Treasurers scramble to navigate FX headwinds as greenback soars
Corporates are increasingly turning to VaR techniques to help them cope with FX challenges unleashed by the soaring US dollar
Corporates are increasingly turning to VaR techniques to help them cope with FX challenges unleashed by the soaring US dollar
The US dollar is soaring again with little sign its strength will ease any time soon and with volatility and rising rates globally pushing up the cost of hedging currency risk, treasurers are under intense pressure to review their FX strategies and ensure they are fit for purpose.
Major companies including Coca-Cola and Microsoft have already declared a hit to their first quarter profits due to the negative impact of a strong dollar on their financial results. They are not alone in suffering FX headaches. The Currency Impact Report, the latest quarterly reading by Kyriba on the impact of FX exposures among 1,200 multinational companies based in North America and Europe, reveals a combined impact of $11.21 bn to earnings from currency volatility in the fourth quarter.
The report, published in May, shows North American companies were significantly exposed to the strong dollar, reporting $4.56 bn in collective headwinds in the fourth quarter of 2021, a 390% increase compared to the previous quarter and a reversal on a three-quarter streak of declining FX impacts.
Commenting on the findings, Wolfgang Koester, chief evangelist of Kyriba, says: “Corporate risk managers face a difficult challenge as inflation and currency volatility are increasing due to the myriad issues impacting global markets. We are seeing a doubling or tripling of their portfolio currency risk and the cost of hedging is also increasing.”
David Jones, chief market strategist at investment trading platform Capital.com, says the US dollar is already up 12% against the dollar index (comprising a basket of currencies) this year, representing a two-decade high against both the Japanese yen, and euro, which is hit parity earlier this month.
“The US dollar started July with the same bullish tone we have seen over the last few months,” says Jones. “Many market watchers, myself included, would have thought that it was vulnerable to at least some sort of correction from its overstretched position but with ongoing concerns about inflation; an aggressive rate hike policy from the US Federal Reserve; a slow-to-react European Central Bank; and of course some political uncertainty in the UK, it continues to be the destination of choice when it comes to foreign exchange.”
The US dollar index has been rising since May 2021 and the trend has accelerated since February this year when Russia invaded Ukraine, according to Jones.
“It still remains very much a ‘buy the dip’ market but sell-offs so far have been short-lived,” he says. “The big drivers on sentiment going forwards will be monthly inflation numbers to see if there are any signs of the spiral slowing and the Fed’s tone on inflation. Until we get some real change here, it is likely that US dollar strength will remain the order of the day.
“It seems unlikely this market will suddenly reverse overnight and finish the 15-month trend. The second half of the year will still see further gains, albeit at a slower pace than in the first half of 2022.”
Andy Gage, SVP, FX solutions and advisory services at Kyriba, says the current strength of the dollar is the culmination of a number of macroeconomic and geopolitical events, notably the pandemic, global supply chain disruption, and the war in Ukraine.
“The combination of those shocks has created a very complex currency situation for corporates. It was back in March-April 2020, during Covid, that things really started to unravel,” says Gage. “We saw a very sharp spike in volatility then – that was the initial step for the dollar run.
“Each successive crisis has created more volatility and one of the most challenging aspects of all that for treasurers is that it has created a lot more uncertainty.”
When it comes to managing currency risk the goal from a corporate standpoint is to neutralise the effect of currencies on financial performance, according to Gage.
“What treasurers really want to be able to say to the CFO at the end of the day is that currency has had no impact on their company’s financial performance,” he says. “The perfect theoretical FX execution is neutral – a gain is just as bad as a loss because it’s indicative that you don’t have proper controls in place.”
While volatility and uncertainty can create considerable headaches for treasurers in analysing the market and developing optimally priced, efficient execution strategies, Gage says “the scariest part, the most challenging dynamic right now” for them is the impact of inflation and the increase in interest rates.
“As a key element of the pricing of derivatives for hedging foreign currency risk includes the interest rate differential between the two economies, rates have a profound effect on the cost of hedging.”
To illustrate the impact of rates on FX pricing, Gage points to the experience of one client that historically has had in place a highly effective hedging programme but due to the recent series of rate hikes has seen its costs grow by half a million dollars a quarter. In instances where treasurers are exceeding their budgets for managing FX, inclusive of gains and losses, the CFO may well deem the performance unacceptable and ask them to develop alternative solutions, he says.
Gage is spending increasing amounts his time working directly with clients to help them navigate the turmoil. One good practice he recommends to them when its proving expensive to hedge is find a way to avoid the need to hedge altogether, or lower the amount being considered.
He stresses, however, that to execute such strategies, companies need to have a clear understanding of their unique FX flows, assets/liabilities, and how currency movements may impact them.
Indeed, Gage has found that what often causes a client a great deal of FX headache is intercompany activity that traverses multiple currencies. Buying and selling products and moving them through the company’s internal supply chain across different currencies, for example, can add to FX limits and result in significant losses.
Potential actions to reduce that internal exposure could include settling intercompany transactions on a timelier basis. If payables are increasing exposure, paying them off sooner could help. And if there is excess cash denominated in non-functional currencies that are adding to foreign exchange risk consider converting them.
“Treasurers and CFOs need to be meticulous in reducing FX risk in areas where the company itself has control – that’s a very strong best practice for them in the current climate. We see a lot of companies trying to do just that,” says Gage.
The VaR option
Addressing FX hedging parameters and figuring out the most efficient way to achieve programme objectives becomes more complex when conducting business across a large number of currencies.
This is where Value-at-Risk (VaR), a sophisticated, statistical, data-driven approach to managing risk can play a key role. The technique blends the exposure of a portfolio with market volatilities and currency correlations to generate a measure of the portfolio’s overall risk. The technique is increasingly finding favour with corporates looking for a solution that can operate in the current, very dynamic environment, says Gage.
“VaR can make a big, positive, difference to FX management and it is one of the most pertinent aspects of conversations that treasurers and CFOs are having now when it comes to FX. If you are trying to get FX budgets back into alignment VaR is potentially a powerful tool.”
As a technology-led solution, VaR offers some big advantages to corporates versus relying on their banks for help.
“Banks can offer a lot of consultative and advisory support. They can bring in teams and the clients can give them data, and they’ll go off and get their very smart mathematicians and risk consultants to come up with different risk profiles in them,” he says.
Gage adds: “The challenge here for corporates is in return for providing that additional advisory service, banks may well expect more foreign exchange business from them. Firms will worry that if they don’t give that bank FX business because it provided some strategic FX advice, then the bank may end up charging more on an FX deal to make up for that involvement.”
The demanding operating environment for corporates, combined with the availability of tech-led solutions like VaR, means firms are becoming more ambitious when it comes to managing FX.
According to Gage the big trend now is corporates having the right FX tools and technology at their fingertips: “They often don’t have the time to send exposure data to banks or consulting firms and then wait for their risk consultants to come back to them with their model outputs and recommendations. They want to action things on a much more real time basis, not least because we’re in a very unprecedented time.
“In the current environment, corporates need to be able to run their FX scenarios frequently and immediately, figure out what works best for them, and VaR enables that.”
He cautions, however, that introducing a VaR solution for FX management is not a trivial matter. Treasurers should be prepared to revisit their FX policy with an eye on giving themselves the latitude to leverage much more sophisticated hedging, logic and decisioning VaR enables.
“Be prepared to rethink the overall hedging strategy and appreciate that leveraging VaR technology needs real time data, lots of it. It doesn’t take a long time to make the required adjustments. It’s also key to work with vendor partners that allow you to be agile and help you respond to complex, fast-moving environments. In six months’ time, for example, we will see the jaws of the recession coming at us and it’s going to be another very different dynamic then.”