FX Risk Q&A with Karl Schamotta, Western Union Business Solutions

Q (gtnews): The classic foreign exchange (FX) risks are transaction risk, translation risk and economic risk. Which of these areas do you think is currently being given greater attention by treasurers?

A (Karl Schamotta, senior market strategist, Western Union Business Solutions): Treasurers have always tended to focus on transactional risks, largely because they are relatively easy to quantify and manage within the typical earnings cycle. However, in a sense, transactional exposures can be considered the ‘low hanging fruit’ of the FX world. Effectively managing the exposures further up the tree can do wonders for a company’s sustainability and competitiveness.

The global economy is currently going through a series of substantial adjustments that will impact exchange rates and business models over the long term. This economic risk is often the least recognised and least well-monitored form of currency exposure. For example, many corporates with operations in China are seeing their operating margins squeezed over time as the renminbi appreciates. The incremental nature of the change has obscured its materiality for many months thus far, but the cumulative effect on earnings is beginning to be felt.

This sort of exposure is relatively easy to manage – proven tools, tactics and strategies are in widespread use. A strong risk management framework can help to raise awareness of economic exposures internally, while also providing treasurers with the mandate to address them.

Q (gtnews): Can you describe some of the tools that treasurers can use to mitigate and manage their FX risks. Which of these are particularly popular today, and how do you see this changing (if at all) over the next 12 months?

A (Schamotta): From a financial instrument perspective, customised outright forwards are the most popular, most efficient tools in usage – by a wide margin. This is likely to remain the case for the foreseeable future. However, we are seeing corporate hedgers putting more focus on market entry strategies, particularly the usage of more complex order types that take advantage of market volatility while maintaining effective protection levels. I’d expect to see this trend accelerate in the coming months, particularly in the event that volatility increases.

However, the most effective tool available to a treasurer is a strong risk management process. Recent market developments should really drive home the point that currency risk cannot be managed by simply throwing a set of financial instruments at the problem. Perhaps I’m being idealistic, but I think that a renewed focus on risk management practices will be the most significant change that we see over the next 12 months.

Q (gtnews): What do you think are the main areas that treasurers need to pay particular attention to in their FX hedging strategies? Are there any common areas that could be improved by treasurers?

A (Schamotta): I think that the risk management process itself is the most common area that can be improved. For many corporates, a set of financial controls currently substitute for a robust risk management policy, meaning that the organisation is continually responding to risks rather than proactively managing them. Instead, a feedback loop should be created between business objectives and the tools and strategies used to achieve them, so that the organisation continually adapts in response to evolving markets and circumstances. Creating a strong formalised process is much more sustainable – and ultimately more effective than attempting to remain au fait on the latest financial instruments.

That being said, one other area that can certainly bear a lot of improvement is trade execution. As many equity investors can attest, picking the right stock is only part of the battle – purchasing it at the right price is just as important. Much the same applies in the FX markets: once the most effective hedging instrument has been chosen for a particular exposure, applying the right trading tactics can generate significant value. All too many companies identify an exposure, strategically choose the right hedging instrument, and then execute by placing the trade with the strongest bidder. Deploying some of the more advanced trading tactics instead can create many openings for opportunistic market entry – harnessing intraday volatility can improve hedging performance considerably.

Q (gtnews): Regulations aimed at bringing greater transparency to the OTC markets have an affect on the FX market and how corporates manage and report their FX exposures. Please describe some of the most pertinent areas of current regulations that treasurers need to be aware of when managing their FX risk.

A (Schamotta): That’s an excellent – and frankly terribly difficult – question to answer. The situation is in flux. With Dodd-Frank, Basel III, and the European Commission’s (EC) proposed reforms all in various stages of debate and implementation, the impact from the interbank market down to commercial hedgers is simply unknowable at this point in time.

However, it’s important to remember that these changes are largely intended to address systemic risks, as opposed to impacting commercial hedging activities. As a matter of fact, the regulators are seeing significant pushback on rules that could lead to unintended consequences in the non-financial sector, on end-users. Many of the proposed changes contain specific commercial hedge exemptions.

Ultimately, I think corporate hedgers will see the greatest impact on their reporting cycles, in the sense that some degree of daily position analysis will become necessary. This is likely a good thing – the monthly exposure cycle should go the way of the dodo anyway. Given the speed and scale of recent exchange rate moves, the old way of doing things can lead to organisational extinction.

Regulatory changes are influencing collateral requirements at the interbank level, although at this point, they have had a limited impact on the over-the-counter (OTC) market – meaning that few hedgers have seen the need to adjust their activities in response.

Nonetheless, the pace of change and the sheer complexity of the legal landscape mean that treasurers are unlikely to remain on top of the situation for long. The devil truly is in the details, so the best strategy is to spend time consulting with service providers, lawyers and international accountants who deal with these developments on a daily basis. Ongoing education and adaptation is vital.

Q (gtnews): What regional trends should treasurers be aware of with their FX risk management strategies?

A (Schamotta): That’s a wonderfully topical question. I believe that this may be a year in which financial decision-makers begin to look the emerging market gift horse in the mouth. Vast resources and monetary flows have poured into countries across Latin America and southeast Asia since the financial crisis, and economies are overheating as a result. In response, we’ve seen a many countries attempt to cool investment inflows, impose restrictions on outflows, and actively intervene in the FX markets. These efforts are well intentioned – fickle foreign investment flows played a large role in many of the emerging market crises that occurred so frequently throughout the 20th century. However, these actions also add new meaning to the old saying: “Emerging countries are difficult to emerge from in an emergency”.

Moving money in and out of the emerging markets is becoming more difficult, and hedging currency exposures is growing more complex. Compounding this, many currencies are no longer participating in the unidirectional secular upswing that characterised the post-crisis period. If anything, the need for effective hedging is increasing. This nuanced risk environment requires that treasurers gather more intelligence on country-specific changes, while also maintaining an awareness of the adjustments that are affecting global capital flows.

Q (gtnews): What role do you think banks can play in assisting their corporate clients manage their FX exposures?

A (Schamotta): FX always has been, and likely always will be, a highly specialised aspect of the treasury function. Creating and retaining this specialised knowledge in-house is a significant challenge for most corporates, particularly smaller ones. This creates an opening for service providers to put highly specific expertise at the service of treasurers, letting them focus on strategic functions rather than on managing FX risk. I also think that service providers can act as a cross-fertilisation mechanism, by which best practices are shared across a variety of business models, and ensuring that robust processes are more widely adopted. Nothing substitutes for the experience gained through observing a number of market events and trading cycles – and this is truly where dedicated currency specialists can add significant value.

Q (gtnews): Can you describe some of the different types of technology that exist which can help treasurers manage their FX risks?

A (Schamotta): Treasurers typically require technological support in three broad areas; generating data on cash flows that may impact the business, identifying and managing the resultant risks, and in executing offsetting financial transactions with external counterparties.

As it stands, these functionalities are often addressed by using three different platforms. An enterprise risk management (ERM) system commonly forms the base of the pyramid, painting a picture of the corporation’s ongoing cash flows. A treasury management system (TMS) then forms a centralised ‘hub’ within which global exposures are captured and overall positions monitored. Counterparty dealing platforms are then used to manage cash, measure market sensitivities, and execute trades.

This framework is rapidly evolving however, and we are seeing increased adoption of integrated systems that are capable of managing exposures all the way through to execution and back again. While these traditionally required an enormous investment in both time and money to implement and maintain, service providers have made quantum leaps in creating bespoke systems that meet the needs of a range of sophistication levels and business sizes. The investment required has diminished significantly.

At the end of the day, however, it is important that these technology solutions are subordinated to your risk management processes. Putting a strong roof overhead is pointless without a solid foundation.

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