Treasurers of global corporations are feeling the impact that currency volatility can have on their business. Volatility has spiked in recent months, as central banks around the world have begun to actively manage their currencies.
“Historically, G-10 central bankers were in agreement,” says Wolfgang Koester, CEO and co-founder of foreign exchange (FX) analytics software vendor FiREapps. They almost universally thought: “‘Whatever is going to happen in the currency markets, we’re going to ensure it’s a concerted effort and we’re going to control the markets so that volatility doesn’t create unnecessary risk.’”
But now that attitude seems a relic of times past. “We haven’t heard that sentiment since the Swiss National Bank made an unconcerted decision to manage their currency,” Koester notes. “Even [European Central Bank president] Mario Draghi made the statement a couple months ago that volatility is here to stay. If somebody like Draghi comes out and bluntly states that, you know everybody is in it for themselves.”
As a result, companies that do business in more than one currency have been taking a hit to the bottom line. According to the “FiREapps Q1 2015 Currency Impact Report,” currency volatility had a bigger impact on earnings per share (EPS) of North American companies in the first quarter of this year than at any other time during the previous four years. See Figure 1, below. Currency shifts reduced EPS in 279 of the 850 companies FiREapps studied, and the average negative impact was $0.08 per share.
The strong dollar deserves some of the credit, Koester says, but the trend is much broader than one currency. “These companies are reporting movements in specific currencies, and not necessarily against the dollar,” Koester says. “Volatility in Latin American, Asian, and Eastern European countries is causing all sorts of heartburn.
“Companies used to focus on their two, three, maybe four largest exposures,” he adds. “But now we’re seeing that that doesn’t work. Most companies did not consider the Russian ruble to be one of their largest exposures at the end of 2014, nor the Brazilian real. But if you look at mentions of currency impacts in our report, these are two of the five most-mentioned currencies.” In fact, executives of North American companies explaining currency impacts in their Q1 earnings calls mentioned the euro most frequently (142 companies) and the yen second most frequently (82 companies), followed directly by the ruble, mentioned on 58 earnings calls, and the real, mentioned on 28.
The idea that a company can eliminate 80 percent of its risk by hedging 80 percent of its exposures just doesn’t hold up anymore, Koester says. The euro-dollar is the currency pair to which many U.S.-based businesses have the most exposure, yet it’s one of the world’s least-risky currency pairs. “In reality, 20 percent of your exposure may well represent 40 percent of your risk,” Koester says. “We are seeing companies’ CEOs and CFOs becoming aware of the fact that they need to manage a lot more currency pairs. The average company we see is exposed to more than 200 currency pairs.”
Steps to Better Currency Risk Management
Koester, whose product provides visibility into currency exposures, says a company’s first step in managing currency risk needs to be better understanding that risk. “Things are moving so quickly today, and many companies are still managing currency risk using pre-2010 processes,” Koester says. “They’re manually gathering data, then putting it in Excel spreadsheets once a month. We hear people talking about changing their policies, and I say, ‘No, first you need to understand your exposure better, so that you can define your policies better. Make sure you put the horse in front of the cart, and not vice versa.’”
Once they understand where their exposures lie, treasurers generally look for internal opportunities to mitigate those risks. “The simplest option is redenomination of purchases from vendors abroad, or of revenues,” Koester says. “Next is redenomination of internal financings.”
In light of the volatile FX environment, some companies are also reconsidering global operational decisions. They’re looking at where they should be producing certain products and whether they can create more natural offsets by moving certain portions of their operations to new locales, Koester says. He adds that one more internal step for mitigating currency risk is “increasing the foreign exchange exposure definitions, not only within the company’s income statement but also in its forecasts.”
After they’ve considered their internal options for reducing currency exposures, many corporate treasurers are also increasing their use of hedges, Koester reports. “The trend is definitely toward lowering risk,” he says. “Generally companies look internally before externally, but they’re looking to increase their risk mitigation, which usually does include hedging.”
Increasingly Difficult Analyst Questions on Earnings Calls
Even hedging isn’t a perfect solution for protecting the corporate CFO from uncomfortable analyst questions around currency movements. Among the 279 North American companies that had a negative currency impact in Q1/2015, 73 percent were asked about currency issues by analysts on their Q1 earnings call. And the questions are getting tougher, Koester says.
“Analysts used to just ask, ‘How much is that currency impacting you?’” Koester explains. “The company would answer and then move on. Now analysts are asking, ‘What does this mean for your cost of goods sold? Can you explain?’ They don’t just want the top-line number, they want the net number. They want revenues and expenses, and then they want to hear what the company’s net operating income impact due to foreign exchange is, as well as how that translates into earnings per share.”
Not only that, but analysts are also frequently asking what effect currency volatility is having on cash. “Analysts want to know this because if a currency issue has a real negative impact on your cash, you’re going to have less money to spend and invest, which is going to negatively impact your business,” Koester says. “Some people think this is only an accounting issue, but it is real cash and can really impact a company’s value.”
To help treasurers prepare their CFOs for earnings-call questions about currency trends, FiREapps has put together a Currency Risk Quick Reference Sheet.