Adopting a systematic approach to identifying and managing financial risk

Anticipating risk events in today’s macroeconomic climate is arguably more difficult than in previous years. Baseline assumptions of zero floors in interest rates, natural levels of inflation and growth and continued globalisation have all been tested to varying degrees. While central banks deploy unconventional and aggressive monetary policy techniques in response to softer growth, regulators are continuing apace in their endeavour to reform the financial markets landscape.

Changing corporate attitudes to risk

The use of currencies as a policy tool has grown in importance as global yields have tended towards zero. The net impact of regulatory and policy change has been an increased frequency in unanticipated and volatile movements in currencies. These form part of a series of events that would previously have been defined as ‘black swans’. The role of corporate treasury within a group finance function has accordingly evolved to help companies prepare for such outcomes.

While anticipating these movements remains difficult, the importance of adopting a more robust and systematic approach to identifying and managing financial risk has become more evident. A growing appreciation of the differing characteristics of individual currencies means that hedging policies are also being reviewed to allow more flexibility to hedge in a manner that addresses the underlying dynamics of a particular exposure. While this is not necessarily an emerging market versus developed market generalisation, we do find that on balance, higher yielding and more volatile currencies substantiate the inclusion of a broader suite of risk management products. This is also where the inclusion of currency options within approved policy tools has proven beneficial.

Increased adoption of currency options

At a time when global growth is close to zero, the impact of economic shocks is less easily absorbed than when conditions are more favourable, hence the move towards more aggressive policy response. This also implies greater impact of such shocks to company balance sheets. Risk management practices (or lack thereof) have drawn greater scrutiny from the analyst community and whether directly or indirectly, risk management practices have more influence now on share price movements.  Add to this the broad reduction in market liquidity due to regulatory change and the increased susceptibility to significant price movements, and the heightened importance of conducting a risk management assessment around key market events becomes evident.

Where some corporates have historically been more accustomed to using currency options to manage exposures contingent on their own activity (mergers and acquisitions (M&A), asset disposal and the like), we see increased adoption of similar tools for managing the wings of probability around external risk events – the most recent being the impact to the valuation of the British pound post-Brexit. The role that currency options play in such scenarios helps avoid the binary outcome of unanticipated, and consequently unmanaged risk events materialising. Changes to accounting practices with the pending implementation of IFRS 9 will make the treatment of option premium more favourable from a profit and loss (P&L) reporting perspective and we expect the trend of adoption of currency options as a risk management tool to further increase accordingly.

To support these evolving requirements, we have developed an analytical framework to help clients determine whether their existing foreign exchange (FX) hedging policies and strategies are sufficiently adaptable to manage the exposures they face in today’s environment. We invest in understanding our clients’ exposure profile, risk management targets and risk appetite while considering regulatory, cost, and accounting constraints. Tailored analysis is then conducted, incorporating cost/benefit analysis per currency, as well as on a portfolio basis using back testing and simulation, and provide input on where we think changes may provide benefits. Potential outcomes of such analyses range from changing the currency composition of debt, the tenor and timing of executing forward hedges, or possibly changing the product mix where suitable.

Why should we discriminate against swans?

Most importantly of all however, is empowering treasurers to decide upon an optimal hedge management framework that is fit for purpose. The key feature here is flexibility; where optimal policy allows corporate treasury to respond to the evolution of their own company’s risk exposure profile, as well as the markets in which they operate. When a treasury committee reviews policy once per annum, the importance of adopting increased flexibility around permissible products and manner of execution is paramount, so the company is not bound by today’s assumptions of future possible outcomes in financial markets. This is especially relevant in the current environment of regulatory change.

The focus then switches to implementation of risk management within the scope of the policy, with the support of partner banks that understand the needs of the business, the market in which it operates and the emerging opportunities to analyse and manage financial risk.

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