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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.

Financial markets predictions have about as much chance of success as a 4 year old playing pin the tail on the donkey

Stories abound about importers who were told that parity was just around the corner and waited before they took out any hedging. But, no sooner had we seen 0.9851, and there was an about turn and the so-called experts began forecasting that the AUD/USD exchange rate would be at 0.4700 by Christmas.   Of course, it hasn’t traded at either of these levels in the last 6 months and if you had been waiting for them then you would have found yourself panicking at not having enough hedging; or panicking that you might miss an opportunity or being forced to take a currency position that may or may not have suited your requirements.

Over the years, mathematicians have attempted to forecast exchange rates; developing thousands of theories and many models. But, to date, there has never been one that works across all currencies and time periods – otherwise we would all be using it!  

So what does this mean for your currency hedging portfolio?  The most important thing is to be able to predict, with a fair degree of accuracy, the exchange rate level at which your business is profitable.   If you can do this, then the task of managing your exchange rate risk becomes relatively simple: you need to be able to take hedge positions at rates better than your budgeted exchange rate.

Of course, if it was really that easy, then there would be no need for any kind of help or expertise.  The subtlety of currency hedging arises when you consider your competition and the prevailing economic climate.   For those businesses that operate in highly competitive industries with very fine margins, a well managed FX hedge book can add substantial profit to the bottom line.  If this is your business, then being aware of your budget exchange rate is the first step.   From there it becomes important to ensure you balance your portfolio with structures that will mitigate losses and those that will allow the potential to benefit from volatility as well as favourable exchange rate movements.

This approach may very well result in missing the absolute top and bottom, or you may be lucky and take a position at those levels.   But it is quite simply delusional to think that you can pick the extreme of a market and take a position that hedges your entire exposure at that level.   If you could do that, you may as well trade financial markets and give up your day job.

Over the last 12 months, we have seen levels in the exchange rate where both importers and exporters could operate extremely profitably.   It’s interesting then that so much of the recent press coverage is discussing how the volatile conditions are negatively impacting corporate earnings. It is not the exchange rate that has impacted corporate earnings but rather the draw of trying to pick a “good” level.

It is not the exchange rate that has impacted corporate earnings but rather the draw of trying to pick a “good” level

Those organizations that have been accumulating small currency hedge positions over longer time horizons will find themselves well placed during these uncertain times. There are two reasons for this:
i. They will not be overhedged and be able to take advantage of shocks that result in large favourable swings

ii. The ongoing volatility will provide opportunities to close out hedging that may be sub-optimal or restructure transactions to provide greater flexibility and profit opportunities.

Predicting the future may well be impossible. Determining an appropriate exchange rate for your business is not. Being able to mitigate adverse movements and participate in positive ones is simply a function of understanding your core business and taking advantage of prevailing market conditions.

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