FX RISK

publication date: Mar 7, 2008

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author/source: Drew Hillier (March 2008)

With risk aversion back in full swing amid rising recession jitters, triggering an across the board sell-off in global equities, credit and commodities, Paul Biszko, Senior Emerging Markets Analyst at RBC comments: “With the general mood again turning increasingly bearish, it could take another big positive surprise to halt the bleeding, with all eyes turned to the U.S. for guidance.” 

It would seem timely, then, to take a closer look at foreign exchange risk - the risk that profits will change if FX rates change. FX risks present complicated transfer pricing issues which, under today’s system of floating FX rates, currencies – as we’ve seen very recently – often move dramatically over short periods, sometimes by several percentage points. Whilst empirical studies demonstrate that FX volatility can significantly affect companies’ profits, multinational corporates face several types of FX risk, such as financial, translational, transactional and economic FX risk. However, we focus here on economic risk, also known as operational or competitive FX risk, which arises, for example, when a multinational business incurs costs in one currency and generates sales in another. Profits may decrease if the cost currency appreciates against the sales currency. Fluctuations in currency prices are one of the sources of risk that may influence the financial results of corporations or individuals having credits/liabilities in foreign currencies. Assuming that the company:
•     has assets or business operations across national borders;invests abroad;
•     has credit or loans in a foreign currency
•     It follows that it is exposed to currency risk, as long as the management does not decides to hedge the positions.

Volatile exchange rate fluctuations that occurred during recent years had a significant influence on the financial results of many corporations, often weakening their position among competitors. Moreover, higher volatility of exchange rates may lead to a decrease in incomes for exporters and more expensive goods for importers.

 For the reasons described above, an increasing number of corporate clients are investigating the possibilities of currency risk management, looking for optimal solutions. But how to assess such eventualities? Jeffrey Wallace, Managing Partner at Greenwich Treasury Advisors, outlines his organisation’s strategy, describing financial risk as being an integral part of overall firm risk. Crucially therefore, Jeffrey says: “This must be managed if the firm is to remain competitive and healthy. Corporate risk management increases firm value because management is in the best position to measure financial risks and then appropriately hedge them in a timely and efficient manner.”

However, as Jeffrey Wallace also points out, the value-added that risk management makes is often not recognized because that value is not explicitly measured. “Without defining the metrics to measure that value, the default metric will be whether the hedging was profitable in an accounting sense, a loser’s game for Treasury. A robust, metric-based financial risk management framework is introduced that is applicable to corporate commodity, foreign exchange, interest rate and investment risks.”

The noun Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event. In everyday usage, risk is often used synonymously with the probability of a known loss. Paradoxically, a probable loss can be uncertain and relative in an individual event while having a certainty in the aggregate of multiple events.

Trading currency is of course a speculative investment; investors attempt to buy and sell currency at the appropriate time in order to take advantage of changes in the exchange rate. If an investor thinks that a currency will become more valuable relative to the currency that his money is currently in, he might want to convert to that new currency, wait for the change to take place and then convert back. Of course, this is a very risky investment because there are no guarantees as to how currency values will change. Arbitrage involving investments denominated in different currencies, using forward cover to reduce or eliminate currency risk.

In respect of the strategic FX issue confronting American multinationals as Jeffery Wallace explains, is their response to the long-term trend of the world diversifying away from holding US dollar reserves and investments. “This is a fact, seen in the decline of USD reserve holdings of central banks and in the appreciation over the last five years in the euro, pound, yuan, real, and other major and non-major currencies. The American causes of the dollar’s decline are well-known, but less frequently mentioned is that the rest of the world is getting better, really better. Euroland is the world’s largest economy. China is China. Brazil is realizing its promise. While we will continue to have periods of dollar strength, the appreciation in those periods will not reach previous highs.

“The American MNC response involves re-thinking many current practices:

1. Hedging foreign currency profits to protect USD dollar profits will lead to lower USD P&L volatility but also to lower USD profits. Foreign currency profits will become increasingly valued by investors.
2. Not hedging long dollar/short second and third world currencies is no longer a sure thing.
3. Exporting product from the US will become increasingly attractive.
4. Commodity hedging will become a necessity, because commodity prices reflect a worldwide price. A weaker dollar with the same supply and demand means a higher commodity price.
5. Corporate pension funds should continue to become more international.

Wallace concludes: “Since WW II, American multinationals had the luxury of not including currency factors in their strategic thinking or in the day-to-day operational thinking. The rest of world could not afford that luxury. Neither can we any more.”