Currency Pulse #26 - Opportunities In A Sparky World

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Opportunity vs. threat: the role of financial derivatives

Like it or not, narratives influence CFOs and treasurers’ perceptions and decisions. When it comes to financial derivatives, very few of these narratives are energising and ‘opportunity-based’. Instead, ‘threat-based’ stories tend to prevail.

This perception directly impacts companies’ financial well-being—and even survival. A Bloomberg article describes the travails of medium-sized South Korean exporters of commodity-like chemicals. Bankruptcy costs are soaring as the rising USD-KRW rate means pricier imports of raw materials.

Yet, a 2023 survey shows that 49% of exporters have no particular contingency plans. Their reluctance to hedge reflects the so-called Kiko derivatives scandal, which led to $5.54bn in losses at mid-sized shipbuilders. This threat-based narrative infuses fear in the minds of unprepared treasurers—with dire consequences that are now on display.

This stands in contrast to the ‘opportunity-based’ story that is taking hold in Morocco, as another Bloomberg article carries the title: “World Cup Host Morocco Plans Derivatives to Help Fund Spending”. The country is set to spend USD 20bn on strategic projects as it gears up for the 2030 World Cup, to be co-hosted with Portugal and Spain.

This happens as Morocco quietly becomes a North African manufacturing powerhouse [see]. At Kantox we take a decidedly constructive and opportunity-centred view of (plain vanilla) FX forwards and swaps. It’s about allowing companies to profit from the value-generating opportunities of ‘embracing currencies’ in our incredibly sparky world.

But this positive assessment should always be based on:

1. A thorough understanding of the business’ FX exposure
2. A complete avoidance of unsystematic, aka speculative hedging
3. The use of automated solutions to remove operational risks

Removing FX gains & losses, Part IV: The automation imperative

Previously published blogs on balance sheet hedging programs to remove the P/L impact of FX gains and losses cover three main points:

• The reasons why CFOs and treasury managers may want to remove the accounting impact of FX gains and losses.

• The mistakes they often make as they implement the corresponding balance sheet hedging programs.

• The market-based programs they can apply to answer these challenges.?

In this fourth and final blog of the series we introduce the automation requirements of a well-run balance sheet hedging program designed to achieve a clean, zero-line in terms of FX gains and losses.

Read the entire blog ?? here.

Bi-weekly backtest: German pig meat exporter (*)

Our bi-weekly back-test concerns a German pig meat exporter with sales in Asia, mostly in USD (77%) and JPY (16%). In terms of pricing, the company is ‘FX-driven’, i.e., an FX rate is systematically part of its pricing parameters.

The firm's net profit margin of 5% —below the 6% average for food processors— means that the company is also ‘FX sensitive’. In other words, currency management is a matter of strategic importance.

With that in mind, we tested a comprehensive solution that addresses the firm’s main pain points:

• Erratic hedging resulting in timing trades to reflect managers’ own exchange rate forecasts
• Unfavourable forward points, as USD trades at a one-year 1.94% forward discount to EUR
• Excessive markups (1.5%) that put the firm’s competitive position at risk
• Manual processes across the FX workflow, including swap execution

We tested a program for hedging FX-denominated orders as they materialise. The program includes automated stop-loss and take-profit orders on EUR-USD. The aim is to delay hedge execution to save on forward points while monitoring markets 24/7 and keeping FX risk under active management throughout.

A market-based pricing program was also tested. The program automatically captures the relevant forward FX rate. Given the forward discount of USD and the time-lapse of 35-55 days between the moment prices are set and the settlement, pricing with the forward rate helps protect profit margins.?

It also helps managers avoid the temptation of applying excessive markups. Overall, systematic hedging reduces risk deviation by 88.7% on annual sales of $244 million. Delaying hedge execution provides an additional 10 bps in savings each year.

(*) Every two weeks, Currency Pulse presents a real-life case. No names are mentioned, absolute values and some details are changed. We use tools to backtest, with historical data and Monte Carlo simulations, our proposed automated hedging programs.

Marc Padrosa: body fitness and FX management in Travel

While reviewing his hectic schedule, Marc Padrosa Cabello , Kantox’s Global Industry Director for Travel, reflects on how to stay fit—and on the opportunity for systematic FX management at bed banks, flight consolidators, Travel agencies, OTAs and rental companies (*).

“I crossed four continents while flying several airlines and types of aircraft. With a handful of payment methods, I spent money in six currencies - each with varying degrees of volatility” — Marc Padrosa.

According to Amadeus, 71% of customers spend more when shopping in their own currency, 74% are concerned about the final bill when buying outside of their own currency, and 84% prefer to pay in their own currency.

(*) See our report Currency Management for B2C and B2B Travel Distributors.?

When FX risk turns into credit risk

On Kantox's podcast, Agustin Mackinlay talks to Damian Glendinning, former Treasurer manager at IBM and Lenovo in Singapore, now with CompleXcountries—Global Treasury Intelligence.?

While focused on FX risk management, the discussion includes topics such as bank relations, data management and the need for treasurers to hone their communication skills.??

“In Asia, IBM invoiced in local currency, except in Indonesia. During the currency crisis, Indonesian distributors who sold in IDR weren’t able to pay us. The only place where we took a loss was the country where we sold in USD.” — Damian Glendinning?

Here are some of Mr. Glendinning’s main points:

1. The nature of treasury operations. The nature of treasury changes with: (a) the type of business; (b) what you’re trying to achieve; (c) how well you do it. When Lenovo bought IBM’s PC business, it went from $4bn in revenue in China to $10bn in revenue in 175 countries.?
2. FX risk management and margins I. In a business with 75% gross profit margins, FX management may not be an urgent consideration. But with gross margins between 16%-20% and net margins around 5%, a 10% fluctuation in the exchange rate wipes you out.
3. FX risk management and margins II. When profit margins are thin, and the weight of FX is considerable, the cost of hedging becomes particularly important. Things to do in such cases: (a) rule out using currency options; (b) pay close attention to the cost of carry.
4. Currency risk and credit risk. Selling in your own currency doesn’t make the risk go away—on the contrary, it creates massive counterparty risk. You are in effect delegating the currency management to your clients/suppliers. You might want to think about that.?
5. Exchange rates are unpredictable. Beware of self-proclaimed experts in FX markets—even within your organisation. Good FX management is about putting a solid process in place, knowing that the law of averages means you’ll end up being neutral over time.

Watch the full episode ?? here.

Technology and FX derivatives

A quick illustration of how technology makes it possible to use FX derivatives in ways that would have not been possible just a few years ago. A Switzerland-based exporter of pharmaceutical products with USD sales implements a quarterly layered FX hedging program.

The corresponding FX trades are manually executed. Given the competitive landscape and the high CHF forward premium to USD (5.1% in one-year forwards) a monthly layering hedging program would help the firm achieve a smoother hedge rate and reduce the forward points impact at the same time.

But this is too demanding with manual execution. The solution: connectivity to a multi-dealer corporate FX trading platform such as 360T. And voilà.?

Five Useful Links

1. Derivatives. A Treasury Today article mentions Kantox’s vision of FX derivatives: (a) FX risk management is more than just the execution of hedges; (b) technology makes it possible to use derivatives in ways that would have been too resource-intensive just a few years ago; (c) companies should be especially careful to avoid ‘unsystematic’ FX hedging.?
2. Aquaculture. The amount of fish farmed globally just surpassed the wild catch. In 2022, 94.4m tonnes of fish were farmed in pens and ponds, vs 91.0m tonnes in open water. (Source: FAO study). Kantox's álvaro Villar comments: "With more predictability, budget-based FX hedging is likely to gain ground vs. hedging only firm commitments".
3. Pricing and markups. A Reserve Bank of Australia paper uses natural language processing to study firms’ pricing parameters. Key findings: (a) firms react more to increasing input costs compared to decreasing input costs; (b) price-setting behaviour differs sharply across industries. Useful material when assessing FX hedging programs.
4. Treasury centralisation. UScellular CFO on centralisation: “In a low-growth revenue business, managing costs is paramount. We’ve moved some functions (including treasury) to one central location. It’s easier to justify investing in new technologies and automation than if you operate out of several locations”. FX centralisation, anyone?
5. The cliff. The Mexican peso tumbles on the heels of recent election results. Bloomberg News quotes Miguel Iturribarra from BBVA Mexico: "As a result we should have an increase in the premium for local assets". Translation to treasury language: a higher forward discount of MXN to USD, now at 5.87% in one-year forwards.

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