Can Currency Risk Management Make You More Profitable?

Exchange rates are continually fluctuating. This creates the potential for a loss of profit whenever you have a delay between purchase and sales contract execution and payment. There is also potential for loss when you have a long-term liability denominated in foreign currency.

Foreign Exchange risk is real and significant:

• In 2010, Fortune 100 companies lost $20B to unhedged currency moves.
• Exchange-rate volatility is currently extremely high and likely to remain so for the foreseeable future
• Sovereign debt and banking risks have never been higher

You can manage this risk and eliminate uncertainty. Seventy two percent of large corporations (those with more than $100M in sales) actively manage foreign exchange risk. Corporate Treasury Departments design and establish GAAP-effective hedges using OTC derivatives, and create internal policies, controls and metrics. Hedging FX risk is considered a “best treasury practice”.

Small and medium-sized companies without dedicated Treasury Departments use Currency Risk Management as their "virtual Treasury Department". Our cost-effective and practical services will save your company money and time. Whether your company is Importing or exporting, exposed to foreign currency liabilities or arranging international M&A, CRM has a program to manage the FX risk component of your business.

Contact our director to discuss your risk management needs
Paul Stafford
email
406.546.8410

Currency Risk Management:
Why It Matters and How It Works

How currency risk can incur loss: We'll use the example of an exporter based in the US and shipping goods to Europe to examine the way business can be affected by exchange rates. The figure below shows the exchange rate of the euro vs. USD during the last quarter of 2011. If our exporter had billed in late October for a December delivery (without using CRM), her business loss is significant - about 10%. This could have been the majority of her expected profit margin.

Our example could just as easily apply to goods shipped to another country, or to an importer paying in arrears. Wherever there is a delay between invoice and payment, there is risk.

International sales always incur currency risk: even if you've been careful to structure your international sales to avoid currency risk - perhaps by using distributors, or by billing your international customers in your home currency - you're still exposed to currency risk. (This brief PDF explains how).

Hedging can reduce or negate the exchange rate risks we’ve pointed out. Hedging is a tool commonly used by large corporations, and small- to mid-sized businesses also can increase profits with hedging. Hedging is a low-risk strategy and fully GAAP compliant; the Financial Accounting Standards Board (FASB) has several chapters devoted to the correct methods to use in hedge accounting.

Constructing an effective hedge can be complex if you are not familiar with the tools and structures used, such as currency options, risk reversals, swaps, and forwards. We have considerable experience with hedging, and our business will help you set up a currency risk program. Based on your specific situation, we will select the most appropriate hedging vehicle, maturity dates and strikes to maintain the desired hedging ratio, and other related tasks.

Simple to Get Started

We will follow these steps to get started with you on your first risk-protected transaction:

1. We start with a 3-page consulting contract that defines how CRM works with your company. The contract does not obligate you to proceed with hedging.
2. We will interview you to quantify your currency risk and to seek opportunities for natural hedges in order to minimize the hedges needed.
3. We will help you establish any necessary banking relationships, since only the largest banks offer the financial instruments needed for hedging.
   Important note: CRM does not touch or handle client bank accounts in any way. We consult on the use of appropriate financial instruments and derivatives, and communicate detailed trade instructions to you and your banking representative; this preserves the security of your account.
4. We will use the analysis of your exposure to design a custom hedging structure that removes the risk from your international transaction.
5. We then communicate the hedge structure to you and your banking relationship officer, making sure all parties understand the rationale of the design. Only then will CRM bill for its services.

What does it cost? The cost of the hedge instruments (forwards, swaps, or options) depends on many factors, but is usually less than a percent of the underlying transaction size, and can often be as low as 0.2%. Our fee for setting up and managing the hedging positions starts at 0.5%, falling to 0.3% with the size of hedged contracts.

Compare this to what a large bank will quote you, which can be as much as 5%.
Or compare this to your value-at-risk (often10 to 15%): CRM offers a very inexpensive way to protect this.

An important service we provide is third-party verification of the cost of the instruments, since pricing can be opaque and banks sometimes use this to their advantage. CRM has access to inter-bank pricing, which enables us to show you what the bank is paying and could save your company a substantial amount of money.

What are the risks? The only risks to a properly-constructed hedge are what are called counterparty risks - that is, the possibility of default by the bank or institution that sold you the hedging instruments. We only use large international banks with high Tier 1 capital levels as prime brokers. Your biggest risk is doing nothing to hedge your international currency transactions.

What are the rewards? Hedging offers distinct advantages to companies using it:

• Protection of value at risk
• Enhanced competitiveness: If your international buyers want to finance their purchases, you can offer terms without the extreme risk that normally accompanies payments over a long time period. CRM has a special program that can enable you to offer finance terms for almost any period, without any FX risk.
• Access to low-cost borrowing: companies in high-interest-rate countries (such as Brasil or India) or companies with foreign investor funding often utilize capital obtained in a foreign currency. Paying these liabilities back over long periods of time incurs considerable FX risk, and CRM has a program to mitigate long-term FX risk, enabling access to low-cost capital markets.

- Contact us today to discuss your currency hedging needs -

CASE STUDY: Hedging multiple EUR payments

Background: NGT, a US company, designs and builds custom non-destructive test equipment used by manufacturers of ceramic cores for catalytic converters. They signed a contract to be paid in euros over 7 months:

Exposure details: The contract is paid in three stages over 7 months:

1. €85k at “major components” (one month)
2. €85k at “factory acceptance” (3 months)
3. €45k at “site acceptance” (7 months)

Total contract value is about €214k, or $308k at the time of contract execution (spot 1.34).

Risk: The value of the EUR vs. USD would vary dramatically over 7 months, creating FX risk for NGT. EUR/USD 3-month volatility was about 16% at hedge initiation. While the EUR had been appreciating for 4 months, there was no assurance it would continue (and in fact the 1.45 level was very nearly the high for 2011.)

Figure 1: EUR/USD prior to the hedge

The Hedge: Selecting optimum hedges depends on many factors – currency volatility, differential deposit rates between the two currencies, and the company’s margins and tolerance for risk. CRM’s hedge structure design consisted of a 100k EUR put expiring May 23, 100k put expiring August 2 and a 42,841 forward with a delivery window of November 15 - December 15. These were selected so that further EUR appreciation would be captured in the near contracts. The far-dated hedge used a forward because option premiums for 7 month tenor and 16% volatility were prohibitive.

NGT initiated the hedges on April 5 with the spot at 1.42.

Results: The first hedge was closed May 23, for a net savings of $4,263. The second closed in August for a net savings of $2,100.

The site acceptance phase was delayed past the original November date. Therefore, the third hedge for the site acceptance payment needed to be extended. Because the forward would be expiring, CRM recommended using a currency swap to roll over and extend the hedge into a new forward with one more month’s expiry. This was done at almost zero cost to NGT.

The chart below shows the EUR/USD after the hedge was initiated on April 1. The spot rate held fairly steady through June and July, but then began plummeting over 15% towards the end of the year. The overall savings to NGT was dramatic, and the net cost was only about 2% of the contract value.

Figure 2: EUR/USD subsequent to the hedge

Conclusion: NGT’s use of hedges captured EUR appreciation profits and preserved the value of its 7 month long contract at very low cost. During that time, the financial markets were quite turbulent, and the second and third contract would have experienced significant losses had they not been hedged. The loss on the last contract alone would have been 14% or $8,300 (of nearly $60k).

The selection and specification of hedging instruments required specific knowledge and experience that NGT did not have internally. Outsourcing this to CRM proved easy and cost effective.

CASE STUDY: Profiting from a hedge

Background: A US sports equipment manufacturer (SEM) has retail distributors throughout Canada. Those distributors pay wholesale prices for SEM’s goods in Canadian dollars. Typically, the distributors place their orders (and thus fix prices) a quarter in advance, while paying up to 90 days in arrears. The distributor’s payments are accumulated in a CAD-denominated bank account in Canada, and repatriated on a quarterly basis.

Goal: SEM’s CFO not only wanted to protect their margin, but to create additional profit if possible.

Details: SEM received the orders for the last quarter of 2011 on September 7, and expected all distributor payments to be received by December 20. SEM expected to repatriate $1M CAD.

Designing hedges that not only protect exposure but generate excess profits requires establishing a direction or range expectation. CRM reviewed USD/CAD historical variation for the previous year, finding a range of .94 to 1.07 (see Figure 1). CRM also analyzed the current economic situation, and determined that it would likely remain in a range of .97 to 1.04 for the next 90 days. Of course, unknown events could easily create a break-out in either direction, so downside risk needed to be controlled.

Figure 1: USD/CAD on Sept 8 at hedge inititiation

Risk: The value of the CAD vs. USD will vary significantly throughout the quarter, creating FX risk for SEM. SEM’s existing exposure is shown by the dark blue line (see figure 2.) As USD/CAD rises above the initial spot (at 1.0), CAD weakens, negatively affecting profit. A 100 day exposure and 12% volatility creates a Value at Risk of $90,000.

The Hedge: CRM designed the 3-option hedge (shown by the light blue dotted line) that, when combined with the existing exposure, would create the payoff shown in RED. If the spot stayed in the range of 0.97 to 1.04, SEM would receive a positive payoff at the end of the hedge period. The maximum profit would be 3.2% if the spot ends at parity. If it fell outside the range, the loss would be limited to only 2%. The hedge was initiated on September 8, when the spot was .9980.

Figure 2: Vertical scale shows P&L per $100k, horizontal scale is USD/CAD spot rate

Results: The hedge worked very well. Figure 3 shows the spot movement during the hedge period.

As expected, it remained within the forecast region for all but 7 out of 100 days. The hedge was closed on December 20, at a spot price of 1.028, with a net profit of $13,000 or 1.3%. This profit was in addition to protecting the underlying exposure. Without the hedge, SEM would have lost $30,000.

Figure 3: The horizontal lines show the limits of hedge profitability, and the vertical line shows when the hedge was initiated.

Conclusion: Simply protecting FX exposure is prudent and straightforward, but also locks in P&L for better or worse. More complex hedges can be designed to extract profit if certain parameters are met. A hedge designed to create asymmetric payoffs like this can and must be designed to limit losses if the underlying prediction is wrong. The bottom line: combining FX options can potentially create positive payoffs in addition to protecting the underlying exposure.

Currency Risk Management and Hedging in the news

December 2011 - Inc. Magazine online
"Doing Business in Europe? You Should be Hedging"
Inc. Magazine author Eric Markowitz interviewed CRM Director Paul Stafford to learn what tools are availble to small- and mid-sized companies for managing foreign exchange risk, and how to avoid common hedging pitfalls.

 

October 2011 - Adhesives & Sealants Council Fall Convention
"Managing Currency Risk in a Volatile World"
Keynote presented by Paul Stafford, CRM Director

 

October 2011 - International Factoring Association presentation
"A Growth Strategy for International Factors" (pdf)
Foreign exchange volatility affects many businesses beyond import/export. Factoring companies often factor cross-border accounts receivable, or are financially sponsored by overseas investors. IFA invited CRM to present a webinar on mitigating FX risk to IFA membership.

January 2011 - Inside Supply Management magazine, vol 21 #11
"Currencies Remain Volatile"
As the euro fell from 1.5 to 1.2 in the middle of 2010, ISM contacted CRM for an article discussing the effect on supply chain cost and risk management.

The Currency Risk Management Briefing

The CRM Briefing is the perfect tool for CFOs and Treasury Personnel. The Briefing saves you hours every week by delivering all the important data you need to plan your hedging strategies.

It includes:

• Relevant world economic news
• "Risk aversion" indicator generated from counterparty risk, TED spread, VIX and other indicators
• Comprehensive review of:
  • comparative fundamentals (CPI, GDP change, current account balance, unemployment)
  • trading sentiment (sovereign CDS rates, Commitment of Traders, 25-delta risk reversals)
  • news and commentary for the 7 major currencies (USD, EUR, GBP, JPY, AUD, CAD, and CNY)
• A compendium of the major commodity indices and relevant news for use with the commodities currencies (AUD and CAD)
• User's guide to understand the data

Download a trial issue of the briefing (PDF)

Get the User's Guide to the briefing (MS Word)

Subscribe now: $50/month, billed monthly through Paypal

Currency Risk Management, LLC
- maximizing your profit by managing your currency risk -

• Expertise: Our staff has deep expertise in currency derivatives, foreign exchange trading, mergers and acquisitions, equity and fixed income derivatives, financial consulting, and capital sourcing. Our access to inter-bank pricing of all spot rates and derivatives frees our clients of excess fees and cost.
• Safety: CRM does not take control of client funds or accounts. All hedge contracts are matched to transactions at inception; no further CRM interventions are needed.
• No conflicts of interest: CRM does not accept commissions from any counterparty, bank or exchange for any of its recommendations to clients. We maintain our independence by avoiding the provision of consulting services to financial instituations and treasury software companies.
• 100% fee guarantee: CRM fully guarantees its work. If you are not completely satisfied with our consulting, we request 30 days to rectify the situation. If CRM has still not performed to your satisfaction, 100% of the consulting fee (less any approved expenses) will be returned.
• Confidentiality: CRM is committed to the confidentiality of its clients. No business or personal data or other client information will be disclosed to any third party.

 

Paul Stafford, Founder & Managing Director (Missoula, MT) Paul Stafford received the Bachelor of Science in engineering from UC Berkeley, and a Master's in engineering from Stanford University. He is a FINRA-designated Investment Adviser and Registered Representative. Paul is an expert at building foreign exchange derivative models for trading and risk management, and using Monte Carlo simulation to analyze effects of uncorrelated random variables for decision-making. Contact Paul: LinkedIn Email
Scott Wolfe, Managing Director (Denver, CO) Scott received his M.B.A. from the University of Colorado; J.D. from the University of Denver; and B.A. from Grinnell College. Scott brings experience in lending, business development, business financial consulting, capital sourcing, and 15 years in the practice of law. Scott's thoroughness, perspective, and sense of fairness are indispensable qualities to Currency Risk Management and to his clients.	Contact Scott: LinkedIn
Stefan Whitwell, Managing Director (Austin, TX) Stefan graduated from the Wharton School of Business at the University of Pennsylvania and was subsequently awarded the Chartered Financial Analyst designation by the CFA Institute. Stefan has18 years' experience in mergers and acquisitions, equity and fixed income derivatives, foreign exchange trading and real estate investment. Prior to founding Empirical Solutions, LLC, he worked for James D. Wolfensohn, Incorporated, Goldman Sachs and Credit Suisse. Stefan is registered with the National Futures Association as an Approved Forex AP, NFA Associate Member and Approved Principal of Empirical Solutions, LLC. Stefan was recently awarded the prestigious Certificate in Investment Performance Measurement (CIPM) designation by thte Chartered Financial Analysts (CFA) Institute.	Contact Stefan: LinkedIn