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:
- Understand your currency requirements in terms of volume, timing of payments and/or receipts and set your prices
- Protect your profits / prices when the market moves against you
- 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who understand that there is no reward without risk but the greater risk is operating in a changing environment using out of date techniques.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.
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.