You Don’t Need ‘Experts’ for FX Risk Management
by Jochen Schwabe, General Manager and Partner, Schwabe, Ley & Greiner
Particularly during turbulent times, good risk management requires professional work rather than better forecasts or superior tools. In this article Jochen Schwabe comments on recent project-related experience.
The level of interest in the issue of FX management correlates with exchange rate volatility. Since the end of 2014/beginning of 2015, this issue has again been en vogue due to the extreme fluctuations of the US dollar, Swiss franc and the rouble, not to mention the recent devaluation of the renminbi. These events trigger the appearance of numerous specialist papers from so-called ‘experts’ who explain how the future policy of the Fed or the Chinese government should be interpreted or who advise us to rely on new, better and superior tools or strategies: more options, ideally structured, overlay strategies and the like. Two key messages here:
- Anyone who knows which direction the markets are going to develop in more than 50% of cases neither works as a consultant nor as an ‘expert’ and doesn’t give interviews in specialist journals; preferring instead to enjoy their wealth in peace and quiet.
- At the end of the day, everything which generates a gain or a loss is speculation rather than a hedging instrument. And no instrument is sustainably better than any other. Arbitrage ensures this.
We have carried out more consultancy projects related to FX risk management in the last six months than in the preceding two years. This allows us to draw several conclusions.
1. Accurate risk identification and analysis are key
Every business model has its own pricing mechanisms. While oil companies pass on the volatilities related to the US dollar and oil prices to us consumers via digital price displays at filling stations in real time (and therefore are not themselves exposed to FX risk), car manufacturers bear risk for periods considerably longer than a forecasting horizon of one year, given that they can’t afford to correspondingly adjust the prices of their products in foreign markets annually.
If you don’t exactly know the mechanisms involved and, as a result, the actual exposures and risk profiles of your own company, you don’t have a basis for a reliable strategy. Our projects have highlighted the following: the risk profiles of many corporates are more complex than you might think. They are often also differentiated in terms of various business lines, products and markets. And what’s more: they are constantly subject to change, e.g., due to the influence of the internet, the opening up of previously protected markets, the market entries of new competitors, etc. While the standard risk horizon of a tour operator, for example, used to be the period covered by a single brochure, i.e., around six months, this no longer applies to at least that part of the business which is sold via the internet where it is possible and/or necessary, due to competition, to pass on changes in cost factors much faster.
Risk profiles tend in reality not to overlap with forecasting periods or financial accounting deadlines. Risk exposures also tend to arise not at the time that they are recorded but some time earlier, when a binding offer is formulated, a contract concluded or when prices are set. Prices are defined and change to reflect markets. It is therefore not possible simply to define risk horizons via policy documents issued from the relative isolation of the corporate treasury department. They need to be analysed ‘closer’ to the relevant transactions.
This might be tedious (see Case Study 1 for an example of the procedure) but is nonetheless essential. Without such an analysis or as a consequence of inaccurate results, any risk management efforts will not only be off-target but perhaps also contra-productive or even risk-exacerbating. If a business division with a price-adjustment horizon of three months in its markets is forced by a group-level policy to ‘hedge’ its forecast cash flows for the next 12 months, then the actual risk exposure is tripled and the relevant prefix reversed due to the fact that Months 4 to 12 were previously not exposed to any risk. For competitive reasons, the business division is forced to take exchange rate changes into account in its prices from Month 4 onward at the latest, despite having ‘fixed’ the originally forecast amounts, i.e., there exists a clear risk mismatch.
Case Study 1 – Risk analysis
The corporate treasury department of a major conglomerate with global operations wanted to review the assumptions about the risk horizons defined in the group-level FX risk policy document. This document stated that at least 80% of all forecast cash flows in FX were to be hedged for a period of 12 months. After a number of changes in terms of the group structure and the business model, doubts had arisen as to whether the uniform assumption of a 12-month risk horizon could apply to all business divisions in practice. It appeared challenging to fundamentally analyse this for all business divisions. We proposed initially analysing one business division where the doubts about the validity of this approach were particularly acute rather than analysing all of the divisions. Applying Popper’s falsifiability principle, the idea was that if the sample division highlighted that the ‘12-month policy’ was incorrect, then it would be possible to investigate other divisions step by step, and this would have also served as the justification for a more comprehensive project.
The first step was a workshop with personnel from the sales, purchasing and controlling departments of the relevant division, i.e., well away from the classic domain of treasury and at the heart of the underlying core business processes. After a two-hour meeting, it was already clear that such a long risk horizon was not appropriate in this case. It was obvious that prices changed in response to numerous factors, of which exchange rates were only one, over short periods ranging between six and eight weeks. It was plausible that this was associated with the nature of the business (oligopolistic situation) as well as the geographical locations of the production sites of relevant competitors (all in the same currency region).
Given that a copy of the minutes of the meeting, full of anecdotal evidence, did not appear sufficient in order to question the validity of the entire corporate policy and to trigger change, the actual sales prices of recent years were subjected to a multiple regression analysis. This procedure is necessary due to the fact that clear 1:1 relationships between exchange rates and product prices are rare. A whole series of factors generally influence prices, as a result of which, in simple terms, it is not possible just to claim: “A change in the exchange rate of x leads to a change of y in the price at time point z”. In reality: “A change in the price at time point b is, inter alia, also a result of the change in the exchange rate at time point a.” The most challenging aspects of such a procedure are often establishing constant and valid time series of the prices themselves as well as the influencing factors to be investigated. This was also the case here. The calculations took into account not only the relevant exchange rates and commodity prices but also the share prices of key competitors as approximations of their relative commercial strength.
The regression analysis clearly highlighted that a change in the exchange rate investigated had a highly statistically significant influence of more than 30% on the actual change in prices as early as one month later. As a result, the assumption of a 12-month risk horizon should be abandoned. Entering into FX futures for Months 2 to 12 didn’t hedge the risks that this division was exposed to. On the contrary in fact. This was an important lesson for the company in question and one which was acquired within just a few weeks and at the cost of just a few consulting days.