Tag: Currency risk
Jul
02
CORE PRINCIPLES FOR MANAGING CURRENCY RISK
So far we have examined currency risk, how to manage and quantify it. Before we go on from theory into practice, it may well be useful to establish a framework, a reference for corporate Treasury of core principles of managing currency risk. There have been several notable efforts along these lines, most notably of course the “Core Principles of Managing Currency Risk” set out by the Group of 31 (US multinational corporations) and Greenwich Treasury Advisors.
Clearly, there is a danger in attempting anything even approaching best practice for corporate Treasury as corporations vary so significantly in terms of their exposures, requirements and focus. Such concerns notwithstanding, the importance of the issue equally requires that the attempt be made to create a reference from which individual corporations can perhaps take what might be appropriate to them. Thus, what follows is my own tentative suggestion of what any such list of core principles of managing currency risk should contain:
1. Determine the types of currency risk to which the corporation is exposed — Break these down into transaction, translation and economic risk, making specific reference to what currencies are related to each type of currency risk.
2. Establish a strategic currency risk management policy — Once currency risk types have been agreed on, corporate Treasury should establish and document a strategic currency risk management policy to deal with these types of risks. This policy should include the corporation’s general approach to currency risk, whether it wants to hedge or trade that risk and its core hedging objectives.
3. Create a mission statement for Treasury — It is crucial to create a set of values and principles which embody the specific approach taken by the Treasury towards managing currency risk, agreed upon by senior management at the time of establishing and documenting the risk management policy.
4. Detail currency hedging approach — Having established the overall currency risk management policy, the corporation should detail how that policy is to be executed in practice, including the types of financial instruments that could be used for hedging, the process by which currency hedging would be executed and monitored and procedures for monitoring and reviewing existing currency hedges.
5. Centralizing Treasury operations as a single centre of excellence — Treasury operations can be more effectively and efficiently managed if they are centralized. This makes it easier to ensure all personnel are clear about the Treasury’s mission statement and hedging approach. Thus, the Treasury can be run as a single centre of excellence within the corporation, ensuring the quality of individual members. Large multinational corporations should consider creating a position of chief dealer to manage the dealing team, as the demands of a Treasurer often exceed the ability to manage all positions and exposures on a real-time basis. The currency dealing team must have the same level of expertise as their counterparty banks.
6. Adopt uniform standards for accounting for currency risk — In line with the centralizing of Treasury operations, uniform accounting procedures with regard to currency risk should be adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the performance of currency hedging.
7. Have in-house modelling and forecasting capacity — Currency forecasting is as important as execution. While Treasury may rely on its core banks for forecasting exchange rates relative to its needs, it should also have its own forecasting ability, linked in with its operational observations which are frequently more real time than any bank is capable of. Treasury should also be able to model all its hedging positions using VaR and other sophisticated modelling systems.
8. Create a risk oversight committee — In addition to the safeguard of a chief dealer position for larger multinational corporations, a risk oversight committee should be established to approve position taking above established thresholds and review the risk management policy on a regular basis.
Clearly, this list of core principles of managing currency risk is aimed at the larger multinational corporations that have the means and the business requirements for such a sophisticated Treasury operation. That said, such a list can also be used as a benchmark for those who, while they cannot or do not need to comply with all elements, can still find some useful. Corporations of whatever size and sophistication must balance the real cost of implementing such an approach to managing currency risk against the possible cost of not doing so. The first cost is tangible, the second intangible — but by the time the second becomes tangible it is too late! That is precisely what we are trying to avoid.
It may be useful for a corporation to split currency risk management into two parts — the first part focusing on the overall approach towards managing of currency risk, the second dealing with the actual execution of currency risk management. Many corporations have this kind of division of labour, whether or not they formalize it. However rigorous a currency risk management policy is, it still runs the risk of being bypassed by events, technology and innovation. Thus, it is very important to have a regular review process to ensure the currency risk management policy remains up-to-date and in line with the corporation’s needs. In this review process, important questions to be raised may include:
Do the currency risk management policy and the Treasury’s mission statement still represent the corporation’s business needs? Should the corporation maintain or change its approach towards managing currency risk?
How has currency hedging performed relative to the established benchmarks? How can the costs of currency hedging be reduced?
Are VaR or credit limits, or the financial instruments relating to currency risk management, still appropriate?
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Jul
01
Advanced Approaches to Corporate Treasury FX Strategy
The management of currency risk by corporations has come a long way in the last three decades. Before the break-up of Bretton Woods currency risk was not a major consideration for corporate executives, nor did it have to be. Exchange rates were allowed to fluctuate, but only within reasonably tight bands, while the US dollar itself was pegged to that most solid of commodities, gold. The responsibility for managing currency risk, or rather maintaining currency stability, was largely that of governments. Needless to say, that burden, that responsibility has now passed from the public to the private sector.
This series of posts deals with the corporate world, how a corporation is affected by and how corporate Treasury deals with the issue of currency or exchange rate risk. More specifically, we will look at:
Currency risk — defining and managing currency risk
Core principles for managing currency risk
Corporate Treasury strategy and currency risk
The issue of hedging — management reluctance and internal hedging
Advanced tools for hedging
Hedging using a corporate risk optimizer
Advanced approaches to hedging transactional and balance sheet currency risk
Hedging emerging market currency risk
Benchmarks for currency risk management
Setting budget rates
Corporations and predicting exchange rates
VaR and beyond
Treasury strategy in the overall context of the corporation
In short, there is a lot to cover. This blog is aimed first and foremost at corporate Finance Directors, Treasurers and their teams. In addition, it attempts to give corporate executives outside of the Treasury a greater understanding of the complexity and difficulty entailed and the effort required in managing a corporation’s exchange rate or currency risk. As we shall see later in the next posts, many leading multinationals have set up oversight or risk committees to oversee the Treasury strategy in managing currency and interest rate risk. This is an important counter-balance for the corporation as a whole, but of course it requires that the committee itself is as up-to-date with the latest risk management ideas and techniques as are the Treasury personnel themselves.
The way the corporation has dealt with currency risk has changed substantially over time. Corporations, many of which were reluctant to touch anything but the most vanilla of hedging structures, have now greatly increased the sophistication of their currency risk management and hedging strategies, particularly over the last decade. In this regard, two developments have helped greatly — the centralizing of Treasury operations, particularly within large multinationals, and the focus put on hiring specifically experienced and qualified personnel to manage the day-to-day operations of risk management.
Before going on I would point out that perhaps to some reading this, it may seem strange and slightly out of touch to be examining advanced approaches to the management of currency risk at a time when the number of currencies worldwide seems to be rapidly diminishing. The creation of the Euro-zone has eliminated a large number of western European currencies, with the prospect that many countries within eastern Europe will enter it from 2004–5 onwards, giving up their own currencies in the process. In the Americas, the creation of the North American Free Trade Area has created a de facto US dollar bloc. Though some may not like to see it that way, that is surely the reality and on the whole it has been a positive development. As yet, the talk that there may be a unification of the US and Canadian dollars is just that, talk, but who knows for the future? There is no such talk about unification with the Mexican peso, as it is doubtful whether any Mexican administration that suggested any such would survive. That said, there is little question that the economic impact of NAFTA appears to have added greatly to the stability of the Mexican peso, rendering the question redundant for now. In Asia, there are occasional mutterings that there could be a single currency, either in Asia as a whole (i.e. the Japanese yen) or more specifically within the ASEAN region of countries. On the first, any prospect of a pan-Asian currency seems far off, not least because a number of Asian countries, notably China, would not accept the dominant role that any such currency would automatically give Japan. In addition, given Japan’s slow economic descent in the 1990s, it is questionable whether anyone in their right mind would want to unify their currencies with the yen and thus by doing so import deflation. The more specifiic idea of an ASEAN currency is a greater possibility, at least in relative terms, though it has not yet been raised to any serious extent. Moreover, the idea of the Asian Free Trade Area (AFTA) has yet to see fruition. It would probably be best to focus on that first, before considering a single currency area. There is no question however that the number of national currencies is on a downtrend. This may cause some to assume that the need for currency risk management should similarly be on a downtrend. In fact, quite the opposite is the case. The desire of corporate executives “just to be able to get on with the company’s underlying business” is a natural one, but it will be some time — if ever — before they will be able to ignore currency risk. There may be a single currency in the Euro-zone, but there is not worldwide — whatever we think of the role of the US dollar — and there is unlikely to be any time soon. Even in the brave new world of the Euro-zone, where currency risk should in theory be a thing of the past, it remains an important consideration. To use John Donne, just as no man is an island, the same is true for the corporation. Within the Euro-zone, currency translation and therefore direct currency risk has been eliminated. However, corporations are still exposed to competitive threats from exchange rate movements between the Euro-zone and the rest of the world. A single currency area such as the Euro-zone can eliminate only one form of currency risk, that is the direct kind. However, it cannot eliminate indirect currency risk for the very reason that the Euro-zone is but one area, albeit an important one, within the global economy. National currencies still have to be dealt with and that is unlikely to change near term.
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