LinkedIn Pulse: Foreign Exchange Risk in 2016: Laying the Foundations for Managing Value
With the UK Referendum on EU membership scheduled for 23 June 2016, currency volatility is front and centre of many companies’ agendas. However, for businesses with multi-currency operations, volatility has been a concern for some time and the recent slide in Sterling is one of many considerations, with the US Presidential election, the stability of the Eurozone and the growth prospects for China ever present in the background.
Company boards, Audit Committees and shareholders are increasingly considering risk management strategies in relation to foreign exchange, questioning whether their current strategy remains relevant in changed and changing market conditions. Questions we hear on a regular basis include:
- What happens to our business if GBP-USD moves 10%?
- Why would I take risk management action/ hedge now when rates have moved against me?
- Although I purchase from China, I pay in EUR so why should I be worried?
- I believe rates will move back in my favour so why should I do anything?
With these questions and many others, there are no simple answers, but that is no reason to avoid a review of an existing or establishing a new risk management strategy. Solutions are available.
Fundamental underlying questions for those new to using derivatives to manage currency risk include?
- Does senior management have a view on an acceptable amount of currency risk to take within the business?
- Do the investor(s) and Board truly understand derivatives and how they can be used to help the company manage risk?
- Do I have a risk management policy in place?
- Do I have a handle on any required regulatory processes?
- Do I have a willing and appropriate counterparty(ies) and potential credit providers?
- Do I understand the accounting implications of any derivative transaction?
Some “no” answers might push a company simply not to address currency risk, or to accept the status quo. However we believe there are four critical building blocks for a sound approach and laying the foundations for successfully managing foreign exchange risk.
When it comes to the topic of derivatives, there is almost always some necessary level-setting to do amongst the Board and company management, and sometimes shareholders. The key to education is keeping the conversation focused on quantifying the risk and ultimately offering simple, easy to explain alternatives to mitigate the risk:
- Forwards – entering into a contract to buy or sell a specific value of currency at an agreed exchange rate on or by a determined future date
- Options – purchasing a right, but not an obligation, to buy or sell a specific value of currency at an agreed exchange rate on or by a determined future date
There are more complex structures that can be utilized, but all would comprise elements of the building blocks described above. Additionally, strategies that involve more complex derivative products have more opaque pricing and often provide hedging banks the chance to include additional fees.
Getting everyone on the same page will help any finance team move forward with a more clear understanding of the benefits (and implications) of derivatives and the ways risks can be managed. This must include ensuring the accounting implications are fully understood.
2. Understanding the Value at Risk
There are three components to assessing Value at Risk, which for a corporate can be defined as the potential range out outcomes of a key metric over the course of a year.
- Determining the Value to be managed – Revenue, EBITDA, net income/EPS, operating margins, cashflow, and equity value are all examples of metrics used by organizations. The priority(ies) will be different for companies and will be influenced by many factors including ownership (public vs. private), leverage and covenants, dividend policy, investment programmes, stage in lifecycle (particularly for portfolio companies of funds) for example.
- Accurately measuring the Value at Risk. This is influenced by the quality of the input data, the detailed analysis and the correlation of the currencies within the business. One key flaw we often see when risk is measured is that currency pairs are looked at in isolation. The question “What happens to our business if GBP-USD moves 10%?” should not be thought about as a simple recalculation of GBP and/ or USD transactions as other currency pairs will move alongside any such move which could increase or decrease overall risk in the business.
- Running appropriate shock scenarios is key – a 10% shock may not be high enough in some circumstances. Many currencies and commodity prices have been subject to 2 standard deviation moves over the course of the past year, thus indicating a need to truly capture “tail” risks inherent in these markets.
Failure to establish the Value at Risk accurately creates an unstable foundation and could result in an inappropriate risk management strategy which at a minimum does not achieve desired results and in the worst case can add financial risk.
3. Policy and programme approval
Just as you wouldn’t begin a long road trip without a map or GPS device, a hedging policy is critical to setting up the appropriate boundaries or ‘guardrails’ prior to entering into derivatives transactions. The hedging policy should fit hand-in-glove with the company’s overall treasury policy in terms of establishing the goal of the risk management programme (desired destination) as well as the specific tools that the investor(s)/ company will consider using (choice of road).
By identifying the risks that the investor(s) and company are attempting to manage and by making it clear that derivatives will never be used speculatively, the policy will communicate to all stakeholders that they intend to be thoughtful about choosing an appropriate hedging strategy.
The policy will be informed by the assessment of Value at Risk and materially influenced by the risk appetite/ tolerance of the Board and senior management, as well as confidence in budgets and forecasts. It will also take account of materiality and programme efficiency, as well as setting review protocols.
4. Counterparty selection
If you think of a currency derivative contract like an insurance policy that pays a claim, then you want to make sure you know who is making the promise to protect you, how likely they are to back up that promise and whether they can provide you with the best and most appropriate protection at a fair price. Whilst it is common for derivative counterparties to be the same institutions as the lenders to the company, this is not and should not always be the case:
- Some lenders are not able to be derivative counterparties
- Some lenders may not be competitive on pricing or terms for a multitude of reasons
- Advice may be based on their capabilities and experiences, not on your needs.
Understanding who the potential counterparties could be and reviewing the counterparty pool should ensure the best “insurance” is purchased.
Finally, keep in mind that there is no such thing as an unregulated hedge in the era of Dodd-Frank and EMIR. Ensuring compliance is no small matter, and is critical to consider when implementing a currency hedging programme.
In the busy work streams of boards and management, finding the “right” time to address currency exposure policy is always challenging, and often it arises at crisis time, when the pain is already felt by the company. Making time now, to review your risk management policy, should reduce the risk of crisis in the future.
In the words of Johann Wolfgang von Goethe:
Knowing is not enough; we must apply.
Willing is not enough; we must do.
Victoria Bell is Director of Client Relationships for Corporates and Private Equity Funds in Europe at Chatham Financial.
Chatham Financial is an independent global leader in financial risk management providing comprehensive interest rate, foreign currency, inflation and commodity hedging expertise and comprehensive services and technology solutions to more than 2,500 companies across a broad spectrum of industries worldwide.