Could FX be one of the key risks currently faced by Treasurers?
François Masquelier, chairman of ATEL
The FX markets have been highly volatile these last months for different reasons. The political situation in some regions and the trade tariff war launched by some big countries can even exacerbate this volatility. The cost of hedging is increasing over year while the hedging has never been so necessary.
No one can deny that the risk associated with exchange rates (i.e. FX risk) have grown in recent months, for various reasons that we won’t examine in depth right now. We can, however, outline a few of the principal reasons behind this resurgence of FX risk, namely increased volatility on financial markets, serious geopolitical problems (with a resulting trade tariffs war) and considerable fluctuation in raw material prices (including that of petrol, which has doubled in a year). Not only has the risk increased, but hedging costs have also soared due to factors such as the inclusion of the counterparty risk over time (i.e. DVA/CVA) and the greater impact of the cross-currency basis swap.
Having foreign exchange credit lines is not as straightforward as it was in the past, when it was generally sufficient to just ask your bank manager for your FX credit lines to be increased. These days, however, a bank might well refuse, as many take the view that this “commodities business” is costly and that it would be preferable to charge the business by volume, limit it or collateralise it (i.e. apply collateral when the “mark-to-market” value is negative). In other words, even though the EMIR has not imposed it on NFCs, there is a growing trend for demanding or recommending bilateral collateral agreements (i.e. of the “CSA” type).
We live in a multi-speed economic world, which explains why monetary policies and interest rates vary from one country to another. The widening of interest rate differentials increases hedging costs, sometimes making them off-putting and even prohibitive in certain scenarios. Consequently, it is vital to understand the risk, to gauge it and to adopt strategies on an ad hoc basis for possible hedging requirements. Not hedging a risk due to the high expense moving forward is a dangerous strategy but nonetheless one which many managers are examining closely, as there’s no actual obligation to always hedge everything. Sometimes, not hedging and instead “monitoring” can prove to be the best choice in terms of foreign exchange strategy. That’s certainly the case for the more exotic currencies and recently, we’ve also seen the base rates of Argentina and Turkey explode, creating an effect akin to an earthquake on the markets. The example of the US dollar versus the euro is interesting in terms of swap points, with nearly 3% offset per year. This gives you an idea of the hedging costs for the dollar seller. This is creating heavy weather in terms of exchange for sellers of German cars or of European aeroplanes. It would seem that, more than ever, a case-by-case analysis is required in order to negotiate a path through this disrupted climate, as each individual needs to fine-tune their strategy in response to the different and fluctuating current context. Having said that, your strategy should not be tailored to the market’s possible volatility, nor should it be reviewed whenever the slightest change occurs on the market, because it is stability and consistency that allow a good exchange strategy to be effective and the results to be maintained over time.
Judging by the number of enquiries and discussions between companies, it would seem that some have suffered exchange rate losses over the past two years. And in a world marked by growing political protectionism, tax rage, customs tariff war and fierce competition between players from the same sector, they are keener than ever to limit the damage and protect their profits. All industries, without exception, are at the same time undergoing a root-and-branch digital transformation (sometimes even a fully-fledged revolution). This factor is in no way facilitating optimised fund management, but is encouraging greater efficiency in order to protect the evolving economic model.
Also worthy of mention are the new accounting standards, with IFRS 9 (the replacement for IAS 39) in particular opening the door to more sophisticated or more “derivative” products, most notably via the treatment of the time value of options. The accounting aspect will perhaps permit hedging that is more efficient and lower-cost, or potentially with a higher contribution, if things go smoothly (i.e. the up-side). But it’s also clear that companies are tending to resort to this type of optional product more often than in the past, given the current exchange rate differentials on certain currency pairs.
The other driving force is market volatility, which is real and significant but, at the end of the day, confined to a certain range. This makes it possible to use satisfactory protective barriers. Being able to use optional derivatives with limited or zero cost, while at the same time guaranteeing accounting treatment as hedge accounting, is an incentive that is aiding the review of exchange rate strategies.
Conversely, the uncertainty regarding the direction of the EUR/USD pairing, for instance, is illustrative of the general uncertainty and the desire for greater and more effective hedging, amid the prevailing doubt. Exchange hedging is therefore taking up more and more of fund managers’ time and energy.
It would also appear that fund managers are hedging for longer periods than in the past, despite the wider rate differentials. It is clear then that the time seems to have come to review the strategies and approaches applied to exchange rate risk management. In my humble opinion, this is going to be one of the major challenges of the coming months. The approach to exchange risk management also seems to be becoming more strategic in order to more effectively mitigate risks. Many CFOs are even considering investing more cash resources and increasing their current staff numbers. Lastly, the technological aspect cannot be neglected. The digitisation of the tools is aiding greater understanding, as well as making the management of the risks involved more specific and above all more dynamic. So while you might think that the management of this highly specific exchange rate risk is not among fund managers’ top priorities, it’s undoubtedly worth taking advantage of this specific context to review exchange rate policies and the best strategies to adopt.