Transactions that encounter different currencies naturally bring the added risk of currency fluctuations – one of the many risks a firm operating in international markets must acknowledge and actively deal with. Indeed, for companies stretching across national boundaries, either through regional subsidiaries or with a client base in different geographies, the pitfalls of foreign exchange (FX) risk can – if not dealt with efficiently – put significant strain on a company’s financial health. Fortunately, a variety of FX risk management tools and strategies have developed as markets have become more and more globalised, with treasury and finance departments becoming using more and more adept in dealing with the risks inherent in international transactions.
While there are many tools and instruments available to a firm’s management, used individually or as part of a tailored platform on which a number of the instruments are used collectively, risk assessments should be ongoing as part of the company’s risk assessment and changing appetite for different types of risk. But fundamentally, a company’s ability to use currency hedging tools and optimise its place in the international marketplace while making successful exchange rate forecasts will determine its success. There are a number of markets and strategies a firm will enter.
One established way of mitigating currency risk is by entering a forward currency contract. Although forwards are not specific to currency transactions – they are often used between entities in exchanging interest rates and other financial devices – they have long been accepted as useful currency hedging strategies. In its most simple terms, a forward contract is a unique, customised contract agreed upon by two entities to buy or sell a certain amount of a currency at a set rate of exchange at a future date. A company will find use in this type of agreement should it require a certain amount of a currency for payment of another core business transaction at a set time in the future and has concerns about the fluctuating value of that currency. Forward contracts are not traded on an exchange, and are referred to as over-the-counter (OTC) instruments. As they are not traded on exchange, they have an increased amount of counterparty risk – the risk that the entity on the other side of the transaction will not be willing or able to fulfil its side of the agreement.
To mitigate counterparty risk, a firm may wish to enter the futures market. Here, standardised contracts are traded on an exchange, where there are hundreds of different products opening, exchanging and expiring constantly – providing a firm with a plethora of options to suit its needs. Exchanges have less counterparty risk as they have a wide variety of customers, members, clearing house systems and are thoroughly regulated with their own risk management procedures and tests. Currency futures markets are used both for speculative purposes and as a mechanism for currency hedging, and once a contract is entered into there is a formal obligation for all entities involved to buy or sell at the terms speculated in the contract.
This is where options contracts become an incredibly appealing proposition for many entities aiming to mitigate currency risk. These contracts work on the basis that although the entities have agreed to exchange a set amount of currency at a given rate some time in the future, the entity on one side of the agreement is not obliged to do so: it has the option to see the contract through or effectively cancel it. This gives that party the optionality to see through the contract and take the currency at the stipulated rate, or enter the spot market for that currency if its exchange rate is more favourable to that outlined in the option agreement. There are other things to consider when entering and exiting an options contract – such as the cancellation and strike price – but the flexibility it provides firms is particularly appealing for treasury and risk managers.
Within each of these mechanisms, firms have a wide range of options in who to deal with, given the volume of organisations keen to enter currency markets in order to mitigate FX risks. Within the OTC space, large firms regularly enter contracts among themselves, and it’s not unusual to see companies in similar industries or business interests entering currency hedging agreements. There is a variety of brokerage firms assisting and mediating with this process, as well as risk management advisory companies – such as Chatham Financial – established in the marketplace to create and develop currency hedging solutions. Separately the volume of individual speculative investors has increased substantially over the past few years, with the increase in internet platforms offering currency trading solutions. That’s added both volatility and liquidity to the market.
Frontier management
With the increase in FX trading over the past few years, financial markets have become more widely inspected by regulators. In the US, a number of entities are responsible for monitoring the markets, from the Securities and Exchange Commission (SEC), to the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). In the United Kingdom, the Financial Conduct Authority (FCA) keeps a watchful eye for issues of market manipulation and illegal trading, and in Europe, the European Securities and Markets Authority (Esma), creates directives at the European Union level for updating member states on changes in the marketplace. Each jurisdiction has its own financial regulator in charge of FX markets, but problems can arise when market abuse occurs across jurisdictions in establishing which regulator should be providing oversight on a dispute.
OTC and exchange-based platforms offer a wealth of options to treasury and finance managers in mitigating FX risks, providing short-term solutions that allow firms to change their risk profiles and operate with greater certainty. The regulation of the products offered in these marketplaces further adds to that certainty, and provides direction and a degree of control over the systems in place as well as guidance for market participants. However, while these markets provide short term fixes to currency fluctuations around deals, there is a raft of other strategic considerations a company must bear in mind as it enters and exits different geographies and financial regimes.
Over the medium to long term, finance and treasury managers must constantly be looking internally, at the changing corporate direction of the firm, as well as shifts in the economic landscape in the jurisdictions in which it operates. Price adjustments of goods and services in comparative areas must be borne in mind, and how much risk is generated attached to the currency in which these tools are produced. The variance and covariance of the linkage between these and the currency in which they are denominated will be crucial as to how the firm will wish to adjust its output, and hedging strategies. Further, the frequency of changes to these links will need to be assessed in order to counter fluctuations.
The location of the markets in which a company chooses to produce and distribute goods and services is crucial when assessing exposures. Some countries’ regulators will have stable, long term plans for their currencies, while others may have a history of intervening for their own political and economic prosperity. Each jurisdiction has its own attitude toward setting interest rates, for instance, which has a profound impact on rates of inflation and the fluctuations in different currencies’ rates of exchange. Complicating matters, if a firm imports goods or services in one currency to a satellite office in another jurisdiction for manufacture, then produces financial reports at a head office in a third currency, the company’s treasury and financial risk managers have an added layer of adjustment to make.
Depending on a firm’s strategic advantages, and appetite for gaining greater pricing power, these issues will factor heavily in its assessments of where it chooses to base itself.