From the March 2010 issue of Treasury & Risk magazine

Living With Volatility

The world of finance has changed dramatically over the last two years. Movements in the markets that used to take months or years to develop now actually take place in a day or over a couple of weeks,Volatility in the markets has made risk management a top priority for companies that do business globally. Consider the euro, which since December has lost almost 10% of its value against the dollar. On a trade-weighted basis, the dollar declined by more than 16% in 2009 after reaching its peak in March, says Custom House's Ganesh Rao, in answer to T&R's questions on FX risk.

T&R: What trends are emerging so far in 2010?
Rao: More firms are revising their risk management processes by implementing more strategies to ensure that they are not caught on the wrong side of large currency swings. Some companies are using international payments to help reduce costs and have incorporated this process into their risk management strategy. For example, companies that were importing raw materials saw their costs increase dramatically last year. They have learned that not having a risk mitigation strategy in place, whether simple or complex, can have a negative impact on their bottom line. As 2010 sets up to become a strong run for the U.S. dollar, more companies are looking to manage their international payments exposure more effectively and ultimately add to their bottom line.

T&R: What is driving this outlook?
Rao: Given that some of the euro zone countries are deeply in debt (including Portugal, Ireland, Italy, Greece and Spain), the outlook is for the greenback to strengthen against the euro. The German government is currently working on a resolution to help Greece address its debt problem, and it's only a matter of time before other European Union countries come to the aid of their faltering neighbors and ultimately put further financial strain on themselves and the euro.

This situation is going to put much pressure on the euro and, more importantly, on the European Union as it copes with monetary and political differences. The EU is going to work hard to ensure that these countries don't default on their debt because that could have a domino effect on the global financial system. It doesn't want a repeat of what happened in September 2008 to take place on that side of the pond. It is going to be interesting to watch what transpires in Europe in 2010. Last year the greenback was the currency to watch, this year it's definitely the euro.

T&R: What other factors will play out?
Rao: The U.S. dollar should stay strong and should continue to gain against the euro and other European currencies this year. The debt problems in Portugal, Ireland, Italy, Greece and Spain will persist. We should also see some strengthening of the dollar against the yen as we move into the summer and the inevitable increase by the Federal Reserve in its target rate, which currently sits at 0.25%, in either the third or fourth quarters. Fed officials will undoubtedly raise rates as they are wary of having inflation on their hands even though many pundits are now discussing deflation. Commodities will also play a role once again if we see global growth. This will certainly help the commodity currencies, including the Australian dollar, the New Zealand dollar and the Canadian dollar, against the U.S. dollar.

T&R: What can treasurers and senior finance executives do to help minimize FX exposure today?
Rao: Management teams should revise their hedging strategy to ensure that it reflects current market conditions. Companies should review strategies on a quarterly basis instead of bi-annually or annually, and include their FX providers in this iterative process. The risk mitigation process that a company found successful last quarter might not provide the same positive results in the current quarter. Then, companies should consider paying suppliers in local currencies instead of paying with U.S. dollars. It's a simple solution, often overlooked, that can provide considerable savings.

T&R: Why pay suppliers in their local currency?
Rao: The U.S. dollar is viewed as the world's currency, so it's a handy vehicle to use for payments. This is not always advantageous because foreign suppliers are exposed to currency fluctuations like the rest of us. In fact, incorporating a one-solution-fits-all approach may not be the best strategy. It's important to note that most foreign suppliers mark up (or hedge) their price in U.S. dollar terms to ensure that they don't erode any of their margin when they convert it back to their local currency. Paying foreign suppliers with U.S. dollars could generate significant costs for many firms. Keep in mind that it's not uncommon to receive a discount of 2% to 10% when paying foreign suppliers in their local currency instead of U.S. dollars. This could lead to substantial cost savings and ultimately impact your bottom line.

T&R: What risk management strategies are key?
Rao: Given that there is a market trend for a stronger dollar this year, it might be worthwhile to look at forward contracts, especially for firms that import or export their services or products. Take the example of a U.S. firm that exported its product to Europe in December 2009 and expects payment in 90 days, but did not "cover" or hedge that receivable. Given that the euro weakened during this period, the firm effectively lost 10% on the foreign exchange transaction. Hopefully, it had enough of a margin built in to absorb the transaction exposure. However, this is not always the case as competition does not allow for ample margins.

With this in mind, firms should follow a simple rule that is sometimes overlooked. The tighter or narrower a company's profit margins for foreign sales are, the more of their sales the company should hedge (for example, 70% to 80%). On the other hand, firms with wider profit margins have more flexibility and have the ability to hedge less (for example, 50%) of their foreign sales. Obviously, the percentage margin that is used will ultimately depend on the goals and risk appetite of a firm's risk management team. This is critical for those firms that routinely need to repatriate profits from their foreign subsidiaries.

T&R: Where should companies begin with hedging?
Rao: Although firms are recognizing that they need a hedging strategy that will help them manage their currency risk to protect their profit margins and manage costs, many have never implemented a hedging strategy and naively embark on hedging their foreign payables or receivables. Inadvertently, they introduce more risk to their day-to-day business operations. One of the major goals of any hedging strategy is to manage risk, not create it. These simple steps can help create a robust and flexible strategy, and make it easier for any firm to effectively mitigate its currency risk:

l Identify your exposures.
l Formulate a currency risk management policy.
l Determine budget rates and goals.
l Devise a distinct hedging strategy.
l Execute the hedging strategy.
l Evaluate the results.

Questions to Ask When Building A Hedging Strategy
What is the hedging scheme attempting to achieve or protect?
Is there enough bank credit to have a proper hedging strategy?
Who is the provider here?
Does my provider have a foreign exchange hedging process?
Can my provider offer liquidity in exotic currencies?
Does my provider have a strong knowledge of my business process to help implement a strategy that will meet my unique objectives?

Ganesh Rao has more than 15 years of business, trading and relationship management experience in the foreign exchange (FX), payments and technology sectors. He is vice president, U.S. corporate, for Custom House, a Western Union company that provides international payments solutions.