Using Hedgebook to make smart fx hedging decisions

Has anyone told you lately that they know where the currency is going? Lots of people think they know if it is going up or down but the reality is that no one knows where it is going in the next 5 minutes, 5 days or 5 years. We might all be able to have an educated guess but that is all it is – a guess.

As a former risk manager I know how hard it is to advise corporates on the risks around fx management. I can remember going to a potential client and explaining to the owner of the business the importance of having a treasury policy and why you should follow it. We could add value in helping with the strategic decisions and the instruments to use but by the way we can’t pick the currency because no one really knows where it is going and we don’t try to. After listening to all this sage advice the owner turned to us and asked what use were we to him if we didn’t know where the currency was going? End of meeting.

It is true no one can pick where the currency is heading. What is important is:

  • Understanding the impact on your business when foreign exchange rates move.
  • Knowing the impact on budget rates or costing rates when foreign exchange rates move.
  • Knowing whether the business can afford to not cover i.e. if exchange rates go any further against you are you losing too much margin or indeed are you out of business.

Having the ability to compare the amount of foreign exchange hedging in place with the impact of exchange rate movements on the uncovered portion is vital information in making rational decisions in an irrational market.

Whilst we can’t pick currencies at Hedgebook (we are still working on that one) we can tell you the impact on your business if rates go up or down. We can tell you in dollars and cents what the impact will be  on unhedged foreign cashflows, what the exchange rate needs to be to achieve the budget or costing rate and what the value of existing hedges are.

Today’s fx risk management isn’t about picking exchange rates but about giving businesses greater visibility over its foreign exchange position. This allows for smarter foreign exchange hedging decisions using all available information. Sometimes the information isn’t what you want to hear but at least you don’t need to hope that things go your way. You can avoid the knee jerk decision – and chuck out the crystal ball.

Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.

Why Timing is Key for Hedging!

Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!

Take the NZDUSD pair from January 2003 to December 2009:

NZD/USD Spot Rate

In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).

For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!

The next blog post will illustrate how market positioning can be used in timing.

The Benefits of Hedging, and Managing FX Risk: Part 1

Many small- and medium-sized firms engaging in import and/or export activity tend not to hedge. The reasons not to hedge come in all shapes and sizes: it’s too complex; it’s too costly; there’s a misconception that it is speculation; or even that that firms don’t know about hedging tools and strategies available to them. And in the case that companies don’t hedge despite being aware of its benefits – the excuse is often that exchange rates might even hold steady! These are costly, misguided beliefs!

Many studies show that hedging is a necessary activity for firms operating in the contemporary globalized economy. Benefits include:

– Increase ability to forecast future cash flows

– Minimize the impact of exchange rate volatility on profits

– Diminish the need to attempt to forecast exchange rates

– Helps ‘buy time’ for a company to adjust its marketing and sales strategies should the domestic currency rise in value, thereby reducing the firm’s competiveness abroad

Needless to say, if a firm has the financial ability to hedge at a reasonable cost, there’s no reason not to! Essentially, hedging is like FX insurance.

The next blog post will cover the steps involved with hedging.

Explaining Different Types of Exposure Risk

Importers and exporters alike face foreign exchange risk, or currency risk, when engaging in economic activity outside of their domestic currency. As explained in an earlier blog post, currency risk materializes for exporters when exchange rate volatility results in the company repatriating fewer revenues abroad, when the domestic currency strengthens relative to the foreign currency. For importers, this risk is the exact opposite: currency risk materializes when the domestic currency weakens relative to the foreign currency.

When shifts in foreign exchange rates are not hedged against, firms unnecessarily take on transaction exposure, or FX risk that negatively impacts cash flows. Typically, small- and medium-sized firms do not hedge against transaction exposure, despite the negative impacts it may have on profitability. Consider the FX relationship between two closely knit economies, Australia and New Zealand: the AUDNZD exchange rate has been as high as 1.3277 (December 2011) and as low as 1.2370 (October 2012) over the past year.

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This exchange rate volatility demonstrates why hedging is necessary. Let’s say that a New Zealand firm sold A$100,000 worth of product in Australia in April 2012, when the AUDNZD traded at 1.2600. Given the exchange rate, the New Zealand firm would expect to receive N$79,365 in return. However, if hedging wasn’t utilized, and the New Zealand firm repatriated its funds in July 2012 when the AUDNZD traded at 1.2950, it would only receive N$77,519 in return. By not hedging, the New Zealand firm cost itself N$1,846.

There are two other main types of currency risk posed to importers and exporters: accounting exposure and economic exposure. Accounting exposure comes about when firms have liabilities overseas, and must convert the foreign denominated liabilities back into the domestic currency. Unless exchange rates remain stable (a less common occurrence over the past few years), the liability conversion results in either gains or losses. Economic exposure tends to be limited to firms only operating domestically. For example, if a New Zealand firm only sells at home, but the New Zealand Dollar gains in value, consumers might look to competitors overseas given increased purchasing power; despite not being a participant in international markets, the shift in exchange rates could still have a negative impact on business.

The next post will discuss why it is thus important to hedge, and what the necessary steps are for a company to manage its foreign exchange risk.