Managing FX currency risk

As the dol­lar strength­ens against the euro and emerg­ing mar­ket cur­ren­cies, both Euro­pean and Amer­i­can com­pa­nies are find­ing that move­ments in the cur­ren­cy mar­kets can dis­rupt earn­ings.  With­out effec­tive man­age­ment, rev­enue from export mar­kets and costs from for­eign sup­pli­ers can fluc­tu­ate, undo­ing the poten­tial ben­e­fits of oper­at­ing in a glob­al mar­ket.

This volatil­i­ty seems set to con­tin­ue, accord­ing to Ron Lev­en, head of FX pre-trade and eco­nom­ic strat­e­gy at Thom­son Reuters. “It’s no coin­ci­dence that the upturn in volatil­i­ty we’ve seen since the mid­dle of last year has par­al­leled the mar­ket pric­ing-in of ris­ing inter­est rates,” he says. “It’s prob­a­ble that if high­er inter­est rates in the Unit­ed States con­tin­ue, we’ll see high volatil­i­ty and a stronger dol­lar.

“This cre­ates cred­it-relat­ed risks because much of the world, par­tic­u­lar­ly the emerg­ing world, is dol­lar financed. It would also poten­tial­ly put pres­sure on cur­ren­cies that are pegged to the dol­lar and will there­fore strength­en, thanks pure­ly to that link rather than any­thing in their own economies.”

Major uncer­tain­ty and volatil­i­ty in the euro­zone is being caused by a pos­si­ble “Grex­it”.  How­ev­er, Mr Lev­en points out that even if Greece remains with­in the euro, man­ag­ing its tran­si­tion to a bet­ter func­tion­ing econ­o­my will still cre­ate pres­sures pos­si­bly lead­ing to a re-pric­ing which will affect oth­er coun­tries.

The cor­po­rate trea­sury depart­ment will need to iden­ti­fy the extent to which they can tol­er­ate cur­ren­cy move­ments and when their earn­ings fore­cast starts to look at risk

Set against the back­drop of these Euro­pean and wider glob­al chal­lenges is a renewed focus on for­eign cur­ren­cy risk man­age­ment, in par­tic­u­lar an increased pres­sure to opti­mise work­ing cap­i­tal and ensure effi­cient cash man­age­ment. Giv­en these fac­tors, how can cor­po­rate trea­sur­ers look to lever­age the lat­est tech­nol­o­gy to man­age their for­eign exchange (FX) risk effec­tive­ly?

The first step, says Neill Pen­ney, head of FX work­flow at Thom­son Reuters, is for com­pa­nies to recog­nise the inher­ent risk and devel­op a strat­e­gy for man­ag­ing it. “A company’s cor­po­rate trea­sury depart­ment will need to iden­ti­fy the extent to which they can tol­er­ate cur­ren­cy move­ments, as well as iden­ti­fy­ing when the earn­ings fore­cast they pre­sent­ed to their investors starts to look at risk,” he explains.

“That can dri­ve strate­gic deci­sions, such as where to locate fac­to­ries, in order to cre­ate nat­ur­al hedges where income and costs are in the same cur­ren­cy. It also affects more trans­ac­tion-ori­ent­ed solu­tions, such as whether they’re hedg­ing out par­tic­u­lar pay­ments or rev­enues.”

The sim­plest strat­e­gy for cor­po­rate trea­sur­ers is to lock in rates for their expect­ed for­eign cur­ren­cy pay­ments and receipts. “For exam­ple, if they know that in three months they’ll receive approx­i­mate­ly $1mil­lion-worth of for­eign sales, they might decide to exchange those receipts ‘for­ward’, lock­ing in the rate today for the cur­ren­cy exchange in future. This means that what­ev­er hap­pens to cur­ren­cy rates over the next three months, they’ll know the rate they’ll receive and hence the amount in their home cur­ren­cy,” he says.

To ben­e­fit from this and oth­er for­eign exchange strate­gies, more and more cor­po­rate trea­sur­ers are rely­ing on tech­nol­o­gy to access essen­tial data from which they can make more informed deci­sions about their for­eign cur­ren­cy hedg­ing.

Faced with the need to achieve greater effi­cien­cy and automa­tion, they are on the search for desk­top and mobile solu­tions with tools that pro­vide easy access to trust­ed news, data and ana­lyt­ics, all fil­tered by rel­e­vance to the user’s needs and dis­played in a high­ly visu­al way that’s easy to under­stand and act on.

[embed_related]

As an exam­ple, cor­po­rate trea­sur­ers may look to solu­tions that pro­vide a bet­ter under­stand­ing of the fixed rates avail­able for hedg­ing their FX expo­sures at dif­fer­ent time hori­zons. “This is the so-called for­ward curve and it’s deter­mined by the dif­fer­ence in inter­est rates between the two cur­ren­cies, rather than the market’s view of whether a cur­ren­cy is going to go up or down in the future,” says Mr Pen­ney.

“A cor­po­rate trea­sur­er study­ing the curve may decide that cer­tain matu­ri­ties on it look par­tic­u­lar­ly cheap or expen­sive, depend­ing on their own view of the cur­ren­cy risk. Our trad­ing tools let cor­po­rate trea­sur­ers refine their views by ask­ing for trad­able prices from their FX bro­kers. These prices will depend, of course, on a company’s cred­it rat­ing, the size to be trans­act­ed and the broker’s appetite for that cur­ren­cy at that time.

“The trad­ing tools then let the trea­sur­er move seam­less­ly from com­par­ing prices to trad­ing with the bro­ker of their choice and final­ly to auto­mat­i­cal­ly book­ing the trade in their trea­sury man­age­ment sys­tem. Our sys­tem also cap­tures prices from the oth­er bro­kers, as well as the orig­i­nal indica­tive price, so the trea­sur­er can sub­se­quent­ly estab­lish ‘best exe­cu­tion’ in line with their company’s trad­ing poli­cies.”

How­ev­er, increas­ing­ly, cor­po­rate trea­sur­ers are now opt­ing for a more sophis­ti­cat­ed approach using options, accord­ing to Mr Pen­ney. “The dol­lar is get­ting stronger now, so if you’re a US com­pa­ny that’s sell­ing abroad, you’ll find the same num­ber of euros earned in an export mar­ket gen­er­ate a decreas­ing amount of dol­lar rev­enue. A cor­po­ra­tion might decide that it can tol­er­ate a gen­er­al rise, but at a par­tic­u­lar lev­el the sit­u­a­tion becomes crit­i­cal because the company’s earn­ings fore­cast is now at risk,” he explains.

“Options enable the com­pa­ny to craft a hedg­ing strat­e­gy around that par­tic­u­lar rate. They’ll be able to ensure the com­pa­ny achieves its tar­get lev­el under a much wider set of mar­ket con­di­tions than using for­wards to hedge. But in return, they have to give some­thing up. This might be, for exam­ple, accept­ing a worse exchange rate than a for­ward-based hedge should the mar­ket not move as far as the tar­get lev­el. Over­all, they have a more effec­tive hedge because it’s tai­lored explic­it­ly to their crit­i­cal lev­els and holds under a wider range of mar­ket move­ments.”

Mr Pen­ney adds: “Usu­al­ly, rather than a sin­gle option, cus­tomers will want a strip of options that match the var­i­ous pay­ments and receipts they’re expect­ing. Design­ing a hedg­ing strat­e­gy is best done by exper­i­ment­ing with dif­fer­ent what-if sce­nar­ios. It involves find­ing a bal­ance between the dif­fer­ent mar­ket risks the trea­sur­er is con­cerned about and the cost of neu­tral­is­ing those risks.”

With accu­rate infor­ma­tion and mod­el­ling tools to hand, cor­po­rate trea­sur­ers can work more effec­tive­ly with their FX bro­kers. Many of them find elec­tron­ic trad­ing plat­forms fur­ther help them by automat­ing the exe­cu­tion and book­ing of the select­ed hedg­ing strat­e­gy.

It seems as if the glob­al eco­nom­ic and polit­i­cal uncer­tain­ty will con­tin­ue, with the effects on for­eign exchange mar­kets pre­sent­ing seri­ous chal­lenges to com­pa­nies trad­ing abroad. In this volatile world a proac­tive, for­ward-look­ing hedg­ing strat­e­gy, sup­port­ed by accu­rate, time­ly infor­ma­tion, is essen­tial for cor­po­rate trea­sur­ers.

Thom­son Reuters offers a com­pre­hen­sive range of solu­tions for cor­po­rate trea­sur­ers. For more infor­ma­tion vis­it financial.thomsonreuters.com/corporate-treasury