For businesses managing Foreign Exchange (FX) with legacy approaches, staying on top of risk can be time-consuming, complex and stressful. This is especially true when corporate treasurers and fund managers lack the resources to dedicate to the task while they’re primarily focused on managing cash, fundraising, identifying opportunities, and keeping the businesses as a whole profitable. However, with the right approach, FX risk management can significantly improve performance, margins and returns, augmenting other functions and reducing capital risk as a whole.
It’s important to mention that technology is only half the battle. While modern tools create the opportunity to better understand and minimize FX risk, using methods ranging from simple normal distribution calculations to complex Long Short-Term Memory (LSTM) neural networks, everything starts with strategy, culture and planning.
Here we explore four common misconceptions, on the human side, that can hold your business back, and how you can avoid them.
Don’t Count on Mean Reversion
Intuition is an attractive standby for anyone dealing with risk, especially when you haven’t got the time, data or resources to take a more in-depth approach. But in practice, fund managers and CFOs attempting to smooth over the intricacies of FX risk management by leaning on the mean reversion theory expose themselves to being caught out by a market that stubbornly resists predictability.
What is Mean Reversion?
Mean reversion is the principle that an asset's price will, over time, converge towards its average, balancing gains and losses. However, when it comes to foreign exchange and those tasked with managing its associated risk, this strategy isn’t borne out by the data.
Firms and funds are not buying and selling currency based on these indicators. Instead, they're generating regular monthly revenues, or deploying and harvesting capital on specific schedules unrelated to the spot rate. The only scenario where mean reversion would hold is in the absence of a long-term trend, with reversion occurring within a short time frame. And in our own ML-driven research on the matter, even huge data models failed to find any reliable pattern in any relevant time frame for the goals of corporates and funds.
Why It Fails
Any survey of both major and Emerging Market (EM) currency pairs reveals the presence of persistent, multi-year trends in almost every pair, coupled with a highly asymmetric distribution of returns.
The reality is that no CFO or fund manager can outguess or outwait these trends – the timeframes are simply too long to be of any practical use for managing FX exchanges on the normal window of business transactions. A reliance on mean reversion as a viable approach to FX risk management is an understandable shortcut that nevertheless leads to a dead-end.
By working with a reliable data and strategy partner, managers can develop a more comprehensive understanding of the market, a keen eye on long-term trends, and a solid strategy to mitigate the impact of these trends on the financial performance with confidence.
Lacking Clear Objectives
FX risk management is a means, not an end. That means any strategy needs to be aligned to your business’s big picture – and adapted in line with changing priorities, market conditions and regional expansion. This is a crucial opportunity for treasurers to lead the conversation in how FX can benefit the whole business, generate value and deliver tangible results.
Whether the objective is to protect the balance sheet, protect Profit & Loss (P&L), or generate alpha, these goals also need to be clearly defined and communicated to relevant teams, stakeholders and leaders. However, in many businesses, FX is siloed in its own box, cut out of the big picture planning – but the right tools and data can give you the support you need to change that.
The Value of Putting FX Earlier in the Process
Modern business strategy requires integrating FX and risk into your planning processes at the highest levels. After all, strategies made in a bubble based on a dream of perfectly predictable FX markets don’t tend to survive contact with reality.
Consider launching a brand new investment fund, taking both local investors and foreign. Even if your fund managers do a sterling job of investing and growing your partners’ capital, FX mistakes can erase those gains in a moment. For example, a fund might show a 40% return for local investors but only a 5% return for US investors due to FX fluctuations.
In this scenario, an FX strategy that focuses on balancing earnings-per-share across your customer base can become a key part of attracting and retaining investors, but only if those conversations happen early and with the right data and decisioning.
Lack of Metrics & Benchmarks
Effective FX risk management in line with your objectives also requires the right metrics and benchmarks, which are often already in use within entities, be it corporates or funds. The distinction is important – metrics define the data point that you want to measure, while benchmarks specify the bar you’re looking to hit.
Without clear measurement, managers are flying blind, unable to assess the effectiveness of their strategies or, worse, unaware of the impact of any strategic mistake. The challenge is that in the sea of financial data available, it can be hard to hone in the metrics that will make a difference for your firm and clients. After all, a hedging strategy is a highly flexible and strategic tool – those who focus on base measurements such as whether a certain hedge made money or not on a certain day miss the bigger picture, and potential, of hedging.
What Metrics Matter?
These metrics can be both time-dependent. Funds may prefer data such as Total Value to Paid-In Capital (TVPI), Distributions to Paid-In Capital (DPI), and Multiple on Invested Capital (MOIC), or market-based, such as Public Market Equivalent (PME) and Direct Alpha. Corporate metrics might include Earnings Per Share (EPS) attributable to FX, net revenue variance, or probabilistic earnings at risk.
Each of these metrics should have an associated benchmark, such as EPS variance due to FX remaining less than 1%. This is especially important for businesses where the model relies on returns that can be influenced by FX.
For example, comparing a fund's local and investor currency results reveals whether FX is significantly impacting performance – providing commensurate returns regardless of investor currency. This comparison often heralds the inception of a hedged share class - investors are more concerned with results in their currency than the local currency of the fund.
Other key considerations include:
Value at Risk (VaR) - VaR assesses potential loss within a given timeframe and a certain probability.
Expected Shortfall (ES), which quantifies the potential severity of losses beyond the VaR threshold.
By harnessing these metrics and benchmarks, treasurers can more effectively manage FX risk, ensuring performance meets stakeholders' expectations and mitigating the impact of unexpected market events. Speaking of which…
Taking a Pure Market View
Recent years have made abundantly clear how little the events of the world care for the health, stability and blood pressure of markets and those who work in them. The wealth of data available for managers, models and systems to make decisions can instill a false idea of security: that markets are predictable, trends will continue and bets can be placed based on a line on a screen.
The Reality of Market Risk
The truth is that in a fast-changing business, geopolitical and regulatory environment, hedging is an essential protection for businesses against unexpected market disruptions ("black swans"). This doesn’t require perfect foresight – on the contrary, hedging is a flexible tool to control risk in the face of the uncontrollable.
The selection of derivatives available —such as forwards, options, and proxies— provide a diverse toolkit for crafting a robust hedging strategy. And with the right tools on your side, businesses can more easily analyze, compare and select the best FX strategy for their hedged share classes.
Making Hedging Work for You
We live in a world of risk – hedging is a key protection for global businesses to protect returns, investment and cash in the face of unpredictable markets. And with the advent of modern finance tools, these tasks can be simplified and executed more accurately, giving more businesses access to the protections it provides.
Armed with the right data, visibility and controls, treasurers can build bespoke FX hedging strategies that align with broader business objectives to support success across the whole organization. In our work with funds and corporates, we’ve seen how challenging it can be to commit to a hedging strategy. The natural tendency when faced with the stress of managing currency is to go on instinct, chasing the chance of upside if only the timing works out.
The antidote is clarity – tools such as Deaglo can help remove the fear of risk and or desire to win, and allow the hedger to make a data-driven decision about the right course of action and stick to it. And with the right technology providing a tangible, measurable view of the market, you can integrate your planning into the wider team to get wider buy-in and support.
Don’t let FX risk get in the way of results – request an assessment with our team today to get more out of your hedging strategy.