Forex Management—Easier to Get It Wrong than Right

By Sharon Constançon, Managing Director, Valufin UK

No one decision is likely to be the perfectly correct decision over time.

Markets move, the volatility and degree of change can be more or less dramatic, but the decades show that nothing changes in that rates are always changing.

Therefore over time, any decision could have been improved upon—so how does a finance director win this game?

The first point to note is that the “house” is not stacked against you. Markets move on supply and demand, expectation versus reality and, over time, on economic trends. The latter is of little value to most as hedging is about now not 10 years from now.

The most important issue to understand is what is important for the business. Its requirement for foreign exchange (forex) comes first—then one must look outside to the “noise”, and work the needs within the emotion, volume and trends of the moment.

Look Inside First

It is important to first determine why the business is in existence? What is its strategy and goals?

For example: an AIM-listed business with a turnover of £50 million which is largely PE (private equity) owned and which imports, manufactures and exports products, will have a different raison d’etre and strategy for the next five years from that of a small-to-medium-sized enterprise (SME) with a £5-million turnover that is owner managed and exports technology and service-based solutions.

The staffing and skillsets will be different, as will the use of accounting systems and recognition of risk. The former will be holding stock as the risk asset, and the latter will have staff hours, software and licence fees, which have a very different risk profile.

Accounting for risk will be different. The time taken from sourcing and paying for an imported component that is then used in manufacture and later sold, together with agreeing credit terms, until funds are received from the final customer could easily be six months with time, credit, delivery, product and pricing risks to be managed. To be competitive, the business will need to address both the import-cost risks and the export pricing to maximise required KPIs (key performance indicators).

In the second case, staff could be on contract, software does not have a holding cost risk and pricing can be very flexible to secure required deals with less risk on profitability over a much shorter time horizon.

These two finance directors should not have the same forex strategy.

False Beliefs

There are two forex myths that I dispel:

• Fully hedged with flexible contracts for each invoice is low risk.

• Totally unhedged is high risk.

My MBA thesis proves that neither of the above is valid in that a managed portfolio which provides protection but allows for opportunity of beneficial currency movements will improve both the fully hedged and totally unhedged strategy.

To have a fully matched hedged strategy is not feasible and is costly as orders change, invoice values differ and timing is flexible.

To be totally unhedged and driven by administrative demands is equally foolish in that movements in the weeks before could have provided better opportunities to hedge.

Flexible Versus Risk

The providers of currency often suggest strategies that are not appropriate in the form of a derivative structure of some kind or another.

The simple instruments are a spot rate for two business days’ time, and a fixed-rate forward contract valid at that rate for a single date in time. These are the most cost-effective instruments to use.

• The spot rate is traded internationally and therefore can be tracked. If value today or tomorrow is chosen, the price is adjusted by the interest rates earned or paid. This is technically simple but open to mispricing to their disadvantage.

• The forward rate is simply the spot rate plus the interest rate earned for the currency purchased and the interest paid for the currency sold.

As interest rates are low and often similar to our trading partners, this variance translated to pips, added or subtracted to the spot to achieve a forward rate, is currently low for both importers and exporters.

The exporter gains a discount when the foreign currency has a higher interest rate than the UK—for example, South Africa, where a hedged position can gain around 6 percent per annum depending on the duration of the contract.

Owing to its simplicity, it is easy to track and manage such that the pricing received is correct.

Any other instruments are ALL derivatives in that they are based on the spot and the forward but structured to provide a floor, cap, collar, non-delivery or some other variance at a price and risk in behaviour.

There are very few occasions where a derivative can surpass a managed portfolio, comprising simple instruments. Simple instruments provide total flexibility, certainty, no surprises and behave in one way only in reaction to time and market rates.

Managed Portfolio

This is the complex bit: how to find time to do the day job and manage the impact of the currency market on the business. This is not an easy balance of skills and finding/using systems that provide valuable decision-making information.

Internal areas on which to focus attention: 

1. Costing of the product

This can be either to the export customer or imports. The balance is understanding the flexibility of pricing, desired gross profit, revaluation, competitor activity, impact on incentives and margin management at a finance department level. Typically a wide margin is added by finance, fixed for a period, and the accounting variance is often not managed, with undesired outcomes in behaviour, market share and profit occurring.

2. Risk appetite

Is there flexibility in pricing or timing of payment? What KPIs are measured, and where will forex movement impact earnings? What is the time horizon; are there imports and exports; how many currencies, product lines, supplier or customer risks, deadlines, shipping uncertainties, etc.? How do these align to the strategy, market share, pricing, profit, and long-term sustainability?

3. Accounting and reporting

Unless you raise the invoice (exposure risk) in the accounting system on the day that you use a spot rate to pay it (cash accounting), and cost it at that rate, there WILL be forex cash flows, revaluations and profit-and-loss variations that need to be understood, accounted for and TRUE profit determined. Information must be accurate and drilled down into the real components.

From the above, a picture will be formed on how the portfolio should be managed. For example:

• The manufacturer could decide to hedge two months’ worth of import turnover in the high-frequency lines using longer dated contracts for interest rate advantage and flexibility of choice; while on the export side, he may decide to hedge six months’ worth of annual turnover to high interest-rate countries and three months to low interest-rate countries, but taking the contracts short-dated and rolling them for interest rate maximisation.

• The technology company may decide to hedge all the annual known licence fees in value and leave all other exposures open and use spot and these contracts together to manage short-term needs.

The next step is the integration of the strategy to actions in the forex market:

• Spot rate

This is the only forex decision: what spot rate do you want to purchase or sell currency? The follow on decisions are: in which pair combination; what time limitations might you have; what is breakeven; and what facilities are provided?

Then there are various ways to manage this based on staff, currency providers, use of orders or watching the rate.

• What choices after spot action?

Once currency has been purchased or sold it can be used, go on account, or be switched to a fixed forward date which gives the best cost or return per day.

• Need currency to flow

Currency is needed to pay or receive funds. As there is a portfolio in place, expected needs, current and expected movements, the decision can be taken to use spot, use some of the cover or a mixture. If cover, which of the contracts will deliver the best rate today relative to their fixed contract date, returning the unused portion of interest premium or discount?

• Transact

The price of the deal needs to be agreed. This is commonly done online or by phone but, importantly, the price expected, (including fair margin), needs to be known, negotiated and agreed. Free access to this information exists.

• Confirm, flow and account

The last stage is accurate and timely recording of the actions relative to the invoices such that the TRUE cost, profit, accounting margin and cash flow timing differences are fully known.

How to Acquire Forex Expertise

Forex made simple still requires focus, processes, understanding and time to support the business properly. There is a critical requirement to combine relevant market knowledge with the needs of the business.

Companies have the choice to either employ full time or outsource on a needs basis to acquire this forex expertise.

Photo Attribution: © Depositphotos/semisatch