FX Risk: To Act or Not to Act

Mufasa, a financial controller in Australia, felt a bit uneasy about explaining the AUD 40,000 foreign exchange (FX) loss to his boss, Ronan, and other executives in the management meeting. He expressed his frustration, saying, "A 20% loss on the original contract amount is incredibly frustrating. The client in Hong Kong is notoriously tough in contract negotiations, and despite our sales team's best efforts, we had to accept their terms. Ultimately, closing deals is the most critical aspect of our business."

To his surprise, Ronan turned to the treasury expert, Django, and questioned him about the situation. Ronan said, "Django, before signing this deal, you had warned us about the increased FX downside risk, but you also recommended following the current approach. I understand that the FX market is volatile, but how were you so sure that the downside risk had increased? Why did you justify not taking more proactive measures?"

Django paused for a moment, avoiding technical terms such as volatility and simulation. He responded, "Looking back to March 2020, the market not only projected a higher likelihood of downside risks but also indicated how severe the situation could become. For instance, within the span of March alone, the probability of a 15% FX loss increased significantly, from 1.4% to 19%. Additionally, the probability of a 20% FX loss went from being negligible (0.01%) to standing out at 12%."?

Django continued, "As a result, I updated my stress testing scenarios to incorporate a 25% FX shock, assessing its impact on our Australian business's bottom line performance. Fortunately, our exposure in those regions is limited, so the negative impact on our bottom line performance is insignificant. Considering the lack of financial and human resources to implement other risk mitigating measures, such as hedging, I recommended sticking with the current process and not taking further proactive measures."

"However," Django added, "when we review the entire 2020 for FX downside risk forecasting, there is both good news and bad news. The good news is that the worst-case downside risk seems to have improved, as all loss probabilities have decreased since April. On the other hand, the bad news is that all loss probabilities remain doubled. For example, the probability of a 10% or 15% loss stayed at 13% and 5%, respectively, compared to 7% and 2.5% one year ago."

Django emphasized the growing concern by saying, "Furthermore, in 2021, as we plan our growth focus to the Asia-Pacific region with a 40% annual growth target, the downside risk from 2021 onward is only worsening. We need to start considering investments in various areas now to be prepared for implementing more effective risk management processes in the future..."

Interrupting Django, Mufasa appeared briefly taken back, "Hold on, Django. Can't we simply contact our friends in the bank and have them handle this for us? What other investments does the treasury require?"

In the subsequent posts, let us explore the points Django is trying to convey.

Disclaimer: The characters and events in this article are entirely fictional.