Since the financial crisis, national regulators have been tasked by industry bodies – such as the International Swaps and Derivatives Association (ISDA) – as well as international market participants to create frameworks that reflect the global nature of financial markets. However, with national regulators driving their own agenda, informed by regional political climate, regimes have diverged somewhat, creating both frictions and opportunities for those market participants active in different geographies. With nationalised agendas seizing global markets, one thing that treasurers and risk managers must assess on a daily basis is foreign exchange (FX) risk, as they move funds between jurisdictions.
FX risk management is far from a new phenomenon. In and of itself, FX exposures are a straightforward concept: it arises principally from the requirement to convert a cash flow or amount in one currency into another as the result of a transaction or internal transfer. As the value of two currencies changes in relation to each other, the value of a cash flow in terms of the other currency will also change.
However, FX risk can present a variety of challenges, but the opportunities possible for those in the know who utilise the spot and futures markets also allows firms not only the ability to dilute the risks of moving funds between currencies but to also profit from each transaction. That said, when entering the market, a thorough assessment of different currency risks and currency hedging strategies should be undertaken in order to consider positions, strategies, and timing of deals and transactions. FX management brings with it a slew of different risks.
There are three main risks to take into consideration:
- Economic risk – the possibility that macroeconomic conditions such as government regulation, political stability and interest rates will impact a firm’s net cash inflows from business activities carried out abroad – can have adverse impacts on that company’s competitive advantages. Should a firm not closely monitor the economic environments of the regions in which they operate, they may leave themselves exposed to unwanted currency risks.
- Secondly, transaction risk must be born in mind. This is the risk raised as fluctuations in the exchange rate between the signing of a transaction and it actually going ahead. For example: company A, based in Europe, agrees to sell a commodity or service to company B, based in the US today with the deal agreed at X dollars. The terms of the agreement stipulate that the funds for the deal must be transferred in one week (or, T+7). Between today (T) and T+7 the rate of exchange fluctuates, and company A loses out on crucial funds and puts it at a distinct disadvantage economically should expected returns be greater than those received.
- The third, and final main risk associated with FX and currency risk is around translation risk. Not dissimilar to transaction risk, this is the concern that for organisations operating in foreign markets, currency fluctuations arise between the time of funds being received from third parties or exchanged among subsidiaries, and the firm reporting its quarterly and annual financial statements. It’s widely accepted that the larger proportions of assets and liabilities denominated in a foreign currency, the greater the translation risk. Note the difference between translation and transaction exposure in that with the former an actual cash flow may not be involved at the time that the risk arises.
Advantages in risk
While the risks may seem substantial active risk and treasury managers can build sophisticated currency hedging programmes to reduce the exposures to FX risks and ensure greater levels of certainty when active in different currency regimes. Often, firms will take up exposures in the futures markets, entering into contracts, trading currency derivatives and analysing the spot markets to get a better understanding of their financial weight, exposures, and where changes to the market could alter where they are in the weeks and months to come.
Currency hedging – if assessed and performed successfully – is considered a useful tool in financial risk management. There are a variety of tools and procedures a firm may wish to utilise when considering entering the futures markets, but perhaps most popular are put and call options. Options are contracts that provide the holder with the option – but not the obligation to carry out a specific transaction at a certain time in the future. Call options provide the holder the right to buy an asset, currency or derivatives at an established price (the strike price) within a specified timeframe. Should the real market price of the asset, or currency, be lower than that outlined in the call option, the holder of the contract can go to the market instead and simply pay the fee for holding the contract.
Put options are the exact opposite of calls, in that they provide the holder of the contract with the right to sell an asset or currency at an agreed strike price within the timeframe stipulated in the contract. By entering into such options agreements, firms have the ability to better control the price at which they buy or sell a certain volume of a currency, and hence control their risks. Options contracts and derivatives range from the straightforward “vanillas,” such as those described above, to the more complex – two and three legged options contracts – as well as those considered “exotic”.
When managing FX risks and considering currency hedging, a firm should bear in mind a number of key factors: the location of the firm’s production or service facilities in relation to its customer base; markets in which the firm purchases services or goods; the nature of the products or services sold by the company – and how exposed they are to currency fluctuations and currency risk; the selection of the markets in which firms sell their products, considering transaction risk in particular; strategic financial decisions such as the currency denomination of debt and capital held; the extent to which cash flows in various currencies can be matched; and pricing policies, and the degree to which a firm can be flexible in response to changes in the economic environment both domestically and abroad.
Within these core principles, firms that operate across jurisdictions must actively consider their risk profiles on an ongoing basis. That is, the amount of risk it is willing to take on at any given time and within the economic environment it finds itself exposed to. In considering the risk profile, the firm’s risk and treasury managers must consider the economic, transaction and translation exposures, weighing each separately and together within its portfolio. It must consider the limit at which exposures may turn into losses, and what would then become the limit at which losses become unacceptable. Further, it must consider if currency hedging is an option, and if so to what extent the firm is willing to potentially expose itself further in futures markets, and with which tools.
“Since the Dodd Frank Act was instigated in the US, and more recently the second Markets in Financial Instruments Directive (Mifid II), global markets have undoubtedly become more fragmented.”
Since the Dodd Frank Act was instigated in the US, and more recently the second Markets in Financial Instruments Directive (Mifid II), global markets have undoubtedly become more fragmented. That puts a variety of pressures on firms operating in more than one jurisdiction to ensure business processes and regulatory procedures are adhered to. But it also raises firm’s awareness to the different climates and diverging economic circumstances across borders, with the likelihood that regulators will continue to diverge in their approaches to risk and treasury management protocols, which could also be reflected in wider economic policy and direction.
That could mean differing policies on interest rates – which would lead to varying rates of inflation across the globe and a greater need for firms to monitor their currency exposures, which could indeed increase. However, as has always been the case when operating across currencies, those monitoring their currency risks and FX exposures most closely, and with the utmost frequency, are likely to come out on top when it comes to succeeding in today’s global markets.
Related reading: What are the objectives of liquidity management?