Why Foreign Currency Risk is Becoming More Significant

Over the past few years, there has been massive
growth in international trade – the world’s quarterly exports have grown 65%
from US$2.71bn in Q1 2009 to US$4.48bn in Q1 2013, according to World Trade
Organization (WTO) statistics. This growth has been further boosted by the more
prominent role some emerging markets such as China and Brazil have begun to
play on the world stage and by changes in tariffs and regulations that have
facilitated international trade.

Many companies have seized this
opportunity by either sourcing materials or manufacturing products in low-cost
countries, and/or by selling their products and services in new, fast-growth
markets. However, pursuing these growth opportunities and optimising global
supply chains has come at a cost: the increased company exposure to the
volatility of foreign currency rates. For some companies operating outside of
their domestic markets for the first time, foreign currency risk is a
completely new risk that had not been taken into consideration in the past. For
others, foreign currency risk has become a growing source of variability in the
company’s financial performance. As a result of the maturation of the global
marketplace, foreign currency has become one of the most significant financial
risks faced by many multinational corporations.

The starting
point: understanding the impact of foreign currency risk on the
organisation:

In general, the company’s business model and
the industry it operates in determine the extent to which foreign currency
volatility is a concern. In particular, a company’s ability to change prices
(to offset currency rate variation), its cost structure and the billing
currency has a significant influence on its foreign currency risk profile. If
the company operates in a commoditised or otherwise cost-driven market, with
low margins and very price-sensitive customers, its exposure to foreign
currency volatility will be higher, all else being equal, than a company that
has highly differentiated products or that operates in an environment with high
margins and customers that are not price-sensitive.

Regardless of a
company’s exposure profile, the most widespread obstacle it faces is in
developing a enterprise-wide understanding of the nature and magnitude of its
foreign currency risk and how it impacts the company, its competitors and its
industry. This challenge extends beyond simply gathering exposure data and
includes important commercial and operational matters. For example:

  • When quoting prices for products and services in foreign currency, does
    the sales force understand the impact of quoting prices in a different currency
    and the techniques that can be employed to mitigate foreign currency risk?
  • When making sourcing decisions, how does foreign currency risk impact
    the cost base of any product or service?
  • How does the company best
    finance itself to balance the currency risk in its balance sheet to match
    foreign currency assets and liabilities?
  • When business units and
    subsidiaries prepare estimates of the foreign currency cash flows, do they
    understand the impact of providing unreliable forecasts?

These
are some of considerations that show the broader scope of FX risk and how it
impacts not only treasury, but procurement, sales and local business units’
financial planning.

What is the right framework to manage
foreign currency risk?

In practice, we recommend that
companies adopt a risk management framework that enables it to link risk
appetite and objective-setting to business planning, process and infrastructure
elements. The successful implementation of this framework will assist
multinational corporations (MNCs) in managing the impact of foreign currency
price volatility in the company’s financial reporting and business operations,
and maintain it within an acceptable tolerance level.

From a
strategy perspective, there are a number of alternative mechanisms available
that can be employed individually or in combination to manage foreign exchange
(FX) exposure. In the short-term, financial and derivative instruments provide
synthetic offsets to underlying exposure positions, mitigating the impact of FX
risk on current financial performance. Over the medium-to long-term, companies
must also consider a number of administrative, commercial and operational
strategies, including:

  • Frequency of price adjustments.
  • Currencies in which inputs are sourced.
  • Plant locations.
  • Selection of markets in which to sell.
  • Efforts to further
    differentiate products and services to gain pricing power.

As
part of selecting the appropriate hedging strategy, the company needs to
consider the following factors that will ultimately impact its hedging
parameters:

  • Foreign currency risk management objectives in
    combination with a company’s risk appetite will support any decision to
    actively manage exposures or not, and will serve as the basis for establishing
    specific hedging strategies.
  • Risk tolerance will inform which
    exposures and how much to hedge.
  • The risk profile itself will provide
    further insight into the nature and magnitude of specific risks to which a
    company is exposed (transaction, translation and economic exposures) and
    indicate appropriate hedging instruments.
  • The relative accuracy of
    exposure forecasts will influence the hedging horizon, hedging frequency and
    the hedge cover ratios.

The appropriate hedging strategy should
be determined by considering the company’s risk profile in the context of its
objectives and risk appetite. These should be aligned with its overall business
objectives. In order to translate these objectives into an effective strategy,
the company must first formalise its risk appetite (i.e., what exposures the
company is willing to bear, and its capacity for taking on these risks) and
tolerance. A leading industry practice is to quantify the risk tolerance in
terms of maximum acceptable loss and articulate it relative to common
profitability measures used by the company (for example, earnings per share
(EPS)). The comparison of actual exposures versus risk objectives and
appetite/tolerance will indicate what to hedge, how much and with what
instrument.

After setting up the foreign currency risk management
programme, the monitoring of any changes of exposure profile becomes more
important as international trade grows. In particular, the factors that may
impact the company’s exposure profile are a significant acquisition or
divestiture, a change in business model, organic growth outside of home market,
or a specific market issue – for example, what to do if the US dollar
weakens.

In addition, achieving the company’s risk management
objective will require a framework that incorporates sound processes, and
robust governance, organisational and infrastructure elements. These should
include:

  • Risk management governance at both the executive management
    and board levels.
  • Clearly defined accountability for the various types
    of foreign currency risk. 
  • Clearly defined – and broadly understood –
    roles and responsibilities of all parties involved in the FX risk management
    programme, including who is responsible for exposure identification, hedge
    strategy design, programme execution and, importantly, hedge accounting and
    control.
  • Formally documented, approved and communicated strategy and
    policy guidelines to all programme participants.
  • Detailed desk-top
    procedures for the entire end-to-end process.
  • Appropriate risk
    management systems and technology to enable programme effectiveness, efficiency
    and control.

Although many companies still rely on manual
processes to gather, aggregate and net exposures, the growing complexity of
foreign currency risk requires technology that can assist the company
throughout the end-to-end process of managing it. Given the demands involved,
it is fundamental to design a scalable and integrated process (from exposure
gathering, to exposure aggregation, netting, trade execution, confirmation, and
accounting), and use technology to increase visibility and automation along the
process. Any technology tools used for FX risk management should be selected
and implemented in a way that meets the company’s specific process requirements
and should be well-integrated within the company’s overall technology
environment. For example, it is desirable to implement automated interfaces FX
trading platforms and cash management systems as well as business planning and
the financial general ledger to enable straight-through processing (STP).

Recent regulatory changes and growth of international trade are
shaping the future of FX risk management

Recent regulatory
changes (for example, Dodd-Frank and European Market Infrastructure Regulation
(EMIR)) have introduced yet another factor that companies need to consider when
developing a hedging strategy. At this point, it’s important to note regulation
is clearer about the requirements in certain areas (for example, reporting);
while others, including clearing and pre-trade mid-mark pricing, have been the
source of much debate and discussion within the industry and continue to
evolve.

In the medium- to long-term, these changes may bring more
transparency to the market; but in the short-term, market participants should
focus on understanding how these changes will impact FX instruments pricing,
liquidity and their overall FX risk management strategies.

In
conclusion, the increase in overall foreign currency exposure coupled with
recent regulatory changes has brought foreign currency risk again to the top of
the treasury agenda. As such, for any company operating in the global business
environment to be successful, it will need to continue monitoring how these
evolving changes are shaping their own exposure profile, and consider the
alternatives for how they should be addressed going forward.

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