Post-crisis Market Challenges in Managing Currency Risk
Developing and implementing a workable foreign exchange (FX) risk management strategy is a key requirement for many businesses. The need has been magnified in recent years, given the eurozone crisis and the huge uptick in volatility in the FX markets and the increasingly globalised market space shared by corporate entities. It is particularly important that corporate treasurers have a grasp of the FX market’s key drivers and how best to mitigate currency risks.
Many corporates have been forced to quickly develop an FX risk management strategy, or revisit and sharpen up existing strategies, due to increasing market volatility. Unmanaged exposures can lead to adverse impacts on profit and loss (P&L) and liquidity, potentially putting the company itself at risk.
Well-developed strategies should align with the overriding objectives of the business, which might seem obvious yet can sometimes be overlooked. Once this is defined, the business can drill down and document a clear currency hedging strategy which involves key stakeholders and is signed off by the board. A vital part of this process should include targeted benchmarking to assess the effectiveness of the strategy undertaken versus the underlying exposure hedged.
Businesses must look at information produced internally to define existing and future exposures after internal FX risk-netting opportunities have been accounted for. Techniques to evaluate risks will vary in relation to the sophistication of the treasury department, but tools such as value at risk (VaR) or cashflow at risk (CFaR) are often useful. This is a fundamental and often complex area, where the scale of risk that the corporate is facing must be quantified.
Once the risk has been identified then businesses can move to hedge, using instruments such as forward contracts, options, swaps, debt instruments and futures. Like most things in the financial markets, you can make hedging as simple or complex as you like. Forward contracts are a good place to start because they represent the easiest and lowest cost product to reduce market risk.
The main risk management objectives identified by businesses are to minimise earnings volatility and manage transaction risk. As such, identifying trends and upcoming events that are likely to have a significant impact on exchange rates is vital. A number of events on the horizon could have a significant impact on the state of the currency markets, from the imminent US ‘fiscal cliff’ to the continuing European sovereign debt problems and, more recently, the snap election in Japan. With interest rates at or near zero across the developed world it is the financial markets’ interpretations of these events that is driving volatility and the market view can change rapidly in the light of new information. FX risk management policies should therefore be reviewed regularly, particularly in the current climate where a single central bank action can be enough to throw the best-laid plans off course.
Legacy of the Banking Crisis
If we review where the currency markets are positioned today, then it is clear that the 2008 financial crisis still hangs over the world economy almost five years on. Central banks had to step in to prevent a full scale meltdown of financial markets, and since then we have witnessed an unprecedented array of monetary easing and a race to the zero bound. The aim was to get credit flowing again for businesses and consumers, but lower interest rates were also aimed at influencing exchange rates and stimulating international export sectors. While fine in theory, monetary quantitative easing (QE) by one central bank usually prompts action by another. Thus we have seen large swings in most markets on the back of monetary stimulus, as each country pursues domestic policy objectives at the expense of other nations by devaluing its exchange rate. We now inhabit markets almost completely controlled by central banks, with the US Central Bank leading the way in unconventional measures and economic fundamentals taking a backseat.
In September 2012, the Federal Reserve sparked a speculative frenzy into risk by announcing QE3, a third phase of quantitative easing, in the form of unlimited US$40bn monthly purchases of mortgage backed securities (MBS); low rates until at least 2015; and the continuation of the so-called ‘Operation Twist’ maturity extension programme in an effort to stimulate labour market growth.
We have also seen central bank action across the rest of the globe with the UK, Switzerland, Turkey and the rest of Europe getting in on the act, as well as China and Japan. The sheer length, depth and scale of ongoing monetary easing are seemingly endless with the Fed’s latest escapade being dubbed by the financial markets as ‘QE for Perpetuity’ (QEP).
The aftermath of the US Fed decision was marked by a distinct rally into nearly all asset classes as a defined move into risk abounded, subsequently driving the US dollar lower across the markets. The unprecedented action has once again reignited a fierce debate that QE3 will exacerbate currency-related conflict as the market moves away from the traditional safe haven of the US dollar into risk-based assets with the hope of riding higher. Commodity-based currencies and emerging market currencies fear the brunt of this shift into risk with an appreciation of their domestic currencies. Such appreciation can lead to measures, or at least the threat of measures, to stem any unwanted currency appreciation.
The question remains as to whether the Fed, the European Central Bank (ECB) and other central banks can maintain this systematic boost of stimulus, and whether it will continue to drive markets higher despite severe headwinds. The markets are facing a psychological fight on the credibility of global central banks to continue driving sentiment over and above the underlying real economy.
The FX market is struggling to adjust to this environment as investors and corporates try to gauge how to make money and effectively hedge risk in an environment driven by the central banks. Notably after recent asset purchasing by the Bank of Japan (BoJ), the yen almost immediately showed an appreciation which surprised the markets. In the UK, Bank of England (BoE) governor Mervyn King recently indicated that further expansionary measures may no longer have the impact that we witnessed previously, as the market assumes the policy as a rule rather than an exception. We are beginning to see signs that central bank risk on trade is starting to fade and this will certainly change the dynamics of the FX markets moving forward, potentially leading to greater unpredictability and corrections.
Looking ahead to the US fiscal cliff concerns we can also see how fear is now very much a prevalent driver in the FX markets. We currently have a marriage of fear and risk, which seems incongruent but this has, in fact, shaped currency movements in recent times. The price action in the financial markets as we approach the cliff is increasingly skittish and we have seen a decline in stocks and a rise in the US dollar (USD) as risk is de-leveraged.
Defensive trading has always favoured the dollar and other perceived safe haven currencies. However a failure to effectively tackle the fiscal cliff will undoubtedly lead to increased volatility in the financial markets and potentially a downgrade of the US credit rating. This will also raise a question mark over the dollar’s safe haven status although some will argue that there is no alternative, with China years away from a legitimate currency and the eurozone still battling a debt crisis. Markets currently anticipate further USD appreciation; however some analysts predict that we could see the dollar sold off sharply – dramatically affecting US dollar-based assets.
Uncertainty associated with the range of fiscal outcomes during the tax cliff negotiations and beyond is currently underappreciated, as evidenced by the index volatility markets. Before the US presidential election, there were signs that investors were willing to pay a higher price for risk than in mid-September when QEP was announced. Had the election truly reduced policy uncertainty, we would have witnessed a subsequent drop in implied volatility. However, the considerable gap between the two parties negotiating federal government tax and spending policy – as well as the range of associated outcomes – is a likely catalyst for more volatility, not less. Equally, it seems unlikely that the tax cliff negotiations will provide a solution that will significantly reduce the macroeconomic risks related to fiscal and monetary policy for 2013, at least not without fallout in the markets and compromises being forced.
Furthermore, despite recent euro stability a euro break up or Greek exit is another real concern that would certainly increase uncertainty in the currency markets. A recent BoE survey assessing systemic risk placed sovereign debt and the threat of an economic downturn as the most challenging risks facing businesses in the near future.
In the context of the current market conditions it is very prudent that businesses conduct a regular review of their underlying FX exposures. This could involve scheduling more frequent risk management sessions to review key risk events and the current FX drivers. Lessons learned from the onset of the financial crisis suggest that past performance and historical data may not offer the best indicators of future performance, and while statistical measures can be helpful, they should be used in conjunction with scenario-based analysis with an eye on the key risk events which lie ahead.