How companies with foreign exchange risk can protect their business from adverse market moves

The liquidity in the foreign exchange market is huge, in fact the daily volume of trade in foreign exchange is USD 5.3 Trillion. London remains the most popular centre by volume with 41% of all FX trading, followed by the U.S. (19%), then Singapore (5.7%) and Japan (5.6%).

Chris Towner comments: “London’s dominance is probably due to its location – FX traders and the global heads of foreign exchange banks tend to sit in London, with the flow coming from Asia, going through Europe and then passing on to the U.S. Whether this will change following Brexit remains to be seen.”

The most popular currency pairings

The most popular currency pairing is Euro/USD. Indeed, 87% of all trades are in USD – this is top heavy with the USD being the main liquidity provider in foreign exchange markets. Towner explained how this works by providing an example: “A Japanese company that wants to buy a UK business for £100 Million, so a Sterling/YEN deal, will look to sell their YEN and they then buy £100 Million. However, the market will trade through the USD, so a trader will buy £100 Million using USD currency and then buy back those dollars to sell the YEN. That is why USD currency is so predominant in foreign exchange markets.”

Towner explained that when companies have a foreign exchange exposure, it’s important to look at the impact of what foreign exchange exposure could be: “So if a business has USD 10 Million of revenue per year, the impact isn’t USD 10 Million – it will depend on the volatility of the market.”

The most aggressive percentage range in the Sterling/Euro rates was experienced during the credit crisis in 2008 (25.2% over the year) which is well above the average range of 12.2%. Towner explained that worst case scenario, if a company had £10 Million of Euros exposure, it could impact their bottom line by approx. Euros 2.5 Million, but on average, it is likely to be closer to Euros 1.2 Million.

Based on data provided by Towner, the Sterling/Dollar rate was seen to be even more volatile, with a 29.6% range in 2008, and an average of 13.3%.

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Members please note: Chris Towner's presentation can be downloaded from the 2017 EMEA Regional Conference page (you will need to be logged in). 

Budget rates

When most corporates sit down to discuss budget rates e.g. if a company has Euro revenues coming in and needs to sell Euros, in 2016 they could have set a budget rate for Sterling/Euro at 1.40. In 2017, this budget rate could have been improved by 10% and still comfortably hedged better than those levels. This would be good news for a UK business that receives Euros.

“The issue we are seeing is on the other side of the equation – a budget would have been set at 1.30 for 2016 - improve it to 1.20 and it is still very difficult to protect in 2017. There has been a reduction in hedging activity going on for corporates that have Euros or Dollars to buy.”

Types of FX risk

Transactional

This is a risk which arises when corporates do business overseas in foreign currency either by importing overseas goods and services or exporting them. The company pays out or receives foreign currencies. Dealing in foreign currencies exposes them to currency volatility, especially when the contract becomes committed.

Translational

This risk arises when a corporate has an asset or liability in a foreign currency e.g. in the U.S. or in Euroland on its balance sheet, and then there is a sharp appreciation in the value of the asset in Sterling terms. Towner explained: “This leads to currency volatility impacting the value of the balance sheet in local currency. This can be hedged as well.”

Approaches to hedging FX risk

Towner provided a step by step approach for companies with FX exposure to follow:
1. First of all, identify the risk and look at whether it can be internally mitigated
2. Secondly, quantify the impact of the FX risk on the bottom line
3. Implement a strategy – there should be a framework or policy. Towner comments: “Many CFO or FDs have too much responsibility, so when FX markets move significantly, Boards can be very unforgiving when a rate drops by 10% but the risks weren’t hedged. Yet if the rates go the other way, the CFO may be asked “Why did you hedge?” Having an FX policy signed off by the Board removes all these emotions!”
4. Conduct the hedging process, ensuring that the business has liquidity margin in place in order to deal
5. Marketing timing and execution.

Event risk and liquidity

Over the years, the FX market has become much more volatile. Towner pointed out that the volume in the FX markets over the last 15 years has more than doubled.

“There are two types of event risk – the known e.g. central bank decisions, elections and referendums – while we know when they will happen, we don’t know the outcomes. And then there are the unknowns or the 'known unknowns' – we know that they happen e.g. terrorism or a hurricane, but we don’t know when they will happen.”

Towner gave an example of one of the biggest moves in the FX markets which occurred in 2015 and was triggered by Switzerland: “The Swiss had been protecting their currency through 2013 and 2014 against the Euro- every time the Swiss Franc went below the 1.20 rate, they would aggressively start selling the Swiss Franc to prop it up and get it trading above 1.20. Then in 2015, the Swiss National Bank announced to the market that it would no longer protect their currency in this way and let the market takes their natural course – the result was that within two minutes, the Swiss currency strengthened by 30% against the Euro to a rate of 0.85. So if a foreign business had had a Swiss asset, this would have appreciated in Euro terms by 30% in just a couple of minutes. In events like these, there is a sharp reduction in volume in that particular currency pair, which leads to a sharp increase in volatility and it becomes very difficult to deal within these illiquid markets.”

Towner explained that the Swiss had a reserve of Euros that was getting bigger than the country’s GDP, so it was at a time when the reserves had become too large.

Impact of Brexit

On the eve of Brexit, Sterling/USD was trading at 1.50, but within two weeks the rate was 1.28. “Brexit gave way to the biggest one day move in GBP/USD in history, 12% lower from 1.50 to 1.32 in one day. That’s the average range for a year just in one day.”

Although the move was violent, Towner commented that it was, to a certain extent, orderly as traders were present on every dealing floor:

“It was a known unknown as opposed to the Swiss move which was a complete ‘unknown unknown!’”

Events to watch

2017 has been surprisingly quiet so far on the FX markets. According to Towner, the so called Fear Index (VIX) is at its lowest ever levels. He explained that this can sometimes happen, only for a big event to occur and cause volatility: “We are dealing with events that we don’t know about, so that is why we recommend that companies that have FX exposure should be hedging, so that when an event does occur, the impact is lessened.”

Common mistakes to avoid when managing your FX risk

1. Not knowing whether you’re exposed to FX risk, or how much. Currency exposure can come in many forms
2. Not having an FX Risk Management Policy in place. Quantify the risk and set out a plan to manage. There should be buy-in from everyone
3. Focusing only on the rate. It’s not the only factor that will impact on a business’s exposure to currency risk but to get a certain rate, businesses will sometimes risk everything
4. Not understanding the breadth of services available to the business. There are a variety of FX tools to help insure a business against the possibility of adverse moves
5. Getting overwhelmed by complex administration. Get the right support to help you function more effectively
6. Not having a handle on compliance. Unfamiliar banking codes and regulatory challenges may delay transactions
7. Poor internal communication. Share and understand how particular currency market exposures fit into the business’s overall exposure
8. Working with a provider stuck in rigid processes. Seek flexible terms
9. Not shopping around. Work with someone who understands the company’s needs and can help achieve the company’s goals.

According to Towner, corporates who know their risks in the future or can confidently forecast their risks should be hedging. The example of a UK based Italian shoe importer was used. This company ordered Euros 3 Million of shoes in June before Brexit, but didn’t hedge and normally buys the currency and pays three months after placing the order. This company required an extra 13% or £362,000. They only bought the Euros once the invoice came in and this impacted massively the amount of Sterling they needed.

Towner added: “Hedging allows the importer or exporter to control their Sterling cash flow – if not hedging, you trade “spot”, i.e. trade on requirement. Or a fixed hedge forward can be used to lock in an exchange rate for delivery in the future if you have a long term exposure. In between these two options, there is flexible hedging using FX options and FX structured products.”

A fixed forward rate

Towner explained that businesses can get protection at a specific rate for six months delivery using a “Forward”. So if advising a UK company that needs to buy dollars in six months’ time, the client can be advised not to hold off it they know exactly how many dollars they will need and secure protection at a specific rate e.g. 1.30:

“If the Sterling/Dollar rate goes down below 1.00, the business is protected at 1.30, and if the rate goes up to 2.00, you are fixed at 1.30 so can’t take advantage of the favourable move. It is static, but it does work. If you know and are committed to the risk, then you can hedge.”

Vanilla option

With this option, Towner explained that a business can take insurance without the obligation, so referring to the above scenario, the company would be protected. And if the Sterling/Dollar rate goes up, the business can take advantage of the favourable move and buy dollars at the spot market. This option comes at a premium but is, according to Towner, a good option for companies that may be involved in M&A activity: “Before the deal is committed, there is a FX risk within the deal but insurance can be taken out to protect against the FX risk before actually committing to the contract.”

FX structured product

Towner explained that this FX product is useful for when a business wants protection “but doesn’t want to pay a premium either.

“Simply put, a structured product is when you buy a FX option to give you protection but in order to reduce the cost to ‘zero premium’ you sell a FX option (to an option buyer). Therefore the premium you receive for selling the FX option covers the cost of the premium for you buying an FX option."

Towner gave the following example: When a US dollar buyer wants protection at 1.20 for six months time, but does not want to pay a premium, he/she can buy a 1.20 protection at a premium of 1.2%. To reduce the cost of this premium to zero, the client sells a FX option to a US dollar seller looking for protection at 1.34.

Collar option

According to Towner, this option is useful when a company wants to protect a balance sheet risk: “The balance sheet doesn’t need to be protected exactly at the money. If it is a Sterling company that has a dollar asset and the desire is to protect against the dollar weakening, the business won’t want to protect immediately if the dollar weakens - you have more flexibility with the balance sheet risk but the business may want to protect the “tail risk” e.g. what happens if Sterling/Dollar rate goes back up to 2.00.”

A 50% participating forward

“This allows most clients to sleep well at night – the business is protected but if there is a favourable move, then this can be taken advantage of upto 50% of that move.”

Towner emphasised that this is “a good structure for a company that has a transactional exposure”. As an example, Towner explained that if a company knows it’s going to need somewhere between USD8-12 Million, this structure is good because “Firstly, it protects them from the whole USD12 Million, and secondly, if the Sterling/Dollar rate goes up, they are only obligated to buy USD6 Million.”

What to watch out for

Conclusion

Towner concluded that businesses should always have some structure to hedging their FX risk: “This gives stability and removes the emotion. Sometimes large events come along that are difficult to forecast - businesses should not hedge around their preferred outcome as that may not happen.”

Towner also advised businesses to be prepared as leaving things to the last minute may prove costly and suggested that business should have an FX Policy that gives the business a comfortable percentage of hedging and flexibility at the same time: “Businesses should not leave themselves exposed to a step up in volatility.”

As a sign off, Towner emphasised:

“Proper risk management means the CFO and Board can sleep well at night!”

Need help with managing foreign exchange risk?

Contact Jake Gosheron at HiFX for information and advice.