Perspectives on Operating Risk

Mitigating the impact of currency fluctuations

This EIU report highlights that ‘firms see volatile exchange rates as the top risk for the year ahead’. With market conditions remaining difficult since the financial crisis and foreign exchange markets more uncertain now than they have been at any point in recent history, this finding doesn’t come as a surprise. Add to this the fact that many companies are increasingly looking to do business in emerging markets to take advantage of their growth potential – in contrast to the flatter performance of Western economies – and the case for a currency risk management strategy has never been stronger. Furthermore, companies face tightening margins which puts them under even greater pressure to limit risk and any resulting potential losses.

In this interview Lucy Grimstead, Director FX Sales at RBS, explains what makes a good currency risk strategy, how to deal with emerging markets currencies and why electronic trading can make all the difference while searching for yet another way to cut costs and increase efficiency.

Ingredients for a currency risk management strategy

Improving risk management systems has moved to the top of many senior management’s agenda following the financial crisis. Looking at it from a currency angle, can you confirm that companies have become more pro-active and sophisticated in the last couple of years assessing and managing risk?

Globally operating companies have had currency risk policies, as part of an overall risk management strategy, in place for a long time. However, these policies had often been fairly simple and didn’t reflect the range of instruments available today to protect them from risk. In light of current volatilities and the long-term demand to operate in a number of currencies, our clients understand that they need to amend these policies – especially allowing for more flexibility regarding which risk instruments can be used.

For companies in the mid-market, the last three years were definitely an eye opener. Despite being aware of currency and other risks, the majority of mid-sized firms didn’t feel the urge to tackle their risk exposure actively. But since the financial crisis, it has become clear that no one can get away with a ‘fingers crossed’ strategy.

Companies – no matter what their size – have definitely become a lot more pro-active about managing risk, and the level of sophistication has significantly increased.

You mentioned internal risk policies – are these also suitable for small firms?

Size does not matter. Exchange rate volatility can affect the bottom line of any business in many different ways, changing the value of your assets, liabilities and cash flows, especially when these are denominated in a foreign currency. If you have committed to either selling or buying goods or services in a foreign currency and the exchange rate fluctuates between agreement and payment, your overall profit from a particular deal can fall, or in low margin deals, could even be wiped out.

Consequently, any company involved in import or export activity or operating internationally via local subsidiaries should consider the impact of the risks they face.

What should companies consider when developing a currency risk strategy from scratch?

Whether a company is looking into developing a strategy or amending an existing one, it is vital as a first step to examine a number of factors such as ‘what proportion of your business relates to imports or exports’, ‘which currencies are involved’, ‘when are the timings of payments’, ‘do you pay and receive in the same foreign currency’. These questions seem to be very simple, but often company executives don’t have a detailed breakdown of these numbers.

As a next step you need to take into account that different risks such as currency and interest rates or inflation risks are interdependent. They can move in the same direction, but they can also offset each other, which could then result in an under-hedging or over-hedging of risk.

Furthermore, companies need to determine whether, in fact, hedging is the most efficient way to mitigate the impact of currency fluctuations. Foreign currency accounts, held with a domestic bank, can be a good option for importers and exporters as they allow the company to net receivables and payables in the same currency. Another alternative is to open a bank account in the country with which you’re trading. We’ve experienced increased demand for such local accounts from clients with larger operations in overseas markets.

Does signing-off the risk strategy means the homework is done?

A currency risk strategy certainly doesn’t guarantee a pro-active risk management of currency fluctuations. Everyone involved in foreign currency-related operations within an organisation needs to understand the risk policy and has to take ownership.

However, the biggest challenge for bringing risk management to life is to anticipate future market movements. This is where a banking partner can help. Since the financial crisis, we’ve seen a significantly larger number of requests for analyst reports and market forecasts.

Currency risks and expanding business to emerging markets Comparing the strength of growth in Asia, where non-Japan Asia grew by 9.5% in 2010, and Latin America, where growth was 7% for the three largest economies (and over 7.5% in Brazil) with the Eurozone (1.7%), the UK (1.7%) and the US (2.8%), it is not difficult to see why emerging market currencies are looked upon with greater and greater interest. Are there any specifics to consider while developing a risk strategy when dealing with emerging markets currencies?

In general, emerging market currencies can be illiquid in difficult times, which we’ve seen over the years, and that can make hedging foreign exchange risk problematic. However, companies always need to be managing their foreign exchange risk, whether they are exposed to emerging market currencies or to the so-called “major” currencies.

Looking at China and the Chinese Renminbi: Have you seen a different approach of clients operating in China towards using the Chinese Renminbi as an alternative to the US dollar?

In the past and with the Renminbi pegged to the US Dollar we’ve seen the majority of exporters using the US Dollar as their trading currency.

Moves by the Chinese government towards liberalising the Chinese Renminbi obviously has been good news for treasurers, offering new opportunities to simplify foreign exchange and cash management in their Asia Pacific operations. However, removing the Chinese Renminbi’s peg to the US dollar last year left corporates doing business in China with an additional currency risk to consider. Since then the Renminbi strengthened to a record high mid-April this year against the US dollar with the central parity rate of the RMB Fat 6.5301 per US dollar.

Corporates can go either way: balancing their payables and receivables in Renminbi as far as possible in order to minimise their foreign exchange risks – although some trading partners will still prefer US Dollar over their domestic currency – or protect their risk exposure via hedging.

We have started opening Renminbi accounts for our clients and have seen a growing demand for those as well as for Renminbi-related products and services.

Tighter margins – how to increase foreign exchange efficiencies Risk management goes hand in hand with simplifying complexity by streamlining processes. In this context, which role can electronic foreign exchange systems play?

With large corporates leading the way, increasingly more clients in the mid-market segment and smaller businesses are considering online foreign exchange systems in order to cut paperwork, resources and consequently costs.

Electronic platforms that link bank and client – such as our RBSMarketplace system – allow clients to carry out a wide range of foreign exchange transactions and access real-time market information. It can also provide management data via customised management reports for a client’s treasury activities. These can then also help when reviewing currency exposure and risk.

About RBS FX risk management services

We are one of the world’s leading banks for foreign exchange with foreign exchange services in over 60 currencies. Voted #1 in the UK for FX Solutions (to corporations by market share) and #5 Globally for FX Solutions (by market share) in the 2010 Euromoney FX poll, the FX team at RBS has significant experience and expertise in assisting to formulate new currency hedging policies, and in evolving existing policies to be more appropriate to the new world order in which we find ourselves.

Why hedge against currency fluctuations?

Below are examples highlighting what can happen if FX rates move in an unfavourable manner.

Example 1 – A Retailer

Situation. A UK retailer buys leather for its handbags from central Europe and pays for it in EUR. His buyers had used a budget rate of 1.2500 and all costing has been done on this basis. The retailer did not hedge this exposure as it was only small relative to its USD requirements.

GBP/EUR moved lower and the retailer revised its buying rate to 1.1200. However, they were unable to renegotiate pricing with suppliers, and given they were not prepared to reduce their margin on the handbag range, they had to increase prices – turning a Ј199 retail priced handbag into a Ј249 handbag.

Result. The price increase meant that the handbags were targeting a different level of consumer. They had priced themselves out of their usual market and as a result handbag sales fell of a cliff.

They couldn’t sell the stock and then took even less margin than they would have done had they left the bags at the original price.

Example 2 — An Acquisition

Situation. Company A was looking to acquire company B for AUD$67m, with the acquisition being funded in cash. While the AUD notional amount was fixed, the GBP equivalent was liable to change with fluctuations in the foreign exchange market.This type of risk can be hedged from the date at which the scheme of arrangement becomes effective to financial close. However, company A opted not to hedge the exposure.

Result. GBP/AUD depreciated by circa 1.8000 to 1.6500 over the three months leading up to financial close. Unfortunately, the acquisition cost the client a further Ј3.4m (or 9%) more than they had budgeted.

In this case, the acquisition proceeded. However the example highlights how currency fluctuations alone can potentially make an acquisition unviable. Calculating the average daily range of the currency pair can give companies an idea of the potential risks they may face. Interestingly, this has been 200 pips since the start of 2010, demonstrating that the GBP requirement for the AUD$67m acquisition has varied by Ј570,000.