Most corporates doing business internationally are well aware of the impact exchange rate fluctuations can have on their cash-flow, profitability, and relative competitiveness. None more so than businesses operating on thin profit margins (2-3%) who lack reliability and predictability in their forecasts.
For the Treasurer or CFO responsible for managing financial risk in these circumstances, the obvious starting point is to look at designing a currency hedging strategy. Immediately they are faced with challenges. Firstly, how do you hedge against a risk that you cannot see or quantify? Secondly, what will the cost of hedging be?
Below is an illustration of a 12-month layered hedging program for AUDUSD and its effect at reducing volatility in the effective rate (c.70% reduction of risk). For corporates with certain characteristics and objectives, this type of strategy is incredibly effective. However, with this particular cohort, the resulting rate is often unusable. Here’s why…
The issue here is that the majority of their competitors will be buying currency at spot rates as and when the requirement occurs. With a layered hedging strategy, the hedger will achieve an effective rate that is more stable, however, that rate will either be above or below the prevailing spot rate. As a result, this will make the hedger more or less competitive from a pricing perspective. This is particularly taxing if you are layering in contracts whilst the CCY pair is in a long-term unfavorable trend, as your effective rate moves further away from the spot rate. Even if the market is trending sideways, on occasion you will still have your sales team knocking at your door saying “we can’t sell at these prices!”.
So what do you do? Speculatively hedge and “hope for the best”? Simply trade on spot and hope everyone else is doing the same? Are there other alternative strategies?
At Bondford, we are advocates of rules-based, quantitative driven hedging solutions. In turn, our clients never have to “hope for the best”; they largely know what the outcome of each strategy will be before it is implemented. When we consider that trading experts like Goldman-Sachs often post losing quarters (most recently, Q4 2018), and often spectacularly ($1B in Q3 2013); given their expertise, access to proprietary data, and enormous resources, it’s no wonder that smaller non-financial firms risk large losses with this approach. Speculation, in our view, is never a viable option.
Alternative strategies? One may take a brief look at various FX options structures, but upon even basic analysis, you will find that these too deliver no joy, with premiums typically exceeding profit margins in basis point cost terms. One may find solace in a zero-cost collar. This will offer protection against a significant market dislocation, but it also caps your upside. In this case, you are left in the same position.
Trading on spot? If the objective is to ensure that the business continues to hold a competitive pricing position relative to their peers, then purchasing currency on spot is the logical option. Technically you hold no protection, but neither does your competition. You are in the same boat.
Treasurers and CFO’s, therefore, need to shift their focus and attention to achieving best execution on each spot deal to ensure limited erosion of profits in spread costs. Many think that by having several, competing counterparties, you guarantee the best pricing. In our experience, this is not necessarily the case. To start, how does one define “best” in this situation? Is it the best quote available from your panel? The limitation of this view is two-fold; one, you are only seeing quotes from a few counterparts, not the wider market which contains thousands of banks, broker-dealers, and market-makers. As such, the best quote available to you isn’t necessarily representative of the best available quote in the market. Two, how can you be certain that your panel have offered you the best price available?
With FX pricing being opaque and market liquidity increasingly fragmented, consulting with an independent currency risk advisor with best-in-class TCA capabilities enables Treasurers and CFOs to stay in control of execution costs, in itself providing the competitive advantage they are looking for.
For more information on us, please see www.bondford.com.