Effective risk management – a new way of thinking

Today’s financial professionals are well equipped to deal with their complicated business problems, but many of them are still learning on the job when it comes to navigating foreign exchange risk. In a world where constantly changing market conditions require hyper-vigilance, the case for effective risk management can be made in two ways – by exposing the negatives and highlighting the positives.

The foreign exchange market is perhaps the most volatile asset class in the world, and companies must therefore adopt ever-more proactive and succinct strategies to manage their exposure to exchange rate risk. This can be daunting for those who are unfamiliar with the process but, if managed correctly, companies stand to reap great rewards.

An exporter, for example, experiencing a surge in its domestic currency, faces a choice that no business would find appealing: Between reducing its prices to remain competitive with a local supplier in the foreign market, or accepting lower profit margins as the value of its revenue is decreased.

Foreign exchange markets are inherently unpredictable. However, at this extraordinary point in financial history, the risks of adverse market movement are increasingly common and have caused a significant shift by companies towards appropriate exchange rate risk management strategies.

Effective risk management

Minimising the risk arising from a change in the price of one currency against another is something that every company should do in order to remain competitive.

Nothing is more likely to focus minds on the need to hedge against exchange rate risk than a period of pronounced market volatility. Cast your mind back to the Swiss National Bank’s recent decision to end the peg of the franc to the euro, and the subsequent volatility gives a stark reminder of how important it is to be prepared for dramatic changes in price. Companies big and small are beginning to look at their hedging requirements in a new light.

Surveys show that over 90% of the world’s largest corporations are using derivatives to manage their exposure to exchange rate risk, while those that saw hedging as the preserve of larger companies are starting to realise that they too can benefit from such strategies. Business investment and macroeconomic risk lead many companies to seek innovative hedging solutions to protect their margins and competitive advantages.

But the complexity of managing risk should not be taken lightly, as only large well-established multinational corporations are likely to have the funds to support a dedicated team for devising and implementing effective foreign exchange risk management strategies.

Ways to hedge foreign exchange risk

Forward contracts
Forward contracts are simple, non-standardised agreements to exchange two designated currencies, on a specific future date, and at a predetermined exchange rate. They are highly effective at providing protection against adverse market movement, and forward contracts also remove the likelihood of nasty surprises. As such, they are most commonly used as a hedging tool.

Foreign exchange options
Foreign exchange options (FX options) are versatile financial products commonly used by commercial entities to reduce their exposure to exchange-rate risk. The use of FX options as part of a comprehensive foreign exchange risk management strategy can give the protection, flexibility, and opportunity needed to fulfil unique risk and reward and/or cost and benefit objectives.
 
In its simplest form, an FX option gives the right, but not the obligation, to exchange one currency into another at a specific rate. A UK-based exporter receiving dollars from a US-based customer can seek protection from a weakening Sterling, while keeping the ability to capture a strengthening Sterling. If the exporter purchased an FX option and the market moves against it, the cost of adopting the option (known as a premium) is worth it. On the other hand, if Sterling depreciates and the value of the exporter’s US dollar-based revenue increases, the premium expense is incurred, but a more favourable rate is captured.

Structured options
Structured options are more commonly referred to as "zero cost" or "zero premium" FX options. The term defines a group of foreign exchange derivative products that have been developed as alternative methods of hedging exchange rate risk to forward contracts and simple FX options.
 
These structures are designed to provide protection against unfavourable market movement (much like a forward contract), but they also transform the inflexible nature of fixed exchange rates so that a favourable market movement, should it materialise, can be captured.
 

What can you do?
 
First, it is imperative to consider a formal risk management strategy. This will focus you on what external and exchange rate risks your company may be facing now and in the future. Consider the implicit cost of being hedged against the cost of not being hedged. Foreign exchange risk is not always predictable, and often the opportunity cost of being hedged is worth it.
 
Second, don’t be afraid of volatility and avoid making decisions based purely on a market view. The difference between hedging and speculating is not a particularly subtle one. An effective risk management strategy reduces risk to an acceptable level; protecting the business, rather than trying to profit from favourable market movements. This does not mean that your market view should be discounted, but your first priority should be to ensure that risk is managed effectively.
 
Third, consider an appropriate benchmark against which to evaluate the performance of your hedging decisions. Without the benefit of hindsight, decisions can only be made based on the information you know today, so include this experience in your processes. Ensure that you develop and implement a system of controls to monitor the adherence to, and success of, your formal policy.
 
Fourth, understand all of the tools available to you when seeking to create and implement your policy. Currencies Direct Financial Markets has extensive knowledge, tools, and expertise to work with your business over the long-term to ensure that your policy is effectively implemented.

Finally, a formal risk management strategy that is periodically updated is a must for any company looking to properly protect itself against adverse market movements. Frequent reassessment of the external risks a company faces is invaluable, because it can ensure that the strategies adopted remain appropriate and relevant. This will enable the company to ensure that its hedging decisions are optimal.
 

Conclusion

Our experience suggests that companies are increasingly interested in hedging their exposure to exchange rate risk using a more portfolio-based approach. In other words, by adopting various products – forward contracts and foreign exchange options – while using different tenors and objectives, a company is best able to manage its exposure within defined and acceptable parameters.

Two key strategies are widely adopted. The first forecasts immediate exposure and hedges short-term exposure on a rolling basis – i.e. repeating a process on a frequent basis to cover cashflow requirements. A second, more dynamic approach involves a layered or ‘portfolio’ strategy. This takes a longer-term view and hedging decisions are made on the basis of reducing exposure over a 6, 12 or 18-month period, ensuring that specific percentages of exposure at each tenor are adequately covered. The second approach is more dynamic and functional, insofar as it reduces vulnerability to short-term trends and often obtains a smoothed average exchange rate over the long-term.

Whether you adopt a formal hedging policy or not, effective risk management strategies will support your business in maintaining its competitive advantage and minimising earnings risk. This article provides a high-level introduction with the variety of ways in which your company can squeeze value out of its hedging decisions.

Your time and resources may be limited, but by working with Currencies Direct it is possible for you to manage your exposure to market volatility, while retaining the flexibility to respond to changing market dynamics and business environments.

To find out more about minimising risk and effective risk management strategies, please email options@currenciesdirect.com
 

Currency options contain risks and may not be appropriate for everyone.

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