CORPORATE FX RISK: IDENTIFICATION, MEASUREMENT AND MANAGEMENT

by Ang Thiam Huat, Honorary Secretary, Association of Corporate Treasure, Singapore

Foreign Exchange Risk is regarded as the effect that unanticipated exchange rate changes have on the value of the firm. Currency fluctuations will impact upon a firm's business, cash flows and value of its assets and liabilities. Consequently, foreign exchange risks must be Identified, Measured and Managed.

How do we measure the currency exposures? Exposures are usually classified under transactional, translation and economic exposures. Every firm's exposure differs given the nature of its commercial transactions and geographical coverage. Ultimately the decision as to the set of most effective and efficient instruments and techniques for the firm would depend on how well the firm's financial and economic interests are protected and enhanced.

The availability of Foreign exchange products depends on the location the firm is operating from, and the currency regime it operates under. Broadly speaking in international financial markets, hedging alternatives ranges from the choice of currency of debts and assets, currency spot, forwards, futures, swaps, options, exotic options and structured products.

What is Foreign Exchange Risk?

Foreign Exchange Risk is a potential gain or loss that occurs from unanticipated change in foreign exchange rate. At an individual level, if a Chinese national owns IBM stocks denominated in USD, the USD/RMB exchange rate is then of great interest to this investor. After all, the relevant returns measure is in RMB, since he is a PRC resident. In other words, the basic objective of any entity must be to at least preserve purchasing power, be it from a local or international perspective.

One may think that a PRC company that procures raw material locally, manufactures and sells locally does not have to face currency risks. But it does. If over time the RMB strengthens against foreign currencies, the relative competitiveness of PRC firms viz-a-viz foreign firms may encourage foreign firms selling more into the PRC market. It is likely that market share and sales volumes would also change given the RMB exchange rate dynamics.

Often besides contractual cash flows, companies also hedge anticipated cash flows. The key is to judge the level of certainty as to the anticipated cash flows. Companies with long business experience are likely to be able to gauge their raw material, sales volumes in various currencies quite well. As to how far out in time should these anticipated cash flows be based upon, this issue is company specific and depends on how confident the firm is in terms of the accuracy of the projections.

Difficulties Faced In Managing Foreign Exchange Risk

Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They hold this view for a number of reasons.

The management team may not fully understand financial markets and instruments. They may view the use of risk management products, such as forwards, futures, swaps and options, as speculative. A lack of understanding and news of financial scandals further add to the fear of financial products. Such fears are unwarranted, since financial risks is inherent in the commercial activities and putting on hedges simply neutralizes the risks.

Currency exposure is often complex and difficult to measure. Despite such difficulties, businesses should continue to improve on their foreign exchange processes and not throw up their hands in despair. It is important to train our colleagues in the commercial department as to the importance of foreign exchange management and the need for good commercial forecasts.

From a transactional perspective, foreign currency receivables and payables may be hedged, but foreign exchange rate movements will invariably affect the business competitiveness of the firm.

Some suggest that there are economic justifications for firms to do nothing about their foreign exchange risk. They believe that firms cannot improve shareholder value by financial manipulations and that investors can hedge corporate exchange exposure by taking out forward contracts in accordance with their ownership in a firm. This of course is not how the real world works, since investors are not privy to the firms' operational exposures, let alone putting on hedges to neutralize the exposures. Some very large multinationals however take the view that since they are exposure in a wide range of currencies worldwide, appreciation in some currencies and depreciation in others would even out the profit and loss effect, and as such they choose not to hedge. By not hedging they also save on the transactions cost of putting on the hedges. There aren't many such firms.

Identifying Foreign Exchange Exposure

It is in the best interest of the firm and its shareholders to ensure that corporate foreign exchange risk is managed well. It is important to identify the nature and magnitude of the firm's foreign exchange exposures.

Firms have receivables, payables, inventories, plant and equipment and other tangible assets in various countries. To gauge impact of exchange rate changes on a firm, we need to measure its exposure or the amount at risk by looking at future cash flows and their associated risk profiles.

Tools and Techniques for the Management of Foreign Exchange Risk

Let us consider the relative features and merits of several different foreign exchange products used for hedging exchange risk, including forwards, futures, debt, swaps and options. Most foreign exchange products enable the firm to take a long or a short position to hedge an opposite short or long position which resulted from a commercial transaction. The cost of these instruments may differ in terms of default risk or transactions costs.

Foreign Exchange Forwards

The forward rate is a price for foreign currency set at the time of the transaction but with delivery taking place at a specified future date. While the transaction amount, the value date, the payments procedure, and the exchange rate are all determined in advance, no exchange of money takes place until the actual settlement date. This commitment to exchange currencies at a previously agreed exchange rate is a forward contract.

Forward contracts are the most common means of hedging transactions in foreign currencies. As the timing of commercial requirement changes, forward contracts can be rolled forward or backward to dovetail into the commercial requirement. Forward contracts require future performance and subject to counter-party risks. If the counter-party is unable to perform on the contract, the hedge disappears and it could be at great cost to the hedger.

Currency Futures

Outside of the inter-bank forward market, the best-developed market for hedging exchange rate risk is the currency futures market. In principle, currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. In practice, they differ from forward contracts in important ways. One difference between forwards and futures is standardization.

Forwards are for any amount the counter-party is willing to quote. Futures are traded in standard amounts, each contract being far smaller than the average forward transaction. Futures are also standardized in terms of delivery date. The normal currency futures delivery dates are March, June, September and December, while forwards are private agreements that can specify any delivery date that the parties agree on.

Another difference is that forwards are traded by phone and through internet FX portals and are completely independent of location or time. Futures, on the other hand, are traded in organized exchanges.

But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the cash flows between parties to the transaction. In a forward contract, whether it involves full delivery of the two currencies or just compensation of the net value, the transfer of funds takes place once at maturity. With futures, cash changes hands every day during the life of the contract, or at least every day that has seen a change in the price of the contract. This daily cash compensation or margining feature largely eliminates default risk.

Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in their applicability. Most big companies would use forwards; futures tend to be used whenever credit or counter-party risk may be an issue.

Use of Debt instead of Forwards or Futures

Borrowing in the currency to which the firm has exposure in or investing in interest-bearing assets to offset a foreign currency payment is a widely used hedging tool that serves much the same purpose as forward contracts.

For example instead of selling USD receivables forward, we can borrow USD and convert into EUR in the spot market, and holding EUR in deposit for say, two months. When payment in USD is received from the customer, the USD proceed is used to pay down the USD debt. Such a transaction is termed a money market hedge.

The cost of this money market hedge is the difference between the USD interest rate paid and the EUR interest rate earned. According to the interest rate parity theorem, the interest differential equals the forward exchange premium or discount, the percentage by which the forward rate differs from the spot exchange rate. The cost of the money market hedge should be the same as the forward or futures market hedge. In practice, the forward market is usually more efficient than a money market hedge, as there are heftier spreads in the loan and deposit markets.

Currency Options

Many companies use forward FX contracts extensively. With a forward contract one can lock in an exchange rate for the future. There are a number of circumstances, however, where it may be desirable to have more flexibility than a forward provides.

A foreign exchange option is a contract for future delivery of a currency in exchange for another, where the holder of the option has the right to buy (or sell) the currency at an agreed price, but is not required to do so. For such a right he pays a price called the option premium. The option seller receives the premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises his option.

Futures and forwards are contracts in which two parties oblige themselves to exchange currencies in the future. They are thus useful to hedge or convert known currency exposures. Options, in contrast, provide the only convenient means of hedging or taking position in volatility risk.

Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the market value of an international firm. At some level, the currency change may threaten the firm's viability, bringing the costs of bankruptcy to bear. To avert this, it may be worth buying some low-cost options that would pay off only under unusual circumstances that would particularly hurt the firm.

Controlling Corporate Treasury Trading Risks

In a company it is difficult to ensure that every risk is perfectly hedged. Not every transaction can be matched, international trade and production are both complex and uncertain. Flexibility is called for, and management must necessarily give discretion to the corporate treasury department in charged of managing foreign exchange risks. However, limits must be imposed on the trading activities of the corporate treasury, losses can get out of control even in the best companies.

Management must elucidate the goals of exchange risk management in operational terms. The risks of in-house trading must be recognized. These include losses on open positions from exchange rate changes, counterparty credit risks, and operations risks. For all net positions taken, the firm must have an independent method of valuing and marking-to-market the financial instruments traded. This is necessary to prevent the hiding of losses. Wherever possible, marking to market should be based on external, objective prices traded in the market. As in all these things, any attempt to cover up losses should be severely penalized.

Finally, counterparty risks resulting from over-the-counter forward or swap contracts should be evaluated in precisely the same manner as is done when the firm extends credit to customers.