In a post-recessionary environment, the growth of international trade means that increasing exposure to foreign exchange (FX) risk has to be managed against a background of an increased pressure to realise returns, at the same time as the overall risk appetite is substantially reduced. No wonder that FX risk management has become a high priority and not simply a technical issue for corporates.
Risk Reduction and Transfer
Typically, corporate treasurers use a variety of hedging strategies to manage and control FX risk. Almost by definition, risk reduction and risk transfer can be achieved in effectively any scenario, but each solution carries a cost: counterparty risk acceptance has a price attached. So the simplest FX risk management strategy – static hedging – is to pay the cost of an appropriate derivative such as an option, swap or insurance contract, and lock in reduced risk. Beyond this approach, which treats the corporate treasury simply as a cost centre, more dynamic strategies may involve active exploitation of arbitrage opportunities between currency rates. Since exchange rate fluctuations have to be managed anyway, the opportunity to profit from the process can bring additional financial advantage. The downside may well be constrained risk reduction. In effect, in the typical FX management process of global treasuries, there is a three-way trade-off between risk, cost and profit. The solution to the trade-off will differ from company to company depending on its overall risk appetite.
However, in the new financial and economic landscape, chief executive officers (CEOs) of companies within and operating into the Asia-Pacific region are realising that effective, and cost-effective, FX risk management involves much more than this.
Transparency and Visibility
Let’s take a step back. In order to manage FX risk it is necessary to locate and quantify it. This isn’t necessarily as easy as it sounds in complex multinational corporations. The FX implications of any transactions and contractual obligations entered into at subsidiary level may be hidden within consolidated figures returned to global headquarters. Fortunately, several global banks now offer easy technology that allows multinationals to gain clear visibility of FX exposures without the costs associated with standardising all their enterprise resource planning (ERP) systems – or even requiring them to be on the same version.
Once exposure is clearly quantified, the need for direct risk mitigation strategies can be controlled and reduced by operational strategies. These should be located within an overall corporate structure of risk management policy strategy and procedure that once again mirrors the strategic risk positioning of the corporation. For example, intra-group structures and relationships are a key source of potential risk – and hence of potential benefit if they are managed correctly. Where are balances kept and in which currencies? Do FX exposures match the respective trading risks? What is the financial relationship between subsidiaries and the global parent? How are they financed, by loans or by equity? In which currencies are they denominated? Effective reconfiguration of these relationships can lead to a more ‘natural’ and automatic hedged position, reducing exposure without direct financial cost.
Externally, however, it is the different contractual relationships with third parties – both customers and suppliers – that determine the nature and extent of FX exposure. Here, the payments process plays a key role. Every cross-border payment has foreign currency exposure risk. When engaging in global trade transactions, many organisations negotiate all agreements in one specific currency such as US dollars or Japanese yen rather than the local currency. They believe they are effectively eliminating exposure to FX rate volatility. This is a common misconception, as FX risk is inherent in all cross-border activity. Even in the absence of foreign currency cash flows, economic exposure to exchange rate movements is inevitable (as shown in the box below).
If the company’s approach is to have a vendor invoice in its headquarters’ local currency, the FX risk is in effect transferred to the vendor. That may seem effective, but as we know, risk transfer almost always carries a cost. Even if the exposure may be hidden it remains real: transferring exposure most likely means the company is overpaying.
Central Ownership and Expert Support
Managing the overall risks in the most effective manner requires central co-ordination, even if it does not necessarily imply transfer of operational ‘ownership’. Many multinational companies have global banking relationships with a large number of different banks. Often, this is a consequence of the global expansion process, where each local entity opens up a relationship with a local bank, in the absence of global oversight. Regional treasury management can’t really address this issue: some sort of central influence is necessary.
Once a high-level coherent structure of responsibilities has been created, a central relationship with a sophisticated global bank can open up new approaches to cross-border payments and FX risk. Global treasurers don’t have to be experts in foreign currency exposure management: all major banks provide that service. The FX ‘desk’ will provide advice on specific queries. Automated online tools are available to help develop programmes and strategies that can then also be automated.
The trick is to centralise what is appropriate. In many instances, treasury activity is with business units. It is possible to leave the payments with the business units (they are most in touch with vendors/suppliers), but centralise everything beyond that. This allows information on cash flow timing and cash flow currency to flow to a centre where there are treasury skills that know how to analyse that information and make recommendations, or see a problem coming and deal with it.
Ensuring the Correct Tools and Partners to Afford Flexibility
More flexible arrangements for payments, receipts and tracking and managing accounts allow stronger defence against dislocations in the market. As with risk transfer, conventional wisdom says you pay for flexibility and generally that is true. Although this may seem expensive, it depends upon how the company is organised and who it partners with. Flexibility can flow from having good access and good information. If flexibility is part of day-to-day operations, it becomes less of a risk and brings benefits as well as costs. As an example, when doing business in other markets it is important to select a provider that can readily convert receipts and payments, provide detailed reporting, and deploy automated solutions to optimise liquidity in multiple currencies outside the time zone of the Asia-Pacific group treasurer.
Challenges of FX Payments
Asia-Pacific-based importers and exporters face several challenges when negotiating in local currencies:
- Inflated prices – local banks may charge the importer excess premiums to convert into their local currency. Also, the vendor will receive less local currency at conversion.
- Loss of control of exchange rate risk – if the home currency falls in value against the foreign currency, the cost of payments will increase.
- Risk of payment delays – home currency transfers sent internationally can take up to three to five business days to reach the vendor, while payments sent in the local currency in some cases can be delivered the same day.
- Lost sales opportunities – an export firm’s customers may choose a competitor’s substitute product because it is priced in the local currency.
- Risk of payment delays – if the home currency strengthens significantly against the customer’s local currency, the customer may be more inclined to wait for the exchange rate to improve in their favour before sending a payment.
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