by Jono Tunney, CFA and Scott Bilter, CFA of Atlas Risk Advisory
The problem of how to best manage foreign exchange volatility has plagued multinational companies for decades, and is usually cited as one of the top concerns amongst Treasurers. Rapidly changing business models make life especially difficult for those who are tasked with managing a company’s foreign exchange risk, and many pitfalls await those who are ill-prepared. What follows is a “Top 10” list of some of the most common—and costly—mistakes multinational companies make when trying to manage their FX risk.
1. Maintaining the status quo
FX groups often have a lot of inertia around their current practices, and fear of change can be a major obstacle. Because the stakes can be so high, the perceived “safety” of maintaining any current approach “because we’ve always done it this way” can be prevalent. The problem with this is that many things have likely changed since a certain practice was established, and various assumptions that may have been true many years ago are no longer true today. FX policies tend to be implemented or updated over time in response to huge FX losses generated by exposures that weren’t previously considered or well understood. You wouldn’t wait until to your house burned down before buying insurance, so why wait until your company suffers a significant FX loss before putting in place the proper processes and procedures that could have prevented it in the first place? A world-class FX organization will think and act proactively, learn from the mistakes of others, and seek qualified expertise.
2. Taking a view on the direction of currencies
Do you or your business partners take views on currencies in order to determine your revenue or expense hedging strategies? Chances are that if you ask five different banks where they think a currency rate will be in a year, you’ll get five different forecasts, and the average will be pretty close to the current spot rate. If there happens to be widespread agreement by the banks on their directional views, this actually has a better chance of being a contrary indicator than a good forecast. A successful hedging program shouldn't be influenced at all by directional views, or by the most recent trends that have occurred. Too often a hedging program is terminated because it's “losing money” just before the underlying exposure begins to lose value and the hedges (now non-existent) would have had offsetting gains. The success of a hedging program needs to take both the underlying exposure and the hedge into consideration when determining its effectiveness. Trying to guess what would happen to only one side of the equation is not effective risk management.
3. Not engaging enough with business partners
If you hedge your company’s local currency revenue exposure, do you understand the competitive environment in the various geographies where you do business, and the specific pricing dynamics? Do you have any pricing power if there is a huge move in FX rates?Whether your primary exposures are revenue or expense related, there are several factors that would influence how much and for how long you should hedge, whether to use options or forwards, whether to layer in hedge rates, how to interact with sales/procurement in terms of quoting/purchasing in local currency, and other considerations. A company may also need multiple strategies for differing product lines or businesses. A good way to test if a hedging strategy makes sense is to “stress test” it with different “What if?” scenarios, which should include some modeling on how you and your competition, suppliers, and/or partners would react. If you can’t live with the results of a significant currency shock in either direction, chances are your hedging strategy needs some adjusting.