Published: September 01, 2012
Sunday 17 June saw Coca-Cola Hellenic’s entire treasury team gathered in the office waiting for the result of the crucial Greek general election, which many observers had billed as a referendum on the country remaining in the Eurozone. If the anti-bailout parties won, the team would start executing changes immediately.
In the end the pro-bailout parties won and the fears of an imminent Greek exit receded. However, Coca-Cola Hellenic, like many other companies, continues to face the challenge of identifying and managing risks - from commodity volatility to interest rate and foreign currency risk.
In June 2012, right after the aforementioned elections, Reval hosted a webinar with Coca-Cola Hellenic to discuss the financial risks treasurers face as a result of the Eurozone crisis. We asked the more than 100 treasury professionals who attended a series of polling questions, which revealed their concerns and preparations for a potential ‘Grexit’.
Perhaps unsurprisingly, given the nature of the Eurozone crisis, 45% of those surveyed said foreign exchange risk affected them most in today’s turbulent marketplace. While no-one knows yet what will happen, the essence of managing foreign currency risk is managing uncertainty. Treasurers are struggling with the impact of extreme market volatility and watch as euro spot rates shift, often as a result of political events, such as Greece borrowing money from the International Monetary Fund in April, the launch of long-term refinancing operations (LTROs) by the European Central Bank in August and lately the Greek elections.
To manage FX risk proactively, corporates should identify exposures across the enterprise. While this may not be a new tactic, the euro crisis adds a new dimension as it is not enough just to monitor exposure to the euro, but rather to the individual countries within the Eurozone. For example, if Greece were to exit the Eurozone and a new currency to be introduced, companies need to know their exposure to Greece. Many traditional treasury systems are not able to make this distinction.
One of the ways to reduce risk is natural hedging. Many corporates are looking to match revenues and costs in the same currency and, more importantly, match funding in a country to the investment in that country. This reduces the number of hedges, reduces costs and complexity and avoids unhedged positions.
When hedge accounting is applied, the time and effort invested in understanding markets and volatilities could pay off for corporates. If the effectiveness of the hedges is monitored continuously, over-hedging can be avoided and dynamic changes can be made. Also, although many banks are eagerly trying to show the benefits of hedging with options, risk managers who analyse volatility curves and understand underlying constructions will realise that collar strategies may actually be inefficient in emerging markets. It is important to analyse hedge accounting strategies and find out whether a forecast transaction is highly probable in the current environment, as this is a requirement for compliant hedge designations.[[[PAGE]]]
Like FX markets, interest rate markets are also uncertain. Unsurprisingly, 20% of the treasurers we polled said they were most concerned about interest rate risk. Today, leading companies are designing contingency plans in which they develop potential scenarios, assign probabilities to each of those and then determine action points to address each potential risk identified.
At the height of the 2008 global financial crisis, the financial community saw tenor basis risk in the most liquid currencies rally to 80 basis points, which significantly impacted their pricing and in turn the valuation of certain financial instruments. It is unsurprising that interbank swap spreads and EURIBOR rates are again widening and increasing, mainly due to counterparty risk. In addition, headlines in the business media highlight the widespread concern over the functioning of the LIBOR market. As a consequence, organisations are moving to overnight index rates in product types and also considering overnight discounting for valuation purposes, depending on collateral posted.
Companies need to have an educated view on the expectation of forward markets. Clearly treasurers that chose to swap liabilities into floating rates would have achieved a cash gain of lower interest charges. However, it is not as simple as choosing between floating or fixed rates; factors such as the industry the company is operating in or exposures to emerging markets must also be considered. Cash-Flows-at-Risk (CFaR), correlations between other risk factors and scenario analysis should all be utilised to professionally manage interest rate risk.
It is also becoming apparent that fewer European corporates are trying to raise US dollar funding as the credit valuation adjustments on long-term cross-currency swaps are increasing to a prohibitive level. As currency basis swap spreads widen, so too do funding costs increase. Timing is of essence. In today’s turbulent times organisations should no longer raise debt when they need it, but rather whenever possible.
Commodity risk is another top risk concern. There is no question about ‘if’ commodity risk should be monitored; the question is ‘who’ should manage it - either procurement or treasury? There is a significant shift in responsibility from procurement to treasury as treasurers are tasked by CFOs to provide an integrated view of risk and align hedging activities and hedge accounting more closely. To do this effectively treasurers must consider moving away from a traditional TMS system and leveraging a treasury and risk management (TRM) solution to manage and identify commodity exposures and value and account for derivatives to hedge those exposures. In the constantly shifting financial environment we operate in today, TRM solutions are emerging as the next generation of treasury technology. Awareness of risk, both in daily planning and long-term decision making, puts the ‘R’ in TRM – a key distinction that sets TRM apart from the outdated concept of TMS.
Because commodities are experiencing extreme volatility across the globe many leading corporates are using CFaR to understand exposure across different asset classes. Organisations that consider correlation between risks can reduce almost 50-60% of CFaR, which can potentially deliver huge savings. Similarly, by being selective in what hedges to execute, as opposed to hedging 100% of exposure, hedging costs and accounting implications can be minimised.
Where is your company in the supply chain? Who are your company´s counterparties and how are they managing exposures? Where are your investments kept? For the 30% of respondents who said that counterparty risk was their top concern, these are the questions they are asking.
Credit risk needs to be considered from many angles – counterparty banks for debt issuances, derivative transactions, investments, suppliers for purchases, as well as the company´s own credit risk, i.e., taking into account the company’s own risk of default and factoring this into account in positions that are held at fair value.
Earlier in the global financial crisis, European sovereign debt was considered a safe haven. Today however, Spanish and Italian credit default swaps (CDS) have grown to between 500 and 600 basis points, almost trebling in the last year. Even German CDSs are at 100 basis points, a huge leap from the 15 and 20 basis points the euro’s anchor state witnessed in 2007, which even then was considered high.
Furthermore, the ongoing changes to credit risk are an issue for accounting. For example, IAS 39 [1] and IFRS 13 [2] state that credit risk (both counterparty and a company’s own) must be included in valuation. Out of conviction, or perhaps because of a lack of modern TRM solutions that support credit risk in valuations, there are still a large number of corporates that are not compliant with these regulations. In addition to the potential consequences of non-compliance, hedge effectiveness results could be affected by refusing to update the valuation strategy.[[[PAGE]]]
When we asked how quickly their company’s systems would be able to adapt to changing market requirements, such as a return of the drachma, 38% of treasurers polled said they could do it within one month, 27% said within one week and 17% claimed they could adapt within a day. The remainder said it would take more than a month. The fact that most respondents say they would be ready within one month could be a result of the 42% who, in a separate question, said that they still use spreadsheets for treasury and risk management.
This continued and widespread use of spreadsheets is a real concern. Many of the risk management challenges treasurers face today can be addressed more easily with access to dynamic and competitive analysis on hedging decisions, risk cover and correlation between asset classes. None of this can be handled effectively with spreadsheets. Leading TRM solutions typically leverage web-based or cloud technology to efficiently gather financial data centrally and provide visibility into global cash and risk. These latest generation tools support treasurers in calculating risk figures such as CFaR, Earnings- and Value-at-Risk, or with scenario analyses.
As the global financial crisis demonstrated, every market participant is affected by extreme market events, whatever their approach to risk management. Today, counterparty risk remains a treasury fundamental, and commodity risk is a growing area for treasurers, but these need to be combined with a robust approach to ‘what if’ scenario testing and management, with a firm grip on cash flow forecasting, liquidity risk as well as FX and interest rate risk management. Only with complete visibility into all these risks can treasurers be confident in their risk management practices and mitigate against market events, extreme or otherwise.
Notes
1 International Accounting Standards 39: Financial Instruments: Recognition and Measurement
2 International Financial Reporting Standards 13: Fair value measurement
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