Credit crisis FX exchange markets

Like a stone thrown into a pond, this summer’s credit crisis rippled out from
the US sub-prime mortgage markets to affect almost every financial asset class –
bonds, equities, cash and even foreign exchange.

Sharp movements caused by the unwinding of the yen carry trade saw the dollar
fall almost 9% against the yen in the space of just a few weeks, and served to
underline the volatility of the FX markets.

FX is the world’s largest financial asset class with $2 trillion changing
hands on the markets every day. The majority of this volume comes from
speculative transactions which makes the market very volatile and almost
impossible to predict.

Investors are more demanding about the way companies manage their foreign
exchange exposure. Wolfgang Koester, chief executive of FX software company
FiREapps, says: “Investors are questioning executives at US companies about why
there is any volatility at all in the foreign exchange gains or losses booked to
the balance sheet.”

But FX advisers say that persuading some finance directors to manage that
risk can be tricky. “Many finance directors lack the tools to take a close look
at the true level of exposure,” says Koester.

Tony Wilson, a director at Travelex, often has to explain to FDs that hedging
FX risk should be seen as a form of insurance. “There are executives who are
prepared to insure their property but are not willing to protect their financial
budgets,” he says.

Accurate forecasting

Hedging foreign exchange helps companies to remove the uncertainty from their
financial forecasts. The exchange rate may not be as favourable as last year,
but at least it means that a more accurate budget can be drawn up with no nasty
surprises at the end of the fiscal year.

FX hedging is best when it is simple. For many companies buying simple
forward contracts that will deliver the foreign currency in three to six months
can be the most effective way to hedge FX exposure.

Tony Brown, FD of Universal Cycles, says his company has started to use
forward contracts reflecting the change in the company’s customer base over the
past five or six years from individual bike shops to big chains like Argos and
Tesco.

“That presents a problem when it comes to managing our FX risk. When we
supplied individual shops the price would fluctuate over the year, but with the
multiples the prices are set up to six to 12 months in advance,” he says.

The company has to hedge its FX risk because it operates at such low margins
that if the price moved against them, the company could find itself not making
any profit. The company looks at the business it has in the pipeline and then
aims to hedge 60% to 80% of this using forward contracts.

Complex case

In some cases, a more complex product can make better sense. A company that
has exposure to the Japanese yen, for example, could find a forward contract an
expensive option because of the differential between interest rates in the UK
and Japan. A more sophisticated product could offer better value.

But FDs must keep a level head when assessing the value of a particular
product. Stuart Perry at Baydonhill says: “FDs tell me how only one person out
of four or five from an investment bank will understand the product. The FD then
says, ‘If only one of them can understand it, how are we meant to understand
it?’”

It makes sense for a company not to fully hedge its position so that it can
take advantage of favourable currency movements. But the purpose of hedging is
to protect the company’s profits and not to profit from exchange rate moves.

It can be a fine line between using financial contracts to protect a
company’s underlying business and playing the markets. Wilson says: “If a
company is bidding for a tender overseas, it is often so finely priced that the
exchange rate movement can mean the difference between profit and loss. A
company has to take out an option or a forward contract even though they don’t
know if they will win the tender.”

The FX markets may have calmed down recently, but executives should not rest
on their laurels. Chris Towner, senior economist at HiFX, says: “It’s often when
FX moves start to impact the bottom line, that executives start to be interested
in hedging, but it should be something that is constantly managed.”