Thinking the Unthinkable: A new chapter in FX risk management
by Helen Sanders, Editor
Some weeks ago, I came to the realisation that if I had to start another article with the words ‘the financial crisis’ then I would probably go mad, but on this occasion, I think it is justified and will therefore try to hold on to my sanity for just a little while longer. The theme of this article does indeed start with ‘the financial crisis’ but for once, it is focused on neither liquidity nor credit risk. One of the other implications, but which has received far less attention, has been the impact on the way that corporate treasurers have approached their foreign exchange (FX) risk.
One of the major implications of the crisis has been the increased focus on FX risk and what it means to the business.
The whole concept of risk management has changed unrecognisably over the past two years. The volcanic ash that closed airspace in the UK and much of Europe is an example in point. As treasurer of one of the major airlines told me earlier that week, you model the cash flow (as well as logistical) impact of planes being grounded for 24 or 48 hours, but certainly not for a week. The same applies to FX risk. With unprecedented market volatility, combined with uncertainty of revenues, the way that companies approach FX risk has changed considerably.
Impact of the crisis
With unprecedented volatility in USD rates in particular, one of the major implications of the crisis has been the increased focus on FX risk and what it means to the business. As Anders Aslund, Corporate Risk Advisory, Commerzbank, explains,
“The importance of FX risk management was accentuated strongly during the crisis. Even if exposures are small, the potential financial impact of market movements can be significant if volatility is high.”
This volatility is not simply created by the impact of market movements. As Chris Leuschke, Global Head of FX Sales, RBS, emphasises,
“Treasurers have been forced to deal with volatility in terms of the impact of market movements, but also uncertainty in revenues, which in turn creates more FX risk.”
The combination of FX volatility and business flows that differ substantially from forecasts has resulted in many companies being over- or under-hedged. However, as Anders Aslund, Commerzbank, highlights, the implications of FX movements also extend beyond cash flow:
“The implications of FX movements do not only apply to costs and revenues. During a period of extreme volatility, many companies risked covenant breaches on their loan book triggered purely by FX moves, so we have worked closely with our clients to avoid any negative impact. We are also proactive in helping clients to draft loan documentation by analysing potential covenant sensitivities to FX rates and determine the right choice of currency in which to denominate their debt, to match operational cash flows and/or currency composition of net assets.”
The first step to making effective hedging decisions is to forecast cash flow effectively. Over the past two years, the inadequacies of many companies’ hedging policy, such as to hedge 50% of budgeted cash flow, have been revealed; consequently, while an accurate and proactive approach to forecasting has become more important for liquidity management purposes, it is an equally significant element of FX risk management as Aslund outlines,
Treasurers have been forced to map their risks more closely than they have in the past. In this respect, the crisis was helpful, as it has been easier to secure resources for this as FX risks have become much more visible and prominent. This has involved looking at cash flow and liquidity forecasts more deeply; by better understanding exposures and risk, it can be managed more effectively.”
Chris Leuschke, RBS, continues,
“Cash flow forecasting has become more volatile than under normal business circumstances. In the past, earnings and sales could be forecast reasonably easily. Since the crisis first struck, cash flow forecasting has been under more scrutiny, and many companies have found themselves either over-hedged as a result of over-estimated revenues, or under-hedged due to large currency movements. Consequently, treasurers have had to adopt a more rigorous approach to FX risk management.”
Cash flow forecasting can no longer be simply a rolling monthly process, perhaps just using budget information from the ERP, but a highly responsive activity using up-to-date information from business units, and reviewed on a continual basis.