Currency Risk Management: an alternative income stream for business?

Currency Risk Management, real Currency Risk Management, has the reputation of being a complex part of any business.  Like most business challenges significant opportunities exist from complexity.  In this instance it is the ability to generate an additional income stream.

The Currency Risk Management market is opaque and is maintained that way with

  • hidden margins;
  • the perception of complex products and jargon;
  • difficulty in sourcing tailored advice and
  • of course, highly challenging and volatile price action.

But the concept of risk management itself is very straight forward:

  1. Understand your currency requirements in terms of volume, timing of payments and/or receipts and set your prices
  2. Protect your profits / prices when the market moves against you
  3. Take advantage of the currency price action when it moves in your favour

Adopting this type of Currency Risk Management programme creates an opportunity to diversify business income streams as well as develop a culture of innovation and business adaptation.

So why do so many businesses simply lock in exchange rates irrespective of what the exchange rate is?

In a word: it’s easy.  But to be fair, often business owners and finance executives don’t have the tools or the time to closely monitor the exchange rate and so the argument is put that locking in the exchange rate completely removes the risk. 

This, of course, is not the case.  The risk still exists. 

In the immediate term it’s now just called opportunity cost and over the medium to long term the exchange rate still has to be addressed every time an order is placed, a payment made or funds received.

With a shortage of expert advice in this area, there is also the view that there is no-one business owners can rely on who will act to keep them informed, so it’s very much a DIY environment.

Having developed risk management frameworks for business leaders for more than 17 years, those that successfully implement a true risk management approach are those business owners with a relentless pursuit towards doing things better, who understand that there is no reward without risk but the greater risk is operating in a changing environment using out of date techniques. In this way they have an unrelenting desire to build a resilient and adaptive business and see challenges as a source of innovation that will allow their business to thrive. 

So, if the concept is straightforward, why is the execution so difficult?  The answer is largely that financial markets tend to be very unforgiving teachers and a successful programme has many moving parts. 

The key elements of a long-term successful Currency Risk Management Programme are:

Create a culture of innovation

Over the last 30 years I have met many business owners and finance executives who find currency markets daunting.  Their response is to lock in exchange rates as quickly as possible with little or no consideration of the impact on the business.  This type of behaviour can be highly detrimental to fostering a mindset of innovation as it focusses entirely and only on process.

True innovation requires stopping old behaviours and “unlearning” traditional solutions to consider problems from a new perspective.  Perhaps one of the most dangerous elements of current approaches to managing currency risks is the existing rhetoric that has been used to describe it.  Such long held ideas as:

  • Currency risk can be eradicated using simple hedging products
  • Business owners should focus on their core business and leave the currency for the bank to manage
  • Profits should only come from core business activities

Comments such as these have become accepted norms over the years as a result of their successful application when the currency was first floated more than 30 years ago.  But with increasing competition and globalisation, these assumptions have become flawed and limiting.

To move beyond this, business owners must apply both a convergent and divergent mindset.  The convergent mindset allows improvement and refinement of the things they know.  Divergent thinking embraces the unknown which helps anticipate what’s next and is the key to adaptation.

Access to expertise

Successful financial markets education is typically mentor based which means that you ordinarily look towards outside expertise.  For decades, domestic banks held this role.  But over time the market has become saturated with new international and regional banks, non-bank product providers and specialised consulting services who typically offer product choices without advice.

When it comes to risk management you might look to incorporate this specific product expertise from a bank or other market participant as well as a specialised consulting service, such as Interfinanz, that can both tailor a risk management framework, incorporate appropriate products as well as oversee the ongoing execution of the programme.

It can be tempting to source advice from “trusted advisors” that might already provide some services to your organisation.  However, developing successful solutions to address currency volatility are likely only to be achieved when a deep understanding of the existing challenges facing the business is combined with an equally profound knowledge of financial markets.  The resulting shared ideas are likely to result in appreciating currency risks from a new perspective.

A learning mindset

The art of adaptation and innovation is not a one-off, full scale immediate transformation.  It is about making incremental changes: addressing changing market and business circumstances regularly and frequently.  It is a learning and iterative environment which is undertaken in a series of small steps.

Over time, this approach is likely to lead to a consciously designed framework tailored to the specifics of the business operations.  Each and every decision will be intentionally formed and become ritualistic to form part of the everyday workflow.  The results can then become part of the broader performance measurements of the employee and business unit.

Key business information

One of the most significant inputs into any currency risk management framework is the actual business variables.  The more precise these are, the more successful the currency risk management programme will be.

Generally, budget exchange rates can be set with reference to the prevailing market.  However, significant exchange rate movements often result in budget rate reviews. If you are operating with a true risk management approach, there is NO NEED to change your budget rates because you will already be taking advantage of favourable market movements or you will be protected from significant negative moves in the exchange rate.

Where there is often some uncertainty, is in the actual volume of the currency requirements both from an annual perspective as well as the weekly / monthly requirements.  This is most evident where fixed currency transactions exist against forecast currency amounts and it turns out that these forecasts are now wrong (a common bi-product of the pandemic where orders dried up; payment terms were renegotiated and supply chains were disrupted).  When it comes to managing the payment profile, flexibility becomes infinitely more important than certainty. 

Performance

Successful and well managed Currency Risk Management Frameworks can serve to provide a sense of purpose for those employees that would typically be considered operational and therefore not profit generating.  Some of the bi-products include:

  • A diversified income stream away from the core business
  • Improved employee experience by giving traditional cost and operational centres a sense of profit contribution
  • Support for the broader employee experience by demonstrating the leadership team’s support of innovative thought and delivery, creating a mindset for change and innovation
  • Support for the overall success of the business ensuring consistent customer experience by providing a coherent company structure focused on providing solutions for customers

Adaptability is an essential skill in today’s economic environment, but it’s not without its challenges.  It requires leaders to continuously scrutinise previously successful behaviours and beliefs and assess whether they are still appropriate for the future. 

The pandemic has provided a rare opportunity to make meaningful changes to business practices and to test outcomes when assumptions are reversed. It has also inspired the best leaders to encourage a culture of flexibility, diversity of thought and innovation.

If you would like to discuss ways to apply these principles to your currency risks, we’d love to hear from you.

Currency Risk Management and Diversification

Every business owner is exposed to some type of risk in their everyday life – whether it’s from driving, walking down the street, selecting stock lines or something else. A business owner’s personality, lifestyle, age and business experience are among the key factors to consider for individual risk purposes. Consequently, each business owner has a unique risk profile that determines their willingness and ability to withstand currency fluctuations. In general, as perceived financial risks rise, greater returns are expected to compensate for taking those risks.

Quantifiably, risk is usually assessed by considering historical price behaviour and outcomes. In the finance world, standard deviation is a common metric associated with risk Standard Deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.

Business owners typically develop risk management strategies to help manage risks associated with their business activities. Measuring and quantifying risk often allows business owners to hedge some risks away by using various strategies including diversification and derivative positions.

Perhaps the most basic (and effective) strategy for minimizing risk is through diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified currency portfolio will consist of different hedging structures that have varying degrees of risk and correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against losses, it is the most important component to helping business owners reach long-range financial goals, while minimizing the risk of potential losses.

There are several ways to plan for and ensure adequate diversification including: 

  1. Spread your currency portfolio among many different hedging structures. Look for a mix of transactions whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your currency portfolio is declining in value, the rest may still be increasing;
  2. Stay diversified within each type of hedging structure. Include a variety of maturity dates and time horizons;
  3. Include structures that vary in risk. You’re not restricted to picking only those structures that provide absolute certainty. In fact, the opposite is true. Picking different hedging structures with different rates of return will ensure that large gains can offset losses;
  4. Consider a variety of transaction providers. When one provider does not have a risk appetite for your business or industry another may.

Keep in mind that currency diversification is not a “set and forget” concept.  As business owners perform regular reviews to ensure that their business is operating at an optimal level, so too can this approach be applied to the review of financial risks within the business.  This will necessarily result in a review of the current currency portfolio and may result in the need for it to be rebalanced to ensure that the risk level is consistent with the redefined overall business strategy and goals.

The Bottom Line

We all face risks every day. In the financial world, risk refers to the chance that a financial transaction’s actual return will differ from what is expected – the possibility that it won’t do as well as you’d like, or that you’ll end up losing money.

The most effective way to manage financial risks is through regular risk assessment and diversification. Although diversification won’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return will help business owners achieve their financial goals through decisions that they can be most comfortable with.

Currency Risk Management for Competitive Advantage

There are many ways to manage currency exposures.  Some give you long term fixed rate outcomes so that your business has complete certainty as to the exchange rate.  Other approaches simply take the prevailing rate of the day with the hope that if the market moves adversely, this can be either absorbed into profit margins or passed on to consumers.

So, this begs the question:

Are all approaches to the management of currency risks appropriate and if not, what does a sound currency risk management strategy look like?  

Ideally, any currency risk management approach should allow you to hope for the best and prepare for the worst.  In our parlance, this is protect your business from unfavourable movements in the exchange rate while allowing it to benefit from favourable ones.

Key to achieving success in this endeavour is to have a comprehensive knowledge of the currency exposure profile with particular emphasis on events that can significantly alter that profile by either making it materially larger or smaller.  This then provides the foundation on which to build the currency strategy.  The more detailed the knowledge of your exposures the more sophisticated your potential currency strategy can be. 

Armed with this information, we can then consider the following:

What is the purpose of our currency risk management strategy?

The answers may not be different from those I suggested above.  You may want:

  1. Certainty as to a long-term exchange rate; or
  2. Being able to achieve the best rate on the day.

But why not take best of both worlds?  We want our clients to be able to use their currency positions when the hedge rates are better than the current market rates while still being able to use a more favourable spot rate if that is available.  Over the long term, this type of approach will generally result in exchange rates that are superior to a long-term fixed rate and very regularly better than the average spot rates over a medium to long term time frame.

Advantageous currency outcomes and therefore, a sound risk management programme, have a very real role to play in the attainment of a business’s competitive advantage particularly as it can provide an additional revenue source that can support lower product margins or provide cashflow for other uses. In this way, the currency risk management programme contributes to a business’ ability to staying ahead of its competition by providing lower prices or greater benefits and services that justify higher prices.

This should not be confused with speculating on exchange rates with a view to generating a profit stream. Rather our goal is to support the underlying business activities of each client by creating an appropriate risk management strategy such that it that can outperform both fixed rate hedging without sacrificing the opportunities that arise from highly volatile markets. 

Measuring Your Currency Risk Management Portfolio

When you commence a risk management portfolio, it’s important to remember that you are making decisions for both the short and medium term.  In most instances, the objective is to attain certainty regarding your currency requirements as well as the attainment of a particular exchange rate level on an annual basis.

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How Important is Collaboration with Your Financial Advisor?

Much has been written about the role of a Financial Advisor. ASIC have suggested that:

Consumers who seek financial advice expect their advisor will act in their best interests and that the advice provided will leave them in a better position. (RG 175.244)

When assessing whether an advice provider has complied with the best interest duty [consideration will be given to] whether a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. RG 175.245)

But what does this mean in practice?

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What is Tailored Financial Advice?

Tailored financial advice is to the financial services industry what Haute Couture is to women’s fashion and a bespoke suit is to men’s fashion.

To illustrate, let’s consider a suit. A suit can be bought for a man or a woman. It can be bought off the rack from a department store or it can be made to your own exacting specifications and body shape.

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The Business of Currency Risk Management – Focusing on Risk and Return

While there is nothing wrong with only focusing on protecting against currency losses. In the current highly competitive environment, there are those who are only focusing on maximizing profits. These are the companies that typically hedge everything with a set and forget strategy when the market is moving against them, or don’t hedge at all when the market is moving in their favour.

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The Business of Currency Risk Management

Unlike most financial markets, currency markets move in relative terms.  They are impacted by the economic and political conditions and policies of one country compared to another as well as the observations of traders and commentators as to the successful (or not) implementation of these economic and political policies when one country is compared with another.

How then, do we take this information and use it to achieve the best possible result as it applies to the management of currency exposures?

In this paper we will discuss:

  1. How to define currency risk management;
  2. The application of Benjamin Graham’s investment approach to currency risk management; and
  3. Why it pays to take a disciplined approach to currency risk management
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Herd Mentality

As experts examine the factors that led to the world’s financial crisis, research offers intriguing insight into the role human behaviour and hormones may have played.

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The Folly of Forecasting

The beginning of the year heralds the time for predictions.  It seems everyone has a view as to the direction of financial markets – equity, debt and FX – and each forecaster can give you a plausible explanation as to why you should believe them.  But financial markets predictions have about as much chance of success as a 4 year old playing pin the tail on the donkey: if you get it right, you have been very lucky.

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