We live in an age where businesses are truly global and no matter the size our companies are, we all face the same uncertainties when it comes to currency fluctuations. “BREXIT’s”, “Trade Wars” “Attempted Political Assassinations” all play their part and can rarely be predicted. So what does this mean? Despite the only certainty being uncertainty, it is the CFOs and their finance team’s job to manage their company's exposure to currency volatility, allowing their firms to continue to grow and prosper.
What can CFOs do?
It’s difficult to determine what hedge strategy to use - which types of risk are to be managed, and what hedging tools to use? However, this is largely due to big bank brainwashing - "if Bank of Somewherica tells me it’s the only way, then it’s the only way". Frankly, hedging best practices and tools are very well developed, and their use will pay large dividends. Two key areas for every CFO to look at:
Transaction costs - You may realize a substantial saving by monitoring your payments provider using TCA (transactional cost analysis). We've seen spreads of 5% for an exotic currency and 2% for a major currency. It's not airport window prices but it's not far off...
Hedging - Is recognized as a best practice, and not reserved solely for large multinationals. Managing forecast cash flow risk offers benefits for firms of any size (as detailed below). Hedging the re-measurement risk of your balance sheet may or may not make sense depending upon internal accounting practices.
How will it affect my business?
1. Protection for income statement and balance sheet
If foreign currency makes up a material part of your company's revenues or expenses (and there are no natural hedges available), then hedging forecasts is the only way to protect a company's income statement from unwanted volatility. Within the majors, rolling or layering hedge strategies can reduce volatility by 70% or more. Hedging against re-measurement of assets/liabilities (i.e. balance sheet) risk removes another source of income statement volatility but requires a well-designed balance sheet forecasting methodology and strong integration with the cash flow hedging program.
Both cash flow and balance sheet hedging enable CFOs to protect your company's profits against adverse market reactions that could potentially turn your profits into a loss.
2. Improved financial forecasting
Certainty is the name of the game. The old adage of "A bird in the hand is worth two in the bush" plays out perfectly with respect to the currency markets. For goods that are imported for sale, hedging lowers the volatility of your COGS. For goods that are sold in foreign markets, hedging enables a stable price in the local currency, increasing competitiveness and leads to enhanced long-term distributor relationships.
Reduction in net revenue volatility not only eases the job of the Controller, but higher certainty enables consistently higher R&D investment and lower risk for new market entry.
3. Increased capacity to borrow.
With an effective FX risk management strategy in place, now it's time for you to look to your growth strategy, potentially using debt to leverage growth. More stable cash flows lead to higher valuations (higher Sharpe Ratio), and an enhanced ability to service debt. A key metric of corporate credit is net foreign exchange exposure. When FX exposures are hedged, this metric improves significantly. Another metric recognised by FASB/IFRS is “earnings quality”, which is a function of earnings stability, persistence and lack of variability. Clearly hedging improves this metric as well.
Hedging foreign non-monetary assets (eg real estate) may or may not play a needed role in enhancing credit. From a risk perspective it may or may not be relevant, but hedging these assets may avoid triggering debt-equity covenants and avoiding higher spreads.
4. New Market entry
Expansion into new markets, whether developed or emerging economies, carries with it increased exposure to foreign exchange volatility. While regions such as Brazil, India, Mexico and others offer large and growing populations, their respective currencies are quite volatile. Long-term hedging solutions are required.
A firm should make use of natural hedging opportunities as much as possible, such as establishing local personnel, offices and warehousing, and local currency debt to offset local currency revenues. To the extent revenues exceed expenses, derivative cash flow hedges should be used.
Going global is more than just attracting new customers and it acts as an exciting way of diversifying your business without straying from your industry expertise. Within your role as CFO, you have the tools at your disposal to stabilize your firm's activities abroad and control the controllable.
It is always our advice that you discuss hedging FX risk with an expert with international experience. If you’d like to speak to one of our consultants you can book a time using the button below.