The phrase ‘a new normal’ has been applied in various contexts recently but an expectation of financial volatility, or at least lasting uncertainty, does now seem commonplace. Views on currency markets are no exception. The inaugural
Currency Risk Outlook
recently published by AFEX, which questioned small and medium-sized enterprises (SMEs) globally, found that around 88% of businesses expect continued or increased currency volatility in the coming 12 months.
Given recent experience that’s little surprise. The pound (GBP) has climbed strongly against the (USD) dollar since the mid-point of last year, while other currencies have fallen sharply. Those of emerging markets (EMs) have been most vulnerable – in addition to the obvious examples of the Indian rupee (INR) and the Indonesian rupiah (IDR), one should the Brazilian real (BRL) and, most recently, the Turkish Lira (TRY).
For businesses operating internationally, that volatility obviously presents a challenge. Annual and interim reports are now littered with references to the impact that adverse currency movements are having and companies of all sizes face that downside risk. The UK small-cap toy manufacturer Hornby stood out earlier this year for the extent of its losses linked to currency movements – £200,000 alone related to the company’s exposure to the price of Chinese renminibi (RMB). Given the size of Hornby, those losses are significant and similar stories – on different scales – could be told each week.
Cards off the table
In that context, how should treasurers and chief financial officers (CFOs) be looking to best manage their currency exposures? Fundamentally there’s a need to fully understand the values at risk with regard to specific currencies and build realistic policies around them.
As is often the case, there’s no catch-all approach. Rather, businesses need to look at their own positions and determine a policy that’s suitable. For example, certain import businesses working to low margins may need to hedge their exposures entirely by locking in a given price to provide certainty. Those with lower currency exposure – such as a manufacturing company with an Asian production line – might decide to hedge 75% of their value at risk, capping the downside while retaining some potential upside should the currency pair move favourably. The specific techniques and financial products used will vary, but the policy should be used consistently.
Formalising an approach within a fixed policy not only ensures that treasury is taking steps to actively manage foreign exchange (FX risk) – too many leave themselves entirely exposed – but it lessens the likelihood of looking to over-trade and beat the market. AFEX regularly works with clients who are inclined to see their FX exposure as an opportunity to enhance profits, when in reality they’re more likely to be increasing the chances of incurring a serious loss.
Those that take a very short-term, opportunistic view will invariably monitor currency prices obsessively and look to exploit movements with intraday trades and positions. While they may make occasional gains, the longer-term likelihood of benefiting is minimal and it is better to encourage clients to focus on being profitable in their core business.
Options are open
At the same time, there are financial products available that open up opportunities to go beyond merely locking in a fixed price. Doing so, with forward contracts, remains the most popular approach for the majority of AFEX clients. It’s worth noting, though, that those contracts – with prices calculated by adjusting current (spot) rates to take into account interest rate differences between two currencies and time to maturity – don’t entirely remove the downside of an adverse currency movement. If a currency is likely to move, then its forward rate should reflect that. Nonetheless, forward contracts offer a hedge against any unforeseeable volatility in the market and, most importantly, enable businesses to build fixed, reliable forecasts from expected cashflows.
While forwards offer a safe means of securing a rate, options contracts offer a more sophisticated means of hedging against currency volatility – in simple terms, and for the majority of clients, they limit the downside of adverse currency movements while retaining some potential upside if exchange rates move in their favour.
By way of example, any UK businesses currently trading with the US, and foreseeing increased interest rates in that market relative to those in the UK, might consider a contract which structures options on the US dollar (USD).
A so-called forward-extra (sometimes known as a risk-reversal or forward-plus) would offer a ‘protective rate’ – effectively guaranteeing the purchaser a price for dollars if the currency strengthens against sterling. If the market moves the other way and the dollar weakens, the opportunity may arise to exploit that shift and buy at a cheaper rate.
On any single option there is a premium involved, but based on personal experience the vast majority of corporate opt to structure options contracts that are zero-premium, effectively by offsetting the cost of one option with another.
In structuring those contracts inevitably that upside is reduced to an extent, but the ultimate gain is in guaranteeing a ‘worst-case’ price while keeping the opportunity to exploit a better one if available.
It’s also very unlikely that dealing only with options contracts will be the best approach. For AFEX’s larger clients typically the recommendation made is for a combination of forward contracts, options and buying in the market at the spot rate. Doing so creates a diversified currency portfolio with the obvious risk management benefits.
Make FX a non-event
The currency market is vast, with values equivalent to several trillion dollars being traded each day. Within that daily activity it can be seen that huge trades barely move prices, while lesser ones can have a significant impact. It’s that seemingly random quality that makes trading currency for its own profitable sake a risky business and while the temptation to play the market to boost the bottom-line is inevitable, CFOs and treasurers would do far better to stick to driving profits from their core business.
Wherever possible, AFEX encourages treasurers, be it through forward contracts or more complex tools, to make currency a non-event. In the long run it’s that approach which will pay off.
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