FX volatility, killer of business margins

FX hedging strategies should not be based on market volatility, whatever its level. If well implemented with appropriate IT tools, a FX policy should work perfectly independently of any market changes. Conversely, to navigate turbulent waters, treasurers must be well-equipped with FX-proofed IT solutions aligned to the pre-defined and tested strategy. A strict discipline in monitoring FX policies enables good results and prevent P&L disasters.

Is FX volatility a hedging strategy factor

Companies generally regard rightly FX market volatility as a bad development to be avoided. Treasuries want predictability of revenue and costs to understand exactly how healthy the company’s cash flow will be and to preserve operating margins. However, according to American Express, a whopping 65% of small and medium size companies would not use any hedging strategy to mitigate or offset their FX risk at all. It may shock treasurers of MNC’s used to largely hedge exposures, according to pre-defined strategies. Only a well-balanced business could offer a proper offset and enable a company to avoid hedging. It exists, but it is seldom. If you think about it, the currency volatility is characterized by frequent and rapid changes to exchange rates in the forex market. Understanding forex volatility can help you decide which currencies to trade and how. Volatility in forex (trading) is a measure of the frequency and extent of changes in a currency’s value. A currency might be described as having high volatility or low volatility depending on how far its value deviates from the average – volatility is a measure of standard deviation. More volatility means more trading risk, but also more opportunity for traders as the price moves are larger. Nevertheless, CFO’s and Treasurers of the “real economy” are not “trading” at all.

FX strategies should be independent from FX volatility, even if extreme

However, when markets are (hyper) volatile, hedging strategies should not change, or marginally be adapted to hedge slightly more of the non-hedged off-balance sheet portion. I don’t think market volatility should completely and significantly change a hedging strategy, if well thought, well implemented and if processes are fully automated and systematically applied. That’s the recipe for not being affected at all by market volatilities and shifts. The problem with currency volatility is the difficulty to identify it and to track it, because volatility is, by its very nature, unpredictable. If unpredictable, how do you want treasurers to adapt strategies? It would be tough and risky (even if there are some methods of measuring volatility that can help traders predict what might happen). Furthermore, to complexify the topic, there are also two types of volatilities that need to be addressed for an accurate measure – historical volatility and implied volatility. Historical volatility has already happened, and implied volatility is a measure of traders’ expectations for the future (based on the price of futures options). Again, as it is complex and not the real economy business, better to implement a solid strategy fully independent from any volatility or crises. Historical charts, market analysis and forecasts are useful to assess market trends and adjust or fine tune the strategies, when there is headroom for such refining.

Exposed SME’s and treasuries with floating FX strategies

In some studies (and course it varies from study to study but gives a fair and rough idea of the situation), we found that a third of SME’s in the US have reported gains, or losses of over a million Dollar due to FX volatility. At the end of the day, whatever the precise amount, gain or loss on your P&L is simply not acceptable. Think about it, in a couple of second the whole margin of a deal can be swallowed by a fluctuation in a currency pair. Too bad! Therefore, the key factor in FX management is “time”. Timing is the element to ensure. The faster a risk is identified and reported accordingly to treasury, the better the hedging level. Ideally, apart from swap points (positive or negative / premium or discount), the spot of an underlying business exposure should be matched and equal to the spot rate of the hedging instrument. It is there that the most often there are problems: in the pre-trade phase before the hedging decision. Why? Because there are no automation between the tools (if any) or XL to capture a business transaction in foreign currency and the message to the treasury department supposed to hedged it according to a pre-defined FX strategy.

Reasons for foreign exchange volatility to remain high in 2022

As said earlier, we should not base our strategies on FX volatility. Nevertheless, as it should remain high, it reinforces the idea of revisiting the FX strategy. There are three reasons for still high foreign exchange volatility in 2022. There are, as always many factors that can bring volatility back or to maintain it at high levels. The first one is the divergent central bank monetary policies. The short-term outlook for continued US Dollar strength looks good. The worst of the pandemic is all but in the past and in the economy is improving fast. That is the paradoxical situation we face with a longstanding COVID with new waves and variants, when the economy seems (in many sectors) to be bullish. However, bearish analysts point to the fact that the Federal Reserve monetary policy should remain unchanged as a sign that the greenback’s strength will taper off soon (again), especially when other central banks are tightening their own policies. Some central banks could be tempted to reduce their own asset purchasing programs while more broadly, some other banks have signaled that they intend to change and tighten their monetary policies. The second risk is the rising inflation. The Federal Reserve is purchasing USD billion every month in treasuries and mortgage-backed securities, as well as maintaining its interest rate at a near-zero level to support economic recovery from the pandemic’s impact. However, it is alert to the risk of rising inflation. It now has couple of interest rate hikes in mind by the end of 2023, which is sooner than it had previously indicated. The first of these is expected at some point in 2022. Some large bank CEO’s even that the banks were “effectively stockpiling” cash, because of a “very good chance” that inflation was here to stay. The third (but not the last one) reason is the asset-purchasing tapering is nearing. While the Fed gives no indication as to when it will start to taper off its asset-purchasing program, it will likely occur in or around the first quarters of 2022. It takes time to the economy to adapt to interest rate increases. Of course, these three themes may cause varying degrees of volatility in FX markets into 2022. There is possibility for unforeseen or unexpected developments. For instance, these could include: the possibility of a new coronavirus variant causing restrictions again. The central bank policies are not yet written (unfortunately) given uncertainties.

Should I stay or should I go?” (The Clash) 

Not hedging is not really an option for corporations. While a company may benefit from foreign exchange volatility, such exposure essentially amounts to speculation or, should a currency’s value fall sharply and without warning, it could be viewed as outright negligence. Moreover, a company can still protect itself from downside risk while leaving itself open to FX gains, with simple tools such as limit orders or options contracts. However, critical to a strong FX volatility strategy is access to highly accurate, detailed FX daily and forward rates kept up to date in real-time.  Solid protection from FX volatility can be simple yet highly effective, if well thought and with ad hoc IT tools to automate processes and be systematic. Companies that use more than one currency needn’t leave themselves exposed to the mercy of the unpredictable FX market. With a simple strategy in place using reliable, precise FX data at its heart, complemented by simplified but efficient tools, clear policies in place, automatic limit orders, spot-forward contract approach, organizations can enjoy markedly improved protection from FX volatility.

Don’t be too complacent to FX volatility

In the past, low volatility in the FX markets was making corporate treasurers complacent. Some thought trends were easily identified (although intraday volatility could be huge). Some smart treasurers explored how while spending money on hedging strategies can appear to be merely a cost, the low volatility atmosphere that we were in at the start of 2020 was very unnerving and changed quickly. I do not think it is the treasury duty to adapt permanently the FX strategies to the economic climate. It would be risky, exhaustive, and time-consuming.

The economic history showed that the markets move in cycles, and volatility may spend some time at the lows, but it will definitely not stay there forever, but not disappear completely either. When black-swan events arise, better to be protected and equipped, with the right IT automating solution and proper policies. And with potential interest rates increases, in some currencies, swap points could be expensive. And it is similar with hyper volatile currencies, as we faced it last year (e.g. RUB, TRY, BRL…), it may be impossible to hedge them, unless you adopt a dynamic hedging strategy with adequate tools like KANTOX.

The solution: a good preparation and perfect tool box

Treasurers and CFOs should have a hedging policy in place that protects them from any adverse FX moves currently priced into the market, but also and more important the ones that are not. The current world economy offers many catalysts that can quickly change the currency markets. A good treasurer must assess the corporation views on the market and risk appetite and tolerance. They must ensure they have FX toolbox (whatever but not only a TMS) in place. The tools must be aligned to strategies. Having a strategy impossible to respect or to monitor would be a non-sense. They should also not perceive hedging as starting at dealing a financial instrument with a platform. It is great to focus on the execution. However, if the exposure has been identified late, it doesn’t make sense.

Take-aways

The take-aways are the following: use a systematic approach because it makes the economic situation largely irrelevant. Centralize hedging at HQ and do not try to push FX risk on your counterparties, it eventually would have a cost. Adopt state-of-the-art technologies (on top of your TMS and FX platform if any). Assess FX financial risks and not the accounting risks and therefore hedge off-balance sheet exposure if highly probable (for qualifying for hedge accounting). These off-balance sheet items hedging require excellent cash-flow forecasting tools too. You should not consider the automated strategies are fixed and cast in stones. An FX policy is never rigid and new IT tools enable to adjust when needed, for example by adopting dynamic hedging strategies, by changing percentage of unhedged portions, by changing the patterns pre-defined, etc.…. Eventually, the more individual transactions a corporation has, the more it requires tool to automate processes and apply one-to-one approaches. The B2C businesses are typically the perfect example. Automation enables to mitigate risks and remove operational risks around one of the most manual management areas in treasury. When crises arise, another complex risk to handle comes from cancelled orders and unwinding of hedging instruments to be properly tracked into the portfolios. As timing has been mentioned as the top priority, the strategy must be applied 24/7 and there again, automation is needed, especially when teams must work from home with all the risks it involves. Some treasuries have been hit during the COVID by the absence of ad hoc tools. And you know that once burnt… IT tools give the flexibility and are not binding at all (the opposite).

François Masquelier, Simply Treasury CEO – Luxembourg – 2022

Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).

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