Why Risk Management Matters More than Ever. U.S. Version. Global Market Volatility and Exchange Rate Risk

Transcription

1 U.S. Version Why Risk Management Matters More than Ever Global Market Volatility and Exchange Rate Risk Never before have U.S. companies been so exposed to market volatility and exchange rate risk. The world s most advanced economies are currently holding an unprecedented amount of debt and experiencing little to no economic growth. As a result, traders and investors are moving rapidly back and forth between risky assets and safe haven assets. With each new economic data release, volatility in fi nancial markets is at an all-time high. At the same time, slow growth in the U.S. is causing American companies to spend an increasing amount of time seeking out new business overseas, where they may have better odds of selling their goods and services. And while international business provides excellent opportunities for growth and prosperity, it also exposes your business to currency risk. If unmitigated, this risk can compromise profi ts and undermine a company s attempts to succeed in new markets. Broadly defi ned, currency risk is any exposure a business holds to currency exchange rate fl uctuations. For example, a spike in a foreign currency can raise costs signifi cantly for an importer. Conversely, a jump in the value of the dollar can make an exporter s pricing that much less competitive to potential buyers in the global market. However, currency fl uctuations may have benefi cial effects as well: repatriating funds when the foreign Page 1 of 9 l Foreign Exchange Risk Management

2 Fed Fund (10 year) This graph charts the dramatic changes seen in the Fed Fund over the last ten years. Many blame the low interest rates sustained from for the real estate bubble that eventually resulted in the global financial crisis of Federal Funds Rate source currency is strong against the dollar makes good sense; buying foreign goods when the dollar is strong, likewise, decreases costs. But, like buying a home and failing to insure it, trusting one s business or bottom line to the unpredictable fl uctuations of a volatile market is a recipe for disaster. Some form of protection is needed. Currency risk management is the strategic use of hedging products and international payment options to reduce a company s exposure to market shifts, limiting the negative effects that fl uctuations in currency exchange rates can have on a company s costs, profi ts, competitiveness, or, ultimately, success in foreign markets. Forward contracts, for example, are hedging instruments that allow you to buy or sell a currency at a stable, unchanging rate for up to a year (or more). If the rate that you lock-in to for your forward ensures bottom line security, you ve effectively protected your profi ts against whatever the market may do. Alternately, in many cases, paying your overseas suppliers in their local currency instead of in dollars can reduce banking and exchange costs and allow you to negotiate better pricing. These are some very common examples of currency risk management. Currency Risk and your Bottom Line Why is risk management important? If your company is doing a majority of its buying or selling overseas, even minor changes in currency valuations can be extremely costly if you re unprotected. Say, for example, that you are an agriculture importer buying wheat from Canada. At the beginning of your buying season, you contract to purchase ten shipments at $10,000 Canadian dollars (CAD) each. With the U.S. dollar at $1.10CAD, this puts your total importing cost (and your exposure to the Canadian dollar) at U.S. $90,000 ($10,000CAD X 10 shipments X U.S. $0.90). You budget and price accordingly. But what happens if the Canadian currency eventually moves to parity (1:1) with the U.S. dollar, so that $1CAD is worth U.S. $1? Suddenly, your costs have increased Page 2 of 9 l Foreign Exchange Risk Management

3 The purpose of currency hedging isn t to generate trading gains. The purpose should be to mitigate risk, not increase it or swap one form of risk for another. by U.S. $10,000 an amount that you will have to price-in to your product when selling (if you can), or take off your bottom line. Assuming your profi t margin is quite wide, this might not be a problem. But what if you are a large supplier, and are purchasing $1,000,000 of wheat instead of just $100,000? Suddenly, your exposure has resulted in increased costs to the tune of $100,000. Now say you re in an industry that imports far greater volumes of a far more expensive product. Or, that you re a small business whose profi t margins are very narrow. Or, fi nally, that you re dealing with a far more volatile currency, such as the euro, which moved almost $0.30 in the six months between December 2009 and June The logic of reducing your exposure to currency fl uctuations, and thereby limiting your costs or protecting your bottom line, becomes obvious and undeniable. Hedging: Three Myths and Facts Once we understand and acknowledge the need for currency risk management, though, where and how do we start to hedge our risks and protect our profi ts? Below are three key insights about hedging that you should know before you decide whether, how, and how much to hedge. Myth: Currency hedging is speculative and risky. Fact: Not hedging is speculative and risky. When organized and executed in line with your business s goals and needs, a risk management program protects your profi ts. Currency hedging is very different from currency speculation. Indeed, one might say that risk management is the opposite of speculation. Speculation involves taking on risk and betting (consciously, if you re a trader, or implicitly, if you re a business), so to speak, on what the market will do next in order to turn a profi t. Risk management involves mitigating risk at a strategic level in order to protect profi ts while, ideally, still allowing you to profi t from advantageous market movements. Admittedly, there are advantages to be gained from certain currency fl uctuations. If you re an importer, for example, and the dollar suddenly jumps in value, it s a great time to buy, as each dollar you spend will go that much further against a foreign supplier s currency, and your importing costs will be that much lower. Likewise, if you re exporting, and the dollar s value slides, your foreign buyer will have to pay that much less for your product (without your profi ts being affected). This makes your pricing that much more attractive than competitors dealing in different currencies and therefore at higher costs. That being said, the opposite is also true, and an adverse market movement can completely erase a business s planned profi ts or worse. Again: if your company is doing a substantial part of your business overseas, you re exposed to foreign currency fl uctuations. And if you re exposed to foreign currency fl uctuations now more than ever failing to assess and, where necessary, mitigate your market risk is a recipe for disaster. While not hedging your currency Page 3 of 9 l Foreign Exchange Risk Management

4 EURUSD (10 year) The euro spent most of the last decade appreciating against the US dollar before experiencing extreme volatility as a result of, first, the global financial crisis, then, the European debt crisis. U.S. Dollars to One Euro /2/2008 7/2/2008 1/2/2009 7/2/2009 1/2/2010 7/2/2010 U.S. Dollars to One Euro Jan 2000-Oct 2001-Jul 2002-Apr 2003-Jan 2003-Oct 2004-Jul 2005-Apr 2006-Jan 2006-Oct 2007-Jul 2008-Apr 2009-Jan 2009-Oct 2010-Jul risk may, if you re lucky, allow you to increase your profi ts merely by way of currencies fl uctuating in your favour, it may also compromise your profi ts or the long-term prosperity of your business if the market moves against you. The potential rewards may be high, but so is the potential for devastating losses to your business. What makes the most business sense is to hedge your currency exposure in such a way that ensures bottom line protection. Take, for example, a manufacturing company that designs and builds gasifi cation equipment and exports it to Europe. Since each unit is custom built, profi t margins vary from project to project. In the interests of simplicity, let s assume our company sells each piece of equipment for $1,000,000, which includes a profi t margin 20%. If the exchange rate from euros to U.S. dollars is at 1.30, our company would effectively be getting paid U.S. $1,300,000 per item, with a profi t of U.S. $260,000 However, if the euro drops to 1.20, their profi ts would be reduced to $240,000, Page 4 of 9 l Foreign Exchange Risk Management

5 The best ways to manage currency risk is to identify your company s FX risks and formulate a hedging strategy to help mitigate those risks. representing a 7.69% decrease in profi t margin. In order to avoid this kind of signifi cant bottom line impact resulting from currency fl uctuations, our company could lock-in to a forward contract to sell euros at 1.30 (or 1.25, or wherever their break-even level lies given their exposure), thereby ensuring that, no matter where the market goes, their profi t margins are protected. Myth: Currency hedging is only for the short term; in the long run, exchange rates always average out. Fact: Currency exchange rates may very well even out, but they may not do so in time for your business. It may seem logical to assume that, while exchange rates may fl uctuate by the minute, and certain periods will see increased market volatility, in the long run, the value of the major currencies will average out and your company s costs and profi ts with them. While there may be some truth to this, there is arguably far more to the saying that markets can remain irrational longer than most speculators can remain solvent. Moreover, many market analysts will go further and claim that, in fact, markets likely won t return to normal anytime soon. Volatility is at an all-time historical high, and many currencies (majors and minors alike) are fl uctuating more drastically and more unpredictably than ever before. Given the back-and-forth that has been going on for the last year between risky and safe haven assets and persistent rumors (and corresponding refutations) regarding the possibility of a double dip recession, there is no end in sight for irrational and unpredictable behavior in markets. What this means is that if a large part of your business is conducted across borders, it s probably wise to implement a hedge, or at least an informed payments strategy ideally one developed with the assistance of a foreign exchange specialist. This doesn t mean you have to lock-in to a forward for the total amount of your foreign currency exposure over the next year, limiting your ability to take advantage of potentially advantageous market swings. But it does mean hedging a portion of your exposure in order to ensure bottom line protection no matter where the market goes. Myth: You don t need to hedge if you do business internationally in U.S. dollars. Fact: Even if you re paying or being paid by foreign partners in U.S. dollars, you re still exposed to exchange rate risk. Exchange rate risk is easy to see when you re exchanging currency: one day, your U.S. $100 buys you, for example, $110 Canadian; a few days later, because of currency fl uctuations, it only buys you $95 Canadian. Then, in another week, it s back up to $105. You can easily see how exchange rates are affecting your costs or profi ts (as it may be), and time your payments or currency purchases accordingly. Page 5 of 9 l Foreign Exchange Risk Management

6 Jan 2001-Jan 2002-Jan 2003-Jan 2004-Jan 2005-Jan 2006-Jan 2007-Jan 2008-Jan 2009-Jan 2010-Jan /1/2008 4/1/2008 7/1/ /1/2008 1/1/2009 4/1/2009 7/1/ /1/2009 1/1/2010 4/1/2010 7/1/ Unemployment (%, Civilian) Federal Runds Rate (effective, monthly avg) Quarterly GDP Growth (%), Smoothed U.S. Dollars to One Euro Four Measures (10 year) Ben Bernanke remarked in July 2010 that we are currently in unusually uncertain times economically. This graph indicates as much: the unemployment rate remains above 9.5% while the Fed Fund rate is at 0.25% and economic growth (GDP) slows. All the while, the euro continues to experience dramatic shifts in value from month to month. Unfortunately, for U.S. companies doing business across borders, it isn t always that simple. Because it s accepted almost everywhere, the U.S. dollar has become known as the world s currency. This means that, as a U.S. company, you almost always have the option of paying, or being paid by, foreign suppliers in U.S. doller. Some countries, such as China, even reward domestic businesses for bringing in dollars as opposed to their local currencies. While this provides a seemingly simple and convenient payment option for American businesses, it also makes foreign exchange risk diffi cult to detect and mitigate. Why? Say you re an American importer buying machinery from the Czech Republic and paying your supplier in U.S. dollars. Your pricing and payment structure appears transparent enough: you determine how many items you want to import and place an order. Your business partner in the Czech Republic gives you a quote in U.S. dollars; you either accept or negotiate for better pricing. At the end of the day, you submit your payment in USD; there are no exchange costs and no rate fl uctuations to account for and price-in. But how is your supplier pricing his product? Keep in mind that, while foreign partners may be willing and able to receive or send USD, they will not necessarily hold a USD account. At some point, their funds will have to be translated into or from their local currency meaning that, at some point, currency exchange rates will come into play in determining how much USD you are paying or receiving. When your supplier prices his machinery, he will determine in advance how much Czech currency (koruna, or crowns CZK) he wants to receive. Then, based on the USDCZK exchange rate, he will calculate how much he needs to bill in USD. He will also price-in the cost of converting your payment from dollars into crowns at his bank, which may be expensive. So, even if you re dealing in dollars, your costs and profi ts are still determined by foreign exchange rates even if you can t see them. This is why one simple risk management technique is to request that your suppliers quote your invoice both in dollars and in their local currency; payment in local currency may increase cost transparency and eliminate exchange rate loss and bank fees. Other viable options include both deliverable (if you re paying in foreign currency) and non-deliverable (if you re paying in USD) forward contracts. Page 6 of 9 l Foreign Exchange Risk Management

7 The best way to manage currency risk is to identify your company s FX risks and formulate a hedging strategy to help mitigate those risks. Conclusion: What you can do to protect your business. Once you ve established that currency risk management is a crucial component of doing business across borders with confi dence and success, there are a few things you should know: 1. In today s unpredictable market, it s worth hedging. If your company relies on international business for a large part of its operations, intake, or profi ts, it s worth hedging. Given the volatility seen in fi nancial markets over the last two years, it is almost impossible to predict which currencies will move, when, how far, and in what direction. The only true certainty, at least at this point, is that economic volatility will prevail, and that this will be evidenced in sudden, sometimes drastic, and frequently lasting currency swings. If your company is exposed to foreign currencies, whether as close as the Canadian dollar or as far away as the Czech koruna, then these currency shifts could translate, devastatingly, into sudden, drastic effects on your profi ts. Consulting a foreign exchange specialist about your exposures and FX needs is often free. Since even a simple risk management policy can mean the difference between taking profi ts or suffering signifi cant losses, it s worth taking the time to establish an awareness and policy around risk management, whether or not you actually execute a hedge. 2. Reduce your risk without limiting your profits. That being said, it s possible to hedge badly. Hedging too little or too much can be just as disastrous as not hedging at all. Oftentimes, companies lock-in to what they feel is a favorable exchange rate on the assumption that the market will soon move in the opposite direction. However, in many cases, the currency pair in question continues to move in the same direction, effectively making their hedge (at a nowunfavorable rate) into an anchor that prevents them from pricing competitively or maximizing their profi ts. Ideally, a hedge is placed at a break-even level, ensuring bottom line protection without preventing some participation in favorable market movements. 3. Don t feel like you have to manage your currency risk yourself. For many businesses, attempting to plan and execute a hedging program internally can be both time consuming and complicated. Therefore, you should reach out to your fi nancial institution or, better still, to a foreign exchange provider, and leverage their experience in helping you establish and implement a risk mitigation strategy that is aligned to your business goals. Your focus should remain on running your business effectively; let the foreign exchange specialist manage the currency risk. Page 7 of 9 l Foreign Exchange Risk Management

8 Foreign exchange companies specialize in FX services, from simple cash currency exchange to international payment systems to currency risk management strategies. And the best and most competitive provide free consultation for FX payments and currency exposure. If you re considering initiating a risk management program, it s worth at least consulting the specialists and doing it right. Ultimately, your need to hedge your foreign currency risk, and the amount of your exposure that you will hedge, will be determined by your business: where you re buying and selling and in what amount, your profi t margins, and your company s appetite for risk as well as for growth. Unless you or someone in your company is fairly well-versed in foreign exchange, your best option is to consult your bank or a dedicated foreign exchange provider in order to determine exactly what your exposure is, how much or little of it you need or wish to mitigate, and how best to go about reducing your exposure in such a way that provides the most opportunity to both protect and grow your business. About the Author Victor Hinojosa is the Director Corporate Payments Strategy for Western Union Business Solutions, and is responsible for providing strategic payments and hedging strategies to our corporate clients. Hinojosa has extensive global banking experience specializing in foreign exchange (FX) and has worked with leading global fi nancial institutions, corporations and fi nancial technology fi rms. Previously, he worked at JP Morgan in New York and London where he leveraged his unique FX and technology background for seven years. Before moving to the US, he spent six years as an FX trader in Toronto. After joining the company in 2007, he has grown the client base exponentially in his region and has developed numerous strategic alliances with accounting and legal fi rms. Page 8 of 9 l Foreign Exchange Risk Management

9 Tel: I Fax: solutions@ About Western Union Business Solutions is a global leader in foreign exchange and a trusted payments provider to clients operating in international markets. With a robust fi nancial network spanning more than 190 countries and access to over 140 currencies, we empower our clients with simple and reliable cross-border payment solutions. Our distinguished service portfolio and deep industry expertise, enables clients to operate across borders and currencies in fast, reliable and convenient ways. Through our account-to-account payment platform, international payment tools, currency risk management solutions, and fi nancial service partnerships, we help clients improve cash fl ow, manage currency risk and seize global market opportunities. Regional Offices Atlanta 3000 Mill Creek Avenue. Suite 450, Alpharetta, GA Tel: Montvale 100 Summit Ave Montvale, NJ Tel: Global Offices United States Custom House (USA) Ltd. Tel: Fax: Canada Custom House ULC 517 Fort St. Victoria, BC V8W 1E7 Canada Tel: Fax: business.westernunion.ca Australia Custom House Currency Exchange (Australia) Pty. Limited Level 13, 130 Pitt Street, Sydney, NSW 2000 Tel: Toll Free: Fax: au Australian Financial Services Licence No: ABN: United Kingdom Custom House Financial (UK) Limited Company Number Registered Offi ce Address: 2nd Floor, 12 Appold Street London, EC2A 2AW Registered in England Tel: Fax: business.westernunion.co.uk Custom House (USA) Ltd. is owned by the Canadian registered company Custom House ULC. Custom House Currency Exchange (Australia) Pty. Limited is owned by the Canadian registered company Custom House ULC. Custom House Financial (UK) Limited is owned by the Canadian registered company Custom House ULC. This report in whole or in part may not be duplicated, reproduced, stored in a retrieval system or retransmitted without prior written permission of Custom House ULC. Custom House has based the opinions expressed herein on information generally available to the public. Custom House makes no warranty concerning the accuracy of this information and specifi cally disclaims any liability whatsoever for any loss arising from trading decisions based on the opinions expressed and information contained herein. Such information and opinions are for general information only and are not intended to present advice with respect to matters reviewed and commented upon. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Custom House ULC or its affi liates to any registration or licensing requirement within such jurisdiction. All material presented herein, unless specifi cally indicated otherwise, is under copyright to Custom House ULC. Page 2010 Western 9 of 9 Union l Holdings, Foreign Inc., Exchange All Rights Reserved. Risk Management