Managing FX Risk in Today's Volatile Markets
Marc Cogliatti, HiFX - 13 Oct 2009
FX risk management is now an important issue for small and medium enterprises (SMEs), as well as the larger corporations. What should be considered when creating a FX hedging strategy suitable for your business objectives?
Throughout 2008, corporate treasurers across the globe will have suffered sleepless nights as a result of the unprecedented volatility in the foreign exchange (FX) markets. Three-quarters of the way through 2009, volatility remains a key theme, although as the economy stabilises and the financial markets calm a little, it has given us an opportunity to pause for breath and reflect on the turmoil that was 2008. Last year’s volatility took everyone by surprise, including experienced traders. For corporates, the impact of the credit crisis has forced companies from board level down to look to contain risks.
As a nation of importers, UK corporates were hit particularly hard by the dramatic fall in pound sterling and left with the uphill task of trying to raise prices or risk going out of business. Of course, there were those who had some hedging in place, but most companies were quickly faced with significantly higher costs for importing their products or raw materials. And it wasn’t just the importers who were left in a difficult situation: exporters who had hedged their exposure (don’t forget, the US dollar had been on a downward path in five of the six proceeding years) were left potentially uncompetitive by more aggressive firms who hadn’t hedged, or by competition from overseas.
What is the Answer?
In an ideal world, an accurate forecast of the FX market would be a starting point but, as in all markets, forecasters have a very mixed record, as one month’s hero quickly becomes the goat in following months.
Looking back at a collection of forecasts submitted by all the major banks from the beginning of 2008, not one forecast lay within 15% of where pound/US dollar actually finished the year. Before 2008, the average annual range for pound/US dollar was less than 15% wide, but not one institution managed to forecast the market within 15% of the eventual outcome (1.46). In fact, the mean forecast for the end of 2008 was 1.9218, which is 24% away from the actual outcome. Does this show that banks are bad at forecasting, or does it simply prove that forecasting is a flawed tool for planning?
In this instance, I don’t believe that it shows either. We have taken an extreme example of volatility during what can only be described as unprecedented times. No bank, regardless of how bearish their stance was on the economy, would submit such extreme forecasts for fear of looking stupid if the outcome was the complete opposite. However, to say that forecasting is a flawed tool for planning would also be wrong. There are often clear trends and patterns that can be extrapolated to produce a forecast and used as a guide to triggering hedge transactions. As long as a company reacts to changes in these trends and has a robust strategy in place, using a forecast can be a useful aid. What is wrong is to base the whole strategy around a forecast. This will inevitably result in disappointment as soon as the forecast turns out to be incorrect.
To construct a robust risk management strategy, a firm must ensure that it meets its objectives. The first step in the process is to identify and quantify the risks. The number of companies that fail at the first hurdle by ignoring this very important process is frightening. It is only after this first step that objectives can be determined. For example, is the aim to cushion the business from adverse moves in the currency market and give enough time to adjust strategy and pricing, or is the company simply looking to hedge at the most favourable levels to gain a competitive advantage? Most companies usually answer this question with the former, although invariably the latter comes into play when it actually comes to implementing the hedges. These two very different objectives will obviously require different hedging strategies.
Once the objectives have been determined, the preceding steps form the all-important foundations for a hedging strategy, and it’s from here that factors, such as how far forward to hedge, are determined. After all, over-hedging is just as dangerous as under-hedging. On one hand, a company needs certainty over cash flows, but hedging too far forward can hamper a firm’s ability to react in a price-sensitive market.
With so many variables to consider, one point that is clear is the need for a consistent and balanced approach. The implementation of an FX policy can prove to be an invaluable tool and help take away some of the elements of fear and greed. The fear stems from the need for security to protect against an adverse move in the market. After all, corporates are in the business of profit making and growth, not speculating in the FX markets. But then there is the greed factor where a favourable move in the market could be used to improve margins and, ultimately, the bottom line. By using a pre-agreed FX policy that defines the parameters that must be hedged, it reduces the chances of falling victim to such emotions.
Only once all the risks have been mapped out, the objectives are clear and an optimal time horizon has been determined, is a company in a position to consider the appropriate hedging tool. Even though an enormous amount of work has been undertaken to get to this stage, mistakes can still be made by choosing a hedging tool that doesn’t fit the stated objectives or timelines. A simple scenario analysis can help map out some of the potential outcomes of different tools, although there are obvious limitations that mean that this approach cannot be used in isolation.
At this stage, it is very easy to feel pressured into implementing hedges quickly in order to contain the risk. However, why rush such an important strategic decision that can impact the business in the medium term? Taking the time to make sure that you are making an informed decision can prevent much greater complications further down the line.
Conclusion
FX risk management and FX strategic planning are now important issues for small and medium enterprises (SMEs), as well as the larger corporations. The importance of getting it right, without hindering sales, growth and profitability is now the remit for finance staff previously unfamiliar with such problems. In the current environment, with high levels of volatility, wide-ranging views on the markets and an increased number of available instruments, the decision-making process has become a difficult minefield to negotiate. Nevertheless, as with any problem, there is ultimately a solution and, with the right guidance, a safe passage can be found.
Charles Darwin once said: “It is not the strongest of the species that survives, not the most intelligent, but the most responsive to change.” This quote is of particular significance given the credit crisis and the impact that the crisis has on volatility in the financial markets. Having to deal with an unexpected rise in volatility is difficult but proper risk management can give any firm the ability to respond to change and therefore, in pure Darwinian terms, survive.
GTNEWS.COM 27-10-09