Steps to prepare your organization for currency risk.
Source: Bob Tull, Global Head of the Financial Risk Solutions Group.
Among the many potential perils and predicaments keeping the C-suite up at night, currency risk often takes a backseat to other more pressing matters—particularly during times of low volatility in global currencies.
Yet, with the Federal Reserve poised to continue raising interest rates and U.S. monetary policy tightening, global currency is poised to make that jump back to front-seat status.
Historically, rising interest rates have gone hand-in-hand with increased relative currency valuations. Although that correlation has weakened in recent economic cycles, there are also other forces at work, including diverging global monetary policies, recovering commodity prices, and political uncertainties—which range from tensions with North Korea to the impact of Brexit.
Incurring a charge due to currency fluctuations may do more than simply impact quarterly earnings: It can, and often does, have a ripple effect on the cash position, capital structure, and long-term strategy of your company.
Whether your organization has direct or indirect currency risk, your best defense is to understand your exposure points, estimate the potential cost or benefit to your company’s bottom line, and take appropriate steps to prepare.
Looking Beyond the Greenback
Planning for currency fluctuations isn’t simply a matter of making a call on, say, the value of the euro against the U.S. dollar. It’s typically far more complicated—currency swings can have both positive and negative implications for any single company. Take the strengthening U.S. dollar for example: While it’s a headwind for exports, it can simultaneously shrink overseas production costs.
Rarely is it a one-to-one relationship, however, and in most cases companies need to contend with multiple currency moves. Likewise, company leaders often assume that as long as they import and export in U.S. dollars, they need not be concerned. Currency movements can still have indirect consequences, though. For example, suppliers, purchasers or competitors may adjust their prices or orders to reflect those shifts.
To be sure, it’s important to see risk from all angles. Many companies focus on the most visible risks, only to discover their bigger exposures come from unforeseen areas.
Taking Stock of Your Risk Tolerance
Before rushing into a hedging strategy, companies should conduct a comprehensive assessment of their currency exposure and understand its true impact on the company.
At Fifth Third, we work closely with our clients to help identify, analyze, quantify and hedge currency risks. After factoring for risk tolerance, we then develop an appropriate strategy.
Hedging programs vary greatly between clients, size, industry sector and seasonality. There is no single answer for how much currency risk to manage. While one company may conclude its balance sheet can withstand dramatic swings, others may want to take steps to mitigate most of their currency risk. Still others may fall somewhere in the middle, opting to hedge a portion of their exposures.
Finding the Right Strategy
A hedging strategy is one way to smooth out the effect of currency fluctuations. But it is not the only approach—much as currency risk tolerance varies from one organization to the next, so do the appropriate strategies for dealing with it.
- Offsetting Cash Flows: For companies with overseas operations, using offset cash flows—that is, keeping local sales and expenses in the same currency—is a relatively simple and sustainable solution that minimizes the effects of currency swings. In this case, companies still have currency risk as it relates to potential earnings or the value of the balance sheet, but this is often a key step to ensure steady cash flow in the face of currency moves.
- Taking a Defensive Stance: Many organizations will seek to hedge against a portion of currency risk for known exposures. Two common scenarios are overseas payrolls and receivables not offset by local expenses. Forward contracts are often used in each case, providing companies the ability to “lock in” a set price on a specific amount of currency on a specific date (i.e. bi-weekly payroll). The forward contract creates cash flow certainty against potentially devastating fluctuations.
- Being Opportunistic: Although some companies view hedging currency risk as a cost of doing business, others see it as an opportunity to express a market view. In those cases, collaboration with bank advisors is paramount to mitigate downside risk and maximize the opportunity. Experience has taught us hedging strategies are often most successful when the risk is clearly identified and several scenarios are conducted to ensure that the strategy reflects the company’s risk tolerance, market views, and cost structures.
As with any risk, it’s important to plan during times of calm rather than attempt to batten down the hatches when a storm rolls in.
Managing currency fluctuations isn’t simply a matter of hedging currency risk. It requires a comprehensive risk discipline that encompasses many facets of currency risk—including unforeseen variables and company risk tolerance—without losing sight of the big picture.
Over the past 40 years, Fifth Third Risk Management has worked closely with companies of all sizes, in different industries and with a wide range of currency exposures. Experience has taught us no two hedging strategies can be the same… because no two companies are the same. And so we work side by side with our clients to help identify their risks, needs, and unique circumstances—then execute the most appropriate strategy.