Five Steps to Managing FX Risk
by Helen Sanders, Editor
There are some aspects of today’s treasury function that have really only emerged over the past decade: financial supply chain management, enterprise risk management etc. Some responsibilities have been core to the role of treasury ever since the first departments were set up in the 1970s, of which foreign exchange (FX) risk management is one. Indeed, the first treasury association, the Association of Corporate Treasurers (ACT), was founded in 1979 as corporations set up treasury functions in response to heightened market volatility, relaxation of exchange controls in 1976 in the UK, and international expansion. Forty years on, have treasurers ‘cracked’ the code to effective FX risk management, and what new opportunities now exist? How do smaller corporations in particular avoid adding complexity when seeking to reduce risk? In exploring this theme, I am delighted to be joined by Martin Keller, Head of Product Management, Mittelstandsbank, Commerzbank AG. In addition, Justin Meadows, CEO and co-founder of MyTreasury offers some engaging new insights into trends and opportunities for online FX dealing.
The business imperative
Given the potential impact that adverse FX movements can have on cash flow though value attrition, liquidity as a result of cash ‘trapped’ in foreign currencies, and ultimately on corporate results, FX risk management is a fundamental issue for treasurers. Even the largest global corporations are not immune to the effects of negative volatility. Despite announcing a record quarter in Q4, 2014, Apple’s CEO Tim Cook commented that “Our results would have been even stronger, absent fierce foreign exchange volatility” which CFO Luca Maestri added amounted to around 4% of quarterly revenues. Some would argue that as most companies operating in a sector with the same base currency will be subject to the same market effects, they only need to manage their risk to the same degree as their competitors. With greater analyst scrutiny (for example, FX was the main topic that analysts wanted to discuss during the Apple quarterly results briefing despite the eye-watering results) and growing competition globally however, treasurers and CFOs cannot be complacent about managing their FX risk.
In Deloitte’s 2015 Global Corporate Treasury Survey, volatility and cash repatriation were identified as the greatest challenges facing treasurers, each of which was noted by 50% of participants, at least 10% more than issues such as cash visibility (40%), treasury technology (40%), entering restricted markets (24%) and managing liquidity (29%). This is not surprising, given the high levels of volatility in both the FX and commodity markets, continuing international expansion resulting in exposure to a growing number of currencies, and geopolitical insecurity in many parts of the world. Furthermore, the ACT’s The Contemporary Treasurer 2015 study shows that 83% of treasuries produce board reporting on risk management (which includes FX), emphasising the importance and visibility of treasury’s role in FX risk management.
An emerging focus on FX risk
Given the scale of the challenge, are treasurers focusing enough on this area? In some cases, it appears that treasurers have paid more attention to liquidity risk over the past few years, with the exception of large multinational corporations and those with particularly large currency or commodity exposures. This is starting to change, however. According to the ACT study referenced earlier, treasurers are spending an average of 39% more time on risk management in 2015 than 2014. This is also the experience we are seeing amongst our readers, and amongst the banks that support them. For mid-cap and smaller corporations in particular, the issue is how to address FX risk efficiently, particularly given resourcing and technology constraints. As Martin Keller, Commerzbank says,
“Not only has the past six months been a period of significant market volatility, but treasurers recognise that this is a situation that will remain. As a result, clients want help in collating market information, and determining what to do with it. They are then seeking to design and implement a risk management strategy that makes sense for their business, and ensure the relevant controls are in place.”
“It can be difficult for many companies, particularly mid-cap and smaller corporations, to design and implement an FX risk management strategy that is appropriate to their business. Ultimately, the aim is to secure the underlying business but it is not always clear how this should translate into a hedging strategy. Furthermore, in smaller organisations that lack a defined treasury function, it is not always clear where responsibility for either strategy definition or execution should lie.”
So what are the steps to an effective and sustainable FX risk management strategy?
#1. Taking responsibility
For corporations with a defined treasury function, responsibility for FX policy definition is usually clear, and the need to manage FX risk at a group level is one of the factors in deciding to centralise treasury. As Keller suggests,
“As companies of all sizes expand their activities internationally, their FX risk often becomes more difficult to manage, particularly where subsidiaries buy and sell in foreign currencies. Larger multinationals overcome this growing scale and complexity of FX exposure by centralising FX risk management into regional or global treasury centres with specialist systems and specific expertise.”
He continues however,
“For smaller companies without a central treasury function, this is more challenging, as the process of information gathering, designing and executing a hedging strategy, and implementing appropriate controls takes significant resource, particularly if responsibilities are shared across different functions or subsidiaries.”
In some cases, even where treasury policy is determined centrally, execution may be dispersed more widely, particularly in companies with a more decentralised treasury approach, and/ or where complex local market conditions make it more appropriate for local entities to manage exposure to a particular currency due to its volatility, currency controls or local liquidity conditions. Consequently, every company needs a clear definition of where responsibilities for defining and executing FX strategy should lie. Where these are disseminated, it makes sense to try to use a common platform to maintain a global view over exposures and hedging transactions.