Currency Pulse #6 - The Golden Middle Path

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Bi-weekly backtest

A Belgian producer of equipment for combustion engines, with USD-denominated imports of industrial metals, displays both insufficient workflow automation and FX program effectiveness.

While most risk management processes are manually executed, the firm struggles to reduce performance variability.

With its current strategy, consisting in hedging 100% of the forecast 12 months in advance on a rolling basis, it also fails to optimise favourable forward points on the EUR-USD rate (the U.S. currency now trades at a 1.80% one-year discount to the euro).

Our proposed solution is an automated layered hedging program that starts 18 months in advance.

With data from 2022, the layered hedging program would have enabled the firm both to reduce the difference between average hedge rates —from 8.02% to 3.66%, thereby reducing FX-induced performance variability—, and to realise €149,500 in savings from the more favourable currency rates (on a €28.75m exposure).

FX risk management for loan originators

To be profitable, fintech lenders known as loan originators often arbitrate currency mismatches on their balance sheet as they fund themselves in low-yielding currencies, while they lend out at higher interest rates in PLN, MXN, BRL, ZAR and others (See: “Tackling Fintech lenders’ Cost of Hedging”).

Is there a way for them to lower their cost of funding by effectively managing FX risk with currency derivatives? This is the subject of a recent ASOFOM webinar led by Kantox’s Renzo Guazzotti and Esteban Lopez.

The first point to consider is the difference between ‘long’ currency options strategies and forward contracts in the context of USD, EUR or GBP- funding on the liability side, and MXN-denominated loan portfolios on the asset side.

Taking into account all relevant cost factors —including interest rate differentials, premium costs and the time value of options—, Mssrs Guazzotti and Lopez strongly come out in favour of automated solutions with forward contracts.

“As loan originators seek to lower their cost of funding with deeply out-of-the money currency options, they inadvertently leave their balance sheets highly exposed to currency risk” — Renzo Guazzotti

However, a key challenge is a proper estimation of loan originators’ FX exposure. Here, nothing beats a good ‘FX risk map’, a simple representation of currency risk across the transaction journey. In this case, it would show two things:?

1. The underlying currency risk does not start when the loan in USD or EUR is made, but rather when the funds are actually exchanged into the local currency.
2. The FX rate to defend is the weighted average of all the currency rates that prevail at the time when conversions are done.

We’ll be discussing these and other automated currency management strategies for Fintech companies in much more detail over the coming weeks and months. Stay tuned.

Book review. Jankensg?rd, H?kan, Alf Alviniussen and Lars Oxelheim: Corporate Foreign Exchange Risk Management (Hoboken, NJ: John Wiley & Sons, 2020).

It is with great pleasure that we read this extremely informative book on FX risk management for corporations. “After reading this book, be prepared to become the go-to person”, is the claim made by the authors in the preface. Let us see if they deliver.

For a start, here’s a list of some of the topics masterfully treated in the book:

• the futility of forecasting exchange rates
• the priority of cash flow hedging (without neglecting the importance of accounting)
• the difficulties in estimating FX exposures (“it can be devilishly hard in practice”)
• the danger of a ‘siloed’ approach to currency management
• the focus on net exposures in the context of centralised FX risk management

Regarding all these topics, we can only say: Bravo! Or perhaps: Bra gjort!

The typically Scandinavian sense of balance is on display throughout the book. When the authors claim that they aim for the ‘golden middle path’, they deliver. Here’s an example: the notion of ‘optimal transparency’ (chapter 10).

When it comes to reporting, firms should disclose enough information to gain credibility — thereby lowering their cost of capital. However, too much information may create confusion by ‘cluttering’ financial reports.

But does Corporate Foreign Exchange Risk Management live up to the lofty promise made in the preface? Not quite. There are no references to the importance of forward points management (see: “Forward Points Optimisation”).

Even more striking, automation is absent from the book. Yet a new software category, Currency Management Automation, was seeing the light of day around 2020, just as the book was published and the pandemic was starting to put business process automation at centre stage.

Ultimately, the question before us is: does automation technology change the nature of currency management itself? Let us mention just two examples.

1. Automated micro-hedging programs make it possible to handle any number of transactions in any desired currency pair. This may already be dealing a decisive blow to some ‘catalogue-based’ business and hedging models that were prevalent, for example, in Travel. Not bad.
2. And what about hedge accounting, extensively treated in chapter 6 of the book? Thanks to the perfect end-to-end traceability that comes with automated FX solutions, the task of compiling the required documentation for hedge accounting can now be easily automated. Another game changer.?

Five useful links

The case for a digital euro, signs of stress in BNPL, two dimensions of the CFO role, behavioural biases, Amadeus’ Traveller Tribes 2033

(1) The case for a digital euro. Writing in the Financial Times, Mairead McGuiness makes the case for a digital euro in terms of the innovation benefits it would bring in payments, an area where Europe is “overly reliant on companies such as Visa, Mastercard, or PayPal”.?

(2) Buy Now, Pay Later. The Wall Street Journal sees signs of stress in the BNPL space as U.S. consumers may be struggling. Time to innovate? What about introducing FX management services like guaranteed FX rates during predetermined time lapses?

(3) Bloomberg CFO series. Workday’s Barbara Larson: the CFO needs team leaders to handle each of the key finance ‘micro’ subjects (vertical dimension of the role). But she also has a strategic role to play in close contact with other members of the C-suite (horizontal dimension of the role).?

(4) Behavioural economics. Treasury Management International has a piece on behavioural economics and its impact in terms of risk management [see]. In our own assessment, we see conservatism bias as the No. 1 challenge for currency managers.?

(5) Travel Tribes 2033. According to the Amadeus report on ‘Traveler Tribes 2033’, 44% of travellers foresee that travel “will be quicker”, while 35% of them think that technology will “reduce problems during trips”. The overall tone of the report is pretty optimistic.

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