Currency Pulse #10 - FX Risk Management & Valuation

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Outperforming the budget rate

Our bi-weekly backtest concerns a medium-sized Italian importer of furniture and appliances for kitchens. The bulk of the purchases from mainland China are priced and settled in USD, meaning the forward points are in favour of the company.

For the period 2023-2019, we back-tested an FX hedging program to protect —and outperform— the company’s budget rate. The program consists of a combination that includes:?

• A static hedging program. This program sets conditional orders that protect a worst-case scenario rate for the budgeted exposure.

• A micro-hedging program. This program hedges incoming firm purchase orders, automatically adjusting the remaining exposure.

The combination of programs achieves a weighted average FX hedge rate that is more favourable than the rate to protect. This outperformance averages 3.98%. It is mainly due to the fact that firm orders are hedged at a better FX rate than the worst-case scenario rate.

The bulk of the quantified benefits comes from the improved hedge rate (71.2%) and from the reduced FX transaction risk (26.1%). The gains from process automation, in this case, are to be quantified by management.?

FX risk management & valuation

A recent paper empirically assesses the link between changes in the value of Indian companies and their FX hedging policies (*). The authors find that non-financial or operation hedging —for example, moving a fraction of production to a foreign facility— has little impact in terms of enhancing the value of the firm.

In contrast, firm value is enhanced in a “significant and impactful” manner by financial hedging:

“The results show no impact from operation hedging on firms' value. In contrast, financial hedging is significant and impactful. Firms' value was enhanced on average by 16.64% – 19.65% through derivative [use]”.

So let us briefly recap the main arguments regarding FX risk management and firm valuation. In Discounted Cash Flow models (DCF), the effects of risk management and currency hedging show up in the growth rates of cash flows and in discount rates:

• Taxation. Smoothing out earnings over time can reduce taxation and increase cash flows. This is especially the case in the presence of convex tax rates (see Removing FX Gains & Losses. Balance Sheet Hedging Redefined).

• Profit margins. FX risk management makes it possible for companies to earn higher profit margins by capturing markups when selling in the currency of their customers, while avoiding them when contracting in the currency of their suppliers.

• Competitiveness. Pricing with the forward rate allows firms to increase their sales-to-capital ratio (a key parameter in long-term cash flow projections) when selling in a currency that trades at a forward premium (see Forward Points Optimisation).

• Cost of capital. Lowering the variability of cash flows with layered FX hedging programs can enhance valuation by reducing the cost of capital. Credit ratings companies pay special attention to policies that contribute to a lower free cash flow variability.

(*) Jyoti P. Das & Shailendra Kumar, S: “Impact of corporate hedging practices on firm's value: Empirical evidence from Indian MNCs”, Risk Management, No. 25, Vol. 10 (2023).

Centralisation is the name of the game

The latest PwC 2023 Treasury Survey emphasises the growing importance of treasury centralisation. For treasurers to act as “generators of cash flow”, there should be “one cohesive treasury unit”. This can lead to a value-adding treasury function that helps deliver “consistent cash flows in excess of investor expectations”.

“As part of improving cash operations, the survey highlights a growing focus on increased centralisation with treasury —specifically, very large multinational corporations have realised the benefits they can generate through scale and have moved significantly toward further cash management centralisation”.

The findings of the PwC 2023 Treasury Survey fit well with our views on the importance of centralisation in terms of avoiding silos. In currency management, centralisation allows finance teams to:

• Build valuable FX expertise in Headquarters

• Achieve economies of scale

• Improve visibility and control at the group level?

According to the survey, 73% of respondents in corporations with $10 bn in revenue or more have an in-house bank and 55% have a process for payments centralisation. Finally, 70% of respondents see Application Programming Interfaces as “the most relevant technology in the next two to three years”.

That’s music to our ears!

Five useful links

Discover Patrick Kunz's views on cash in CurrencyCast, Journeys to Treasury report, the European Central Bank on instant payments, French CFOs on international expansion, the IMF on African currencies and global interest rates.

Read on:

1. Patrick Kunz on Currency Cast. “Cash is the Emperor”. That’s what Patrick Kunz of Pecunia Treasury & Finance told us. Watch the entire episode for a broad discussion of treasury-related issues, from ‘scanning’ operations to multi-currency cash pools.
2. Journeys to Treasury. The 2023/2024 edition of Journeys to Treasury is out. A collaborative effort between BNP Paribas, PwC, SAP and the EACT, JTT discusses, among others, frictionless payments, bank relationships, and the value of treasury in 2023.
3. The ECB on instant payments. Instant payments are credit transfers that make funds available in a payee’s account within ten seconds of a payment order being made. The European Central Bank discusses them in the context of SEPA Instant Credit Transfers.
4. French CFOs on international expansion. French CFOs are keen on expanding their operations abroad in order to spur growth, according to a Globalization Partners survey. The survey, however, does not cover FX-related topics.?
5. African currencies. The IMF discusses the impact of global interest rate changes on African currencies. “A 1% increase in the rate of depreciation against the US dollar leads, on average, to an increase in inflation of 0.22% within the first year in the region”.

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