Last year’s major uncertainty on the international foreign exchange (FX) markets was evident in the resulting high level of FX volatility. One explanation might be found in central banks’ activities around the globe. The European Central Bank (ECB) flooded the markets with excess liquidity in 2015, following the US Federal Reserve’s lead.
The ECB’s bond purchase programme – recently extended from government bonds to include corporate bonds – will supply a total of €1.14 trillion additional liquidity to the markets until the end of September 2016. In early December, the ECB announced that its quantitative easing (QE) programme (monetary policy to prevent recession and deflation) would continue for at least a further six months to March 2017 and that the target volume might be even higher.
Simultaneously, more and more countries have introduced negative interest rates, which have increased the FX market volatility. Ten-year German, Swiss and Japanese government bonds yield below zero. Swedish and Danish government bonds are close to – or already in – negative territories. All of these countries have introduced a negative interest rate policy to fight deflation, to weaken their currencies or to stimulate growth. It is a moot point what consequences this holds for the Swiss franc (CHF) and the steering opportunities of the Swiss National Bank (SNB).
Additionally, it is questionable whether it can be expected that the FX markets will normalise again in the future, or if the corporations should prepare for even more turbulence. What does this mean for global companies, irrespective of whether their registered office is in Switzerland or abroad?
FX management practice in industrial companies
The importance of FX management has continued to grow steadily in Switzerland, across Europea and further afield as it becomes increasingly relevant in strategic terms. Besides increased volatility and the corresponding sharp fluctuations in the value of positions, abrupt changes can also occur as a result of sovereign risk. Such risk exposure is usually not predictable.
At the same time companies often face major currency concentration risk in the euro (EUR) or US dollar (USD) (USD-pegged currencies in America and Asia respectively), which leads to a weak diversification. This particularly affects companies with a high import/export focus as well as major subsidiaries.
FX risk can essentially be divided into three categories:
Economic risk The risk that the (non-secured) net cash inflows from business activities will be lower. Exchange rate movements can permanently alter the structural as well as competitive environment of a company.
Transaction risk: The risk that the (secured) net cash inflows in foreign currency will create additional volatility when converted into a company’s functional currency.
Translation risk The risk arising from the consolidation of the subsidiaries financial statements that were originally expressed in foreign currency.
In the past, it has been evident that the focus was mostly on transaction risk, i.e. companies hedging only the FX risks that arise from buying and selling.
Various surveys, such as the 2007 study Do Firms Hedge Translation Risk? by Bonini, Dallocchio, Raimbourg and Salvi, show that barely half of all companies hedge their translation risks. These risks can nevertheless be substantial, as the following example shows:
A group, reporting in CHF, has several subsidiaries in the US (as well as in other currency zones) with a total amount of CHF eq. 500 million. A 10% strengthening of the Swiss franc against the foreign currency would result in a loss of CHF 50 million of capital.
It illustrates that companies are exposed to high nominal values (total value of participations), which are additionally exposed to increasingly high fluctuations in value (FX volatility). The translation risk is accordingly substantial.
These negative FX influences are increasingly picked up by the press, although a distinction is not always made between transaction and translation-based losses.
As Figure 1 below shows, not only participation (equity-financed subsidiaries) values are affected, but also internal loans – and therefore the debt-financed portion of subsidiaries.
Whether a subsidiary is financed with debt or equity has material implications to the balance sheet treatment in case of a loss:
• Losses on participations are netted against equity during the consolidation process and thus do not appear in the income statement.
• Losses on internal loans are normally booked in the income statement and thus affect profit. This practice should be challenged, given the fact that these fluctuations can be recognised in equity with no effect on the income statement.
Identifying risk – what are the key risks?
In this context, global companies should ask four basic questions:
• How significant is the translation exposure, and in what currencies is it denominated?
• Up to what limit is the company willing to accept losses/fluctuations in value?
• Should risks be hedged, and if so to what extent?
• What instruments can be used for hedging?
The hedging of translation risk has been a subject of discussion for many years. On either side, the representatives are clearly in favour or against hedging. However, the best solution would seem to be in between i.e. partial hedging. The reasons are obvious.
The FX challenges have become more prominent in recent years and only a few companies are prepared – or in a position – to sustain the effects of currency fluctuation and manage the issue within a short time horizon.
Although accounting losses do not have any direct impact on the corporation’s liquidity, they do affect the dividend policy which might have indirect implications on the liquidity situation. In addition, should a subsidiary be sold, potential accrued losses which were netted against equity, have to be realised in the income statement. Consequently, this has a direct impact on the company’s profit for the ongoing year – and could at least be partially offset through accurate hedging. Furthermore, a lower equity volume also has a negative impact on existing credit-related agreements as well as on the rating of the company.
The FX risk should therefore be reduced to an acceptable, predefined level. As a consequence, companies can at least buy valuable time in case any structural changes need to be taken.
Hedging does however carry a (liquidity) risk that should not be underestimated. This can be shown in the following example:
The USD subsidiaries are hedged via FX forward contracts. A 10% strengthening of the Swiss franc causes, as shown beforehand, a valuation loss of CHF 50 million. However, this is fully offset (in the case of 100% hedging) by the FX forward valuation gains.
What if the position is not exposed to an appreciation, but to a depreciation? While depreciation results in a rise in the value of the participations, it causes a loss on the FX forward contracts. Although the risk is perfectly hedged, depreciation affects liquidity due to the FX forward contracts.
This is a key reason for favoring a partial hedge.
This example shows the link between capital and liquidity risk. The reduction in capital risk through the use of FX forwards is accompanied by an increase in liquidity risk. An integrated management of translation risk addresses both risks and ensures that capital – as well as liquidity risks are kept within a predefined limit framework. Using derivative instruments (such as FX options) or debt financing in the local currency is a good way to balance out these risks. Finally, as a third dimension, the different costs of the individual hedging strategies need to be considered.
Risk management – determining, measuring and managing risk tolerance
Once the benefits of partial hedging have been identified, the risk tolerance level and methods to determine and measure risk tolerance have to be defined in a suitable way.
Determining risk tolerance – the maximum accepted loss within a specific period – is the responsibility of the board of directors. It considers the following aspects:
• Internal capital adequacy requirements.
• Requirements of the partner banks, related to credit agreements.
• Expectations of rating agencies and investors.
• Dividend policy at group level.
How is risk tolerance – once it has been quantified – measured and managed in practice?
Basically, a number of options can be found in practice. The two best-known methods are sensitivity analysis and the value-at-risk (VaR) approach.
– Measuring limits through sensitivity analysis
This captures the sensitivity of equity to a predefined exchange rate movements (for example 10%) for all relevant currencies. The advantage of this method lies in its understandability; the disadvantage in determining a suitable stress scenario, i.e. determining the exchange-rate movement. Whether all currencies are exposed to a 10% or 20% shock might heavily impact the limits. The scenario needs to be defined in a realistic manner and should be dependent on the currency and market specific characteristics.
– Measuring limits through VaR procedure
This method also measures the change in equity. The scenario – i.e. the probability of an exchange rate movement is derived from historical observations. This is one of the advantages in contrast to the sensitivity analysis. Additionally, the correlation between the currencies can also be taken into account – i.e. the probability of multiple currencies shifting simultaneously. If multiple currencies are involved, there might be a diversification effect. One disadvantage is related to the higher complexity and the required resource intense IT infrastructure.
The applied method is crucial to manage translation risk properly. The key aspects have to consider appropriate actions (in cooperation with the board, adjustment of policies and guidelines), which can be made within a reasonably short time horizon (defined by the BoD) if the risk tolerance is exceeded.
Switch reporting currency
If the FX effect from the conversion of subsidiaries is substantial and results in an undesirably high level of volatility, a change of the corporate reporting currency might be considered. This has traditionally been done by many companies in the past and is still often discussed as a possible option.
A positive effect on the FX result will be achieved while switching from a strong reporting currency to a weaker one. The key focus should be on the reduction of volatility and on the interests of the investors. The balance sheet and profitability key figures also have to be considered, which can have an influence on the company’s credit rating.
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