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.
Sometimes such strategies are highly effective, particularly if you can pass on currency costs as higher prices to your customers.
But what happens when the market turns right in the middle of your very successful risk management approach?
You have a couple of choices:
i. You can pass on the cost to your customers as increased prices; or
ii. You can absorb the losses until the market recovers
Both of these are very expensive alternatives and will potentially impact the profit line. How large this impact will be will depend on how quickly any price rises can be passed on and how quickly the market recovers.
But there is a third alternative, again borrowed from Benjamin Graham:
adopt a strategy that both protects against serious loss and aspires to an adequate not extraordinary return
It is this type of strategy that most clearly applies the elements of a businesslike approach to currency risk management as it requires the following:
i. Considered decisions regarding appropriate exchange rates for setting prices, the volume of anticipated annual currency requirements and payment schedules;
ii. The setting of the key goals to be achieved in light of market conditions and how these goals should be measured
iii. Regular management discussion and review of the performance against key benchmarks, altering the benchmark parameters if required
iv. Constant questioning as to the direction of the underlying business and whether the currency strategy will continue to support these internal goals while reviewing the broader market to determine whether it can provide unexpected windfalls and benefits
Part of running a businesslike risk management portfolio involves the critical analysis of performance.
It is inevitable that from time to time bad decisions will be made. However, dealing quickly with the difficult admission that mistakes have been made can, over the long term, add to the portfolio’s success. This is achieved by early admission of the error and then looking for opportunities to address the potential loss.
Unlike many investment markets, the relative nature of currency markets means that there are often opportunities to profitably close-out transactions that have turned out to be inappropriate. Providing due consideration and review have been undertaken, the closing out of transactions should simply be considered as one of the choices that makes up a businesslike approach to currency risk management.