designation through PRMIA. Schamotta's market analyses and forecasts have been quoted by such publications as the Wall Street Journal and Dow Jones Newswires. He also contributes to TMAC's member magazine, Canadian Treasurer.