FX Risk Management: “When treasurers doing nothing is the strongest form of speculation”

FX risk management has been long at the heart of the treasury function’s remit and played a key role in the establishment of treasury activities in response to the relaxation of UK exchange controls in 1976, increased market volatility and the international expansion of UK plcs. Given the potential impact that FX movements can have on cash flow (both on the up- and downside) and ultimately on financial results, FX risk management should continue to be a fundamental issue for treasurers.

This makes our observations on the current departure from normal risk management procedure in the face of fluctuating exchange rates even more curious…

Corporate treasurers use hedging strategies, such as forward contracts, to protect against potential movements in future exchange rates and to participate in the upside., Therefore one would normally expect a higher proportion of trades being booked as forward contracts during periods of uncertainty in currency markets.

However, contrary to our all experience and expectations, while corporates are trading more currency through Argentex than ever before, the proportion of this that is on a forward or hedged basis has fallen to the lowest level we’ve ever seen. In 2015, 33% of trades were undertaken as forward contracts, reaching a high of 42% in 2017. However, this fell to 25% in 2018, and then again to 20% year-to-date.

Not only has the past six months been a period of significant market volatility, but treasurers recognise that this state of play will remain, at least until the October 31 deadline. So why aren’t they protecting themselves against downside and taking the opportunity to participate in potential upside for their businesses?

Of course, some would argue that corporates which are looking to hedge their currency risk will have done so already, however we hear that others are discouraged for three key reasons:

1. Overly optimistic forecasts for the pound from many major banks, combined with the risk of a Corbyn-led Labour government not yet priced in, have created a false sense of security. An optimistic market is one that doesn’t feel the need to hedge, hence we see fewer forward contracts being purchased.
2. Second, there has been a trend over the past few years of corporate treasurers taking a more empowered position around the board table. When the referendum took place in 2016, most boardrooms were confident that the UK would vote to would stay in the EU. Treasurers need to come armed with the facts and figures to convince their management team of the need to book forwards.
3. In the mind of the treasurer, doing nothing is a safer option than doing something and getting it wrong (perhaps for the second time in recent memory following the surprise referendum outcome). After making the wrong call in 2016, many corporate treasurers and financial directors are reluctant to put themselves in the same position again at the risk of further FX-related losses.

But it’s not just the portion of forward trades that is faltering. Not only are more companies electing not to hedge but, when they are hedging, they are doing so for shorter periods of time. Our data shows that the average tenor of our clients’ forward contracts – essentially the length of time to which the contract extends out – has declined. It was 153 days in 2017, dropping to 125 days in 2018, and to only 86 days in 2019 year to date – a fall of more than 43% in just two years. This is indicative of treasurers feeling there is a lack of visibility over the pound’s future trajectory to take out a forward contract.

We see this as a real risk for sectors including high street retail and airlines, which are already squeezed, and are unable to pass FX impacts and costs to customers. Usually, we would see our retail and manufacturing clients booking forward their FX transactions by two years.

While technology has revolutionised many aspects of the treasurer’s job, there are some complex problems that fintech can’t yet solve and this is one case where the human adviser is needed. Our clients want help comprehending and anticipating market moves and determining how to use it to design and implement a risk management strategy that makes sense for their business. Undoubtably, for many companies, particularly SMEs, this is extremely challenging (especially when the responsibilities of the treasury function are decentralised or dispersed amongst the finance team) during an unprecedented period of political upheaval.

At Argentex, each of our traders has more than 10 years’ experience of currency markets, enabling us to provide bespoke advice to our clients, and guide them through any FX challenges they may face. When done correctly, forwards are a cost-effective way for UK corporates of all sizes to significantly limit their downside risk and make the most of the potential upside. In our view, a treasurer eschewing the adoption of a FX hedging or forwards strategy is the strongest possible form of speculation at this uncertain time.