FX Risk Best Left to Professional Treasury Managers
Knowledge Base – Articles of Interest
Written by Ramki N.Ramakrishnan
Friday, 29 October 2010 15:56
The finance manager of a large company that imports products from Japan was tossing sleeplessly in his bed. Just five weeks ago, the Japanese Yen was trading near 86 to a Dollar, and he was breathing more easily as the Bank of Japan had intervened aggressively to weaken the currency. But today, it had climbed to a fresh 15-year high, and was within a handshake of its all-time high. The move has resulted in a potential loss of nearly 7%. How was he to explain to his boss that the markets moved too quickly and without any correction for him to put on hedges?
Across the city, the treasury manager of a large retail chain wasn’t having an easy time either. His company imports products from the UK and Europe. A few months ago, when the markets were panicking about an imminent collapse of the Euro zone and the so-called PIGS of the Euro Zone (Portugal/Ireland/Greece and Spain) were all hogging the headlines for being on the brink of default, this manager was blamed because he covered a part of his exposure too soon. He “should have known better” than to run for cover, thereby depriving the company of additional profits! But between May and October, the Sterling Pound has strengthened by 13% and the Euro by almost 19%. This manager now faces the difficult task of explaining why he did not cover the entire requirement of foreign exchange for the next 12 months before the markets rallied.
Any business engaged in international trade is exposed to a variety of risks. But the most challenging risk to manage is the foreign exchange risk. Despite the FX markets being the most liquid market in the world, and the availability of a range of products to manage this risk, the treasury manager has the unenviable task of deciding two questions: When to hedge and how much to hedge? It is ever so easy to criticize the manager with 20-20 hindsight. Unfortunately for the treasury manager, he is usually bombarded with emails from a plethora of banks professing to know where the FX markets are going next, and after reading them all, he is no wiser than when he started. When all the banks seem to agree on the direction of the currencies, they are usually wrong. At other times, when the view is split, where some banks call a currency to strengthen, and the rest say the currency has over extended and hence should move down, the treasury manager does not know who is going to be right until after the move. So how can a manager minimize his foreign exchange risk?
FX rates are influenced by underlying economic fundamentals, including interest rate differentials. Market sentiment is also a key driver. Technical indicators are useful to a certain extent in timing the trade, but the decision to hedge should have been made at a policy level. Once the treasury manager is told that he is responsible to execute the hedging policy, he should not be questioned about lost opportunities to hedge at even better levels. The fear of being questioned no matter what he does often makes a manager wait for better levels when the markets move in his favor. This behavior frequently results in losing valuable opportunities because the markets are often volatile, and at times, a favorable level might not last more than a few hours. At other times, the manager panics when the rates move too far from his desired level, and ends up covering at relatively very bad rates.
At some companies, there is an aversion to pay the cost of putting on a hedge. The management considers that the salary being paid to the treasury manager is a large enough cost to bear, and by some miraculous way this person will protect the company from foreign exchange loss because he ‘should’ know when and how much to hedge. Any additional payment for the hedge is simply not worth it!
Experienced and professionally run companies realize that the treasury manager brings to the table his knowledge of how financial markets work, and his capacity to execute the agreed strategy in an efficient manner. These companies do not saddle the treasurer with the responsibility and blame for not knowing where the foreign exchange markets will go in the future. They are also willing to put in the time and effort to develop a coherent hedging strategy, and agree a range of rates and costs within which the Treasury Manager should execute the strategy.
Knowledge of technical analysis will help in timing his many forays into the market to “average out’ his hedge.
To summarize, the management of foreign exchange risk is best left to professional treasury managers who not only understand how the markets operate, but are also given the freedom to operate within an acceptable range regarding the cost. Those who leave this risk to the mercy of the markets will sadly awaken one day to find that not only has their entire business margins been wiped out, but they are actually incurring a capital loss. It is important to delegate sufficient authority and flexibility to the treasury manager, and have a clear and well-understood hedging strategy in place.
The author is Ramki N.Ramakrishnan, an acknowledged foreign exchange expert and professional treasury manager with international banking background.
Published online by the Arab Times – October 29, 2010.