They had little concept of currency risk management in the 19th century. Even for most of the 20th century it was not important: fixed exchange rate systems were the norm until the 1960s. The post-war Bretton Woods Agreement, in conjunction with widespread exchange control regulations, conspired to limit exchange rate movement by pegging the value of currencies to the US dollar and, through it, to gold. The system fell apart because too many people took the US government at its word to sell an ounce of gold for US$35. They thought gold was worth more than that. They were right. Having got the taste for profitable speculation, investors and banks drove a rapid expansion in foreign exchange (FX) activity during the 1970s, which has continued almost unabated. The most recent survey of FX turnover by the Bank for International Settlements, in April 2007, put average daily turnover at US$3.2 trillion. Roughly a sixth of that activity comes from non-financial companies.
If exchange rates did not move, the bulk of that activity would be pointless and FX risk management would be as irrelevant as it was two centuries ago. Some currencies really do not move; consider the Bermudian dollar, fixed at par to the US dollar, and the Bulgarian lev, pegged to the German mark at one-for-one in the early 1990s and at 1.95583 to the euro since its inception. But most currencies are not fixed and none of the major currencies are pegged to one another and so they move. Strong selling interest pushes them lower just as excess demand takes them upwards. Witness the speedy decline of the UK pound after a failing Northern Rock decimated confidence; see how nervousness in the financial system took the Japanese yen higher as the world bought it for its perceived safe-haven qualities. In theory, the bigger the currency, the less volatile its price. The US dollar can absorb huge inflows and outflows in a way the Australian dollar could never presume to achieve. But it still moves. And any business that might make or lose money as a result of that movement is at risk.
Currency risk can take several forms. At its simplest, it represents the difference between the price of a foreign currency now and the price when you first recognised the need to buy it. That difference will mean an opportunity profit or loss if the risk has been left unmanaged. At the other end of the spectrum is the risk that a domestic producer with a domestic customer base could be undercut by foreign suppliers if their currency were to weaken. Although the international firm has no overt exposure to FX risk, it faces the economic risk of losing out to international competition as a result of exchange rate movement.
For any company with international activities or ambitions, the first step towards effective FX risk management is to ask whether risks might actually exist. With that formality out of the way it requires no great conceptual leap to make an assessment of the risk. Call it an ‘exposure analysis’ or something, to avoid the negative connotations of health-and-safety ‘risk assessments’. The analysis should take into account:
- Payments to foreign suppliers (regular and occasional).
- Receipts from foreign customers.
- Foreign purchases or sales, even if they are currently sterling-denominated.
- Existing and projected foreign investments and subsidiaries.
- Foreign currency loans and borrowings.
- Business plans likely to involve overseas activity, including tenders.
- The power of employees to commit the firm to FX transactions.
Categories of FX Risk
Classically, FX risks can be categorised as ‘transaction’, ‘translation’ or ‘economic’. Let us first examine the one that does not fall within these groups, because it is not peculiar to FX activities: ‘procedural’ risk.
There are numerous stories of employees who have brought their company almost to its knees through unauthorised or fraudulent trading. Perhaps ten times as many instances have never found their way into the media. Nick Leeson brought down Barings Bank by exceeding his trading limits and hiding the losses. Jerome Kerviel’s alleged €5bn loss at Société Générale is the most recent high-profile case. But rogue operators are not solely the province of big banks. In every case these losses mushroomed because management failed to spot their existence. Procedural failures can be identified – retrospectively, of course – in almost every case of rogue-traderism. It is impossible to prevent an employee having a brainstorm, but with appropriate checks and safeguards diligently implemented the risk is reduced. At its simplest, the system demands that counterparties send copies of every trade confirmation to the CEO. Yes, they will find it a pain to reconcile the figures every day, but it would be even more painful for them to stumble upon the problem a month later when it is five times as big. (It is an unfortunate fact of life that such losses always increase over time – they never diminish.)
Less of a problem, usually, is ‘translation’ risk, where a long-term foreign currency asset or liability must be revalued for accounting purposes. Consider a UK company borrowing euros to take advantage of lower interest rates across the Channel. If it borrowed €500,000 in early 2009 and converted the proceeds at, say, €1.10 to the pound, the firm would have posted an original liability of £454,000. With the recovery of sterling to €1.20, that liability falls to £417,000. As a trading decision it is difficult to fault, but if the accounting treatment is clumsily handled, the £37,000 notional profit could mean a tax bill. Translation exposure, because it usually relates to long-term assets and liabilities, is not something that most companies will want to manage actively. To do so would throw up misleading periodical profits and losses.
‘Economic’, or commercial, risk can appear esoteric to a firm with wholly domestic activities. How would a plumbing firm in Thurso suffer any ill effects from a change in sterling’s exchange rate? Such a localised service provider very probably would not. But what about an onion-grower in Dover? The cross-Channel ferry is cheap for someone on a bike and there are lots of onions in northern France. A strengthening pound would spell opportunity the French. Kodak was caught out like this in the 1980s, when a weak yen allowed Fuji to undercut the pricing of Kodak film in its domestic market. Monsanto lost overseas sales at the same time, for the same reason, when it found that its dollar-denominated price list had lost its attraction to customers.
Some argue that exporters and importers can mitigate FX risk by negotiating prices in their domestic currency. It is true, they can, but in doing so they replace transaction risk with economic risk. There is no getting away from risk. It is possible to exchange one sort of risk for another, but impossible to remove business risks entirely without shutting up shop.
‘Transaction’ risk is similarly persistent. Using forward FX transactions, it is entirely possible to provide a customer with a local currency price list valid for the next year or the next ten years. But to what extent is it worthwhile to do so without the likelihood of firm orders that far out? Badly managed, it could be a serious hostage to fortune. Other than for big-ticket capital goods, a closer time horizon will be more appropriate. In most cases, an established business pattern will provide the framework for risk management decisions. A wine importer with annual sales increasing at a steady 10% will probably need to buy 10% more euros (or New Zealand dollars or whatever) next year. But is it sensible for that importer to commit, in advance, to fixing a price for all of next year’s anticipated euros when the government is slashing spending and cutting public sector jobs?
There are many ways to manage transaction risk, none of which is perfect but all of which are better than ignoring it. The ultra-conservative approach is to cover the value of every solid foreign order in full: get an order for US$100,000 of widgets to be delivered in six months’ time, sell US$100,000 six months forward against sterling. It guarantees the sterling value of the income. But anyone comfortable to cover 100% of the revenue should at the same time ponder the idea of covering none. To cover none of it would be to gamble on a fall in sterling’s value. Surely 100% coverage in the opposite direction is just as much of a gamble? And it is. For it to pay off, the pound must be lower in six months’ time than it is today.
Hedging Your Currency Risk
For exactly those reasons many companies are now using more sophisticated methods to hedge their currency exposure. There are several currency option structures available today. Structured in the right way, these options could protect you fully against adverse market movements and allow for participation if the rate moves in your favour.
A good example is the risk relating to the tender process. Having submitted a tender, but with no guarantee of success, the tenderer has a contingent FX risk. If the tender is a winner there will be an immediate exposure. If not, there will be none. In such a situation it may be worth considering an FX option that will protect the downside. The principal benefit of an option – as opposed to a normal FX forward – is that its cost is fixed at the outset. If the tender is successful and the exchange rate moves adversely, the option can be exercised to make up the difference. If the move is favourable, the option goes in the bin and you collect the opportunity profit by dealing at a better price in the open market.
For companies with exposure to international markets, fluctuating exchange rates could have a significant impact on profits, cash flows and, ultimately, shareholder value. By actively managing these risks, one installs confidence among senior management, shareholders and lenders alike. Employing a suitable hedging strategy not only protects businesses from financial shocks, it also provides clearer sight of future cash flows and contributes to a more transparent budgeting process.
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