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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Currency Hedging as a form of Business Investment

With the combination of unprecedented volatility in foreign exchange markets, and an economic slowdown set to impact importers and exporters alike, foreign exchange management is now becoming an important element of business practice.

For many, currency hedging has been regarded as a speculative exercise, often an afterthought that has little positive impact on their business.  At its best, however, currency hedging can be an important investment in a business’ global growth, and for the astute business owner, the current volatile environment will cement their ongoing success.

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