Think the unthinkable

Feature | 30 January 2017
Leicester

When importers and exporters trade, they are exposed to the vagaries of their domestic currency's behaviour against the foreign one. David Morrish explains this vital aspect of risk management

When former British Prime Minister Harold Macmillan was memorably asked by a journalist what was most likely to blow governments off course, he wearily replied, "Events, dear boy, events". And there certainly were one or two of those in 2016.

When former British Prime Minister Harold Macmillan was memorably asked by a journalist what was most likely to blow governments off course, he wearily replied, "Events, dear boy, events". And there have certainly been one or two "events" in 2016.

Good risk management is all about trying to identify and anticipate risk events that might adversely affect any material aspect of the business and taking action to put controls in place to eliminate or at least mitigate the potential damage. Some of these will be obvious. If manufacturing production is wholly dependent on a continuous uninterrupted supply of mains electricity then install a generator and test it regularly. Other risks are less obvious and need more forward planning.

Plenty of column inches have been filled on the impact of the shock events of the year: Brexit,1 and Donald Trump's election victory.2 (Some would have added Leicester City winning English Football's Premier League as a surprise event, but more on this later). With good scenario risk planning could the downside effects have been anticipated and minimised leaving the potential to take advantage of the upside?

FX volatility

One impact of both of these unexpected events was the immediate increase in volatility in the foreign exchange markets. No-one, other than forex traders of course, benefits from such wild volatility.

Buyers, sellers, businesses that buy and sell goods or services overseas and people and businesses who invest in factories, markets or property are all impacted by the change in value of the domestic currency against a foreign currency. Historically, currencies have always been volatile and the exposure to this volatility is known as 'exchange risk'.

Figure 1 illustrates the movement of EUR-GBP rates during 2016. Note that in the months preceding the UK referendum, euro rates had moved, for the most part, within a range of €0.75 to €0.80. Companies buying and selling into Europe may have, not unreasonably, taken the view that with such a limited range of movement that on a 'swings and roundabouts' basis, the risk was not worth hedging; in other words, making a conscious decision to take no action based on the flawed premise of 'more of the same'. From 24 June 2016 sterling declined rapidly, reaching a low of € 0.90 before recovering slightly. Good scenario planning would not have predicted the outcome of the referendum but it would have forced businesses to consider the question, 'what if'?

If through scenario planning businesses decided that they should take action, what methods are available to them to prevent severe impacts destroying value in the business?

Figure 1: EUR/GBP exchange rate fluctuations – December 2015 to December 2016

Source: European Central Bank

Case study: Replica Shirts Plc

Replica Shirts plc, a UK based replica football kit manufacturer,3 sources raw materials from a variety of countries within the eurozone. The company completed its projections for 2016 in January using as its 'worst case', a rate of €0.80 to calculate costs. Its policy was not to hedge. Trading margins were considered wide enough to absorb minor shocks. Only after the UK referendum result and the collapse in sterling did the company reconsider its 'no hedge' strategy.

So what could Replica Shirts have done to mitigate the impact of the exchange rate movement?

Pure currency options

One alternative is to use pure currency options. This gives the purchaser of an option the right, but not the obligation, to buy or sell a given amount of currency during a set period at a specified 'strike price' (exchange rate). The premium payable will be based on the strike price required, the currencies, duration of the contract and the volatility of the two currencies.

Pure currency options are a form of insurance and like any insurance, the more likely that a claim will be made the more expensive the premium. The closer the chosen strike price is to the current spot rate, the bigger the premium. Similarly the longer the duration of the contract and therefore the increased propensity for the exchange rate to move adversely, the larger the premium.

At the start of 2016, the GBP//EUR rate was around €0.73. Buying an option to protect a rate of €0.80 for say six months would be relatively inexpensive; € 0.85 would be cheaper still. This would have given Replica Shirts protection in the event of adverse movements while leaving it free to follow its existing strategy while the exchange rate was within its chosen range.

Until 23 June, it would have made payments to its suppliers at spot (bar a brief blip in April) and then utilised the pure currency option at the end of June at the strike price. Once utilised, a new option could then be bought for the next period.

This is all about thinking through what could hit the business from 'left field' and planning accordingly - hoping for the best but preparing for the worst.

There are other strategies that they could follow.

Foreign currency account

If Replica Shirts is sourcing from Eurozone countries and selling its finished products to say Bayern Madrid4 or Real Munich then if it isn't doing so already, it should make every effort to 'match' income received in euros from sales to outgoings in euros. The simplest way of achieving this would be for Replica Shirts to open a euro account with its bankers. Euro payments would then flow in and out of the account with surplus balances or deficits being corrected from time to time at the prevailing spot rate.

Forward exchange contracts

Alternatively once a deal is struck and Replica Shirts are committed to a transaction, then the exchange rate may be fixed by entering into a 'forward exchange contract'. So if Replica Shirts plc has, for example, sold a consignment of sportswear for €100,000 payable in three months', it could 'lock in' the rate by agreeing to sell the euro to its bank in exchange for sterling at a fixed future date or between set dates. The rate is fixed at the outset so the exporter knows with absolute certainty the amount it will be receiving. Of course if the exchange rate moves favourably in the meantime it should be remembered that, unlike the pure currency option, Replica Shirts plc will be locked into the forward rate, for better or for worse.

As the contract is binding if payment fails to arrive, for whatever reason, then the forward contract will be closed at the prevailing spot rate with the profit or loss being for the account of Replica Shirts. While the forward contract gives certainty, it should only be entered into if there is a very high level of confidence that the funds will be received.

FX risk strategy

The overriding message is that all organisations ought to have a defined risk strategy and regularly revisit it to check that it still works. In the context of foreign exchange management, what are those strategies?

Do nothing

Provided that this is followed as a conscious decision, it is entirely legitimate alternative

Individual transactions may be low in both frequency and value so the management time spent in hedging the exposure would be disproportionate to the risks. Over a period of time, it may be considered that the movements both up and down in the exchange rate is such that the overall effect
is neutral.

Fix everything

The philosophy behind this is that organisations make their profit from the underlying transaction rather than by playing in the foreign market. The risk of adverse movements in the exchange rate, therefore, no longer exists but equally, in the event that rates moves favourably, by fixing everything, this also removes the ability to make an extra turn.

Hedge part

This is about having certainty for a percentage of an organisation's exposure and 'taking a view' on the balance. For example, the exchange rate could be fixed for individual large transactions while the higher volume, lower value transactions could be left to the vagaries of the market.

Scenario planning

While the focus of this article is on the financial impact of foreign exchange rate movements this is just one aspect of how a company's profitability may be affected. Using scenario planning to think through how risks may be identified and mitigated may be applied to any aspect of the business.

In the case of Leicester City winning the Premier League, bad scenario risk planning could have meant Replica Shirts holding large stocks of the wrong clubs' kit, which would have to be offloaded at rock bottom prices, potentially missing out on the opportunity to sell quantities of Leicester City's kit to a bigger market. Are Replica Shirts preparing for a shock Champions League victory, I wonder?

Good risk management doesn't just happen. Plan for events dear boy, events.

David Morrish is relationship director, international trade finance qualifications, London Institute of Banking and Finance

 

References: 

References

  1. See www.tfreview.com/node/14371/

  2. See www.tfreview.com/node/14310

  3. The company name has been changed for this article

  4. Football team names changed

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