Navigating the economic environment requires to master FX risk management.

The critical economic environment we are currently facing is a humbling reminder that market volatility calls for great caution, good risk hedging and a strict, systematic approach. At a time when business can take a beating, opening to new markets and new currencies seems like a good strategy. Of course, FX risk is only one of several financial risks, such as interest rates, liquidity, and commodities. The treasurer is a strategic thinker, provided he can free himself from repetitive, time-consuming tasks – his/her most precious resource. Let's ask ourselves how we can usefully navigate these stormy seas.

FX remains a key priority according to recent surveys

The PwC 2023 global survey showed that currency risk (i.e. FX) remains the most critical and most important of the many serious financial risks. Let's just mention interest rates, for example, or counterparty (banking) risk, which has surged since the spring of 2023 and the bank problems in the USA and Switzerland, in particular. Uncertain" is probably the best word to describe the current, highly paradoxical economic situation. Indeed, one has the impression that, despite all the current problems, economies remain resilient (e.g. wars, political tensions, supply chain disruptions or cost overruns, increasingly violent climate change, sectors in enormous difficulty, such as real estate, anger in certain professions deemed to be mistreated, renewed populism, the disappointing and worrying US election campaign, the economy of the leading Germany at half-mast, inflation and interest rates still too high, etc.). This resilience is reflected in sometimes indecent share prices and record-breaking stock market indices. The world is walking on its head, isn't it? And yet it is in such a climate that treasurers need to be properly armed to face up to the many financial and other risks involved.

Permanent volatility, the new norm?

The paradigm shift must date from the Brexit. One gets the impression that since that date (i.e. 23rd June 2016), which will live long in the memory, volatility has been consistently high and permanent. Three factors are likely to contribute to keeping it high: geopolitical tensions, a rush to low-carbon energies disrupting supply and demand, and finally metallic nationalism, for those who own rare earths and metals, the blessed ones. Commodity markets have also seen their fair share of volatility, particularly electricity over the past two years. Correlation and decorrelation can occur where they didn't before. Any strategist can feel disturbed and disoriented by such sometimes abnormal or exaggerated movements. (for top priorities in treasury, have a look at last EACT annual survey 2023 or PwC global treasury survey 2023).

And not to worry anyone, but the phrase “irrational exuberance” (source: Alan Greenspan in 1996) keeps cropping up in conversations with investors. At the time, the ill-fated dotcom bubble was in full swing, with shares of dozens of untested, unprofitable tech companies soaring to the moon, often on the flimsiest of rationales. In this somewhat complicated, irrational, and unorthodox environment, the treasurer must find his own way. His/her job is more complicated than ever. But this time, it's the combination of disruptive and contradictory elements that makes for poor visibility. So, what's the best way to protect yourself?

Centralization, as one of the best responses to mitigate FX risks

We believe that further centralizing foreign exchange risk management remains one of the best weapons for optimizing FX and mitigating P&L impacts. In this respect, we welcomed KANTOX's launch of an in-house FX solution. In-House FX solution for centralizing exchanges of currencies will change the way to handle FX risks for MNC’s. Such a solution will allow companies to centralize the FX management and trade executions of their subsidiaries, maximizing exposure netting for the group and enhancing liquidity. Managing the FX of various business units poses significant challenges for finance teams, often leading to high trading costs, limited visibility, and a lack of consolidated FX management. Combined with a dynamic hedging technology to seamlessly integrate the FX operations of subsidiaries with the headquarters, it can deliver excellent results and enhancements. Subsidiaries can benefit from 24/7 internal FX transactions, currency risk is managed seamlessly, and with only one trading entity, businesses can centralize and significantly improve bank liquidity terms.

Leading-edge FX solutions, the way to get competitive advantages on peers.

A best-in-class FX management tool enables groups to generate added-value for operations and empower business to navigate the complexities of our world with comfort, efficiency, and confidence. When we talk about In-House FX, we mean tools to ensure a 24/7 liquidity and automated hedging processes, including all group subsidiaries and with customizable markups set by the headquarters. We also need an increased control. The central group treasury must have full control over subsidiaries’ hedging policy as well as internal trades, including reviewing rates and approving or rejecting internal FX transactions that exceed specified criteria. The end-to-end traceability is also an important feature. Finance teams gain full traceability from the original entry at subsidiary level to the execution of external trades. The Headquarters should be able to manage risk from internal trades by executing an external FX transaction before providing a rate and confirming the internal FX transactions (No Book-Holding), immediate confirmation of internal FX transactions (Book-Holding), or by aggregating internal FX transactions into external ones (Back-to-Back). And ideally, we need a single trading entity, i.e. the Headquarters which will act as the sole trading entity, managing netting at the group level on top of subsidiary-level netting.

Dynamic Currency Hedging

Adopting a dynamic currency hedging as risk management strategy is interesting and efficient, providing we have the ad hoc tools to manage it. The aim is to vary the amount of hedging to provide better results than a static hedging strategy. The benchmark for dynamic hedging programs is expressed as a hedge ratio (to be defined and adapted according to circumstances): If the benchmark is 0% or unhedged, the objective of dynamic hedging will be to add value by increasing the amount of hedging when the exposure currency is going down, with the aim of generating profits from hedging that partially offset losses in the underlying portfolio. If the benchmark is 100% or fully hedged, the objective of the dynamic hedging will be to add value by reducing the amount of hedging when the exposure currency is going up, with the aim of reducing the losses from hedging while the underlying portfolio experiences gains. If the benchmark is 75% or another partially hedged ratio, the objective of the dynamic hedging will be to add value by varying the hedge ratio in both directions. As volatility rises in currency markets, investors are re-thinking their currency hedging policies and are looking to improve the risk-return profile of their international currency exposure. Passive currency hedging has been widely implemented to fully or partially neutralize currency exposures derived from international assets. In passive hedging, the Target Hedge Ratio remains static regardless of market conditions, such as currency valuations, economic developments, and sentiment. We believe that allowing Target Hedge Ratios to vary according to factors that are rewarded in currency markets (such as Carry, Value and Trend) is a smarter way to manage currency risk and generate additional returns than a static hedge ratio.? Specialists talk also about an approach of “Informed Dynamic Currency Hedging” model which looks for opportunities to raise expected returns and reduce cash flow drawdown from currency hedging within an investor’s international portfolio. The model aims to improve the effectiveness of a passive hedging program by changing from time to time the target hedge ratio at the currency level such that exchange-rate exposures are tilted toward rewarded factors. But as already said, no appropriated tool, no dynamic hedging. Don’t try to do it form your TMS or from XL sheets, it won’t work.

Automation from A to Z

In conclusion, we can say that good FX management can create value for the business, if it is optimal and fully automated from A to Z. An in-house FX management tool, often complementary to a TMS (as they are insufficient to enable such management), enables you to take your FX management to the next level and achieve a level of efficiency that is formidable, but necessary in a world of rapid and perpetual change. We can only advise treasurers to dare to review their FX processes and consider change for the better. It's time to get away from the comfort of thinking that what's being done is good and satisfactory, without questioning it. These are no longer passive times, and with operating margins under pressure, they need to be guaranteed and protected against currency fluctuations.

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Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg 2024 February