FX risk management cannot be an afterthought
May 2014 | EXPERT BRIEFING | BANKING & FINANCE
In today’s fast-moving and globalised economy, currency volatility has emerged as one of the most significant financial risks for businesses. Typical bank and broker costs for FX transactions include a huge spread, extortionate commission fees and additional delivery charges. This is true for businesses of all sizes – from SMEs to multinationals – though where large corporates have learned how to adapt and maximise profits, small and mid-size companies are often not so well prepared. Of course, levels of risk exposure will depend on a range of factors, from overseas assets and subsidiaries more likely associated with big businesses, to the ebb and flow of FX associated with standard import/export activity. Despite the fact that international trading is increasingly common, the associated risks and potential impact on all-important profit margins are still not well understood by small and mid-size companies.
There can be no doubt that the global economic crisis has completely changed the financial landscape and business attitude to risk. However, in this ‘post-war scenario’, banks are being forced to deleverage, raising their collateral requirements to provide hedging services, which enable customers to offset against the risk of adverse FX movements. This creates a serious problem for companies with limited access to capital, who are struggling to get access to credit and financial derivatives with which to hedge risk. It’s possible, therefore, that the issue these smaller businesses face is not so much a lack of awareness of the risks, but an inability to address them.
Hedging lies at the heart of mitigating FX risk. Insufficient hedging against exposure can see even the largest profits turn to losses, quickly undermining the exciting opportunity and growth potential that comes with doing business internationally.
Mitigating against fluctuations in foreign currencies is not a one-off, ‘tick it once and it’s done’ exercise. It requires continual reassessment (at least once a year) of exposure to risk – a calculation that should not lie solely with the treasurer, but with the senior management team. This group must calculate their exposure, margins, profitability of the business and risk tolerance to establish a coherent FX policy. The policy should be mathematical, and scientific – a decision based on real numbers. There’s no room for hopeful optimism here – forecasts should be based on a worst case scenario outcome. This worst case scenario might be that you lose 30 percent of your revenue due to market volatility. If your profit margin was planned at 50 percent, you lose some money. If your margin is just 5 percent, you have a problem. Put simply, acceptable risk exposure depends on an individual business’ ability to absorb a potentially large FX movement.
Making these sorts of decisions is far easier for large corporates, with access to live market rates, risk management systems to monitor their exposure, and competitive FX hedging offers from traditional banks and brokers. Not so for the smaller players, who may not have an in-house FX expert to offset the increased complexity of the market. Although finance officers will understand they are exposed to risk, knowing and managing that exposure is not really their core business.
This complexity is exacerbated by the banks, who usually try to sell the products that are most profitable to them – needless to say, this rarely includes simple spot forwards. This is certainly true in dealings with smaller clients, who are less skilled in the intricacies of FX management and do not have access to the live interbank market rates. Products that look attractive may hide a great deal of risk – buying advanced products that you don’t understand is never a good idea.
Banks and traditional brokers have created a culture of opacity when it comes to FX transactions, which suits them very nicely. However, the tide is turning. We have seen a wave of innovation in the FX market in recent years, and businesses are now beginning to associate alternative finance options with more choice, better clarity and lower fees.
As the global market becomes increasingly competitive, finance officers must start to take a more proactive approach to risk management, putting hedging policies in place before they suffer a significant FX loss. Part of cashflow planning has to be a focus on protecting margins – sales are nice, but it’s a shame if the profit margin on those sales is lost in poor FX management. It’s nice to grow, but better to grow profitably.
Taking control of the business finances requires thorough research of all the available options to ensure that currency exchange is just that – an exchange. There’s no room for a greedy middle man.
Philippe Gelis is CEO of Kantox.
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