Currency Risk Management in COVID Times

Today we are living in VUCA world and have been for quite some time – volatility , uncertainty , complexity and ambiguity is the norm as a result of the pandemic.
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Everything in the financial markets is relative. Growth potential, rates of return and safety are all considerations which urge capital to flow to one region or asset class over another according to prevailing conditions in the markets. Given its ubiquity, the US Dollar often finds itself a bridge to these shifting winds - for better and worse. Through the opening quarter of 2021, there were significant changes in focus from an incredible charge in retail appetite to anticipation for reopening economies after mass vaccinations to burgeoning inflation expectations that have fed into central bank normalization hopes/fears.

A GROWTH OUTLOOK TO IMPRESS
In the past year, the global economy has recovered remarkably. While we haven't fully returned to the levels of economic output registered before the pandemic swept in, the reversal of fortunes has proven as incredible as the pace of collapse that came with a forced shutdown of economies. As far as tempo goes, the United States contracted approximately -3.5 percent through 2020 - though annual growth through the fourth quarter alone was a fairly robust 4.3 percent. Looking ahead, the IMF has predicted that the world's largest economy is anticipated to grow an impressive 5.1 percent - faster than the Eurozone, Japan, United Kingdom and a host of other developed world leaders. Further, with a pace of vaccinations against the coronavirus through the end of the quarter surpassing 100 million in the US, the country is well on its way to reopen to further boost its heavily services-based economy. With so much capital sloshing around the system and speculative appetite hardly missing a beat during the pandemic, the appeal of a relative growth advantage will draw serious appeal from international investors.

It is with this backdrop that we face the next 12 months – as we look back on the previous year , currency volatility was at an all time high - we saw the Euro move .86 to .94 and now back to .85 against GBP – we also saw the USD go from 1.08 versus the Euro to 1.2300 and back to 1.17 recently and then back to 1.20 .

Irish companies need to manage this uncertainty, be they an exporter or an importer – foreign exchange gains or losses are reflected in cash flow and these known exposures can be on the right or wrong side of a large move, can be extremely positive or negative for a company - this is why this risk needs to be managed and assessed –

TYPES OF FOREX RISK
Firms may be exposed to three types of external foreign exchange risk:

Transaction risk

• The risk of an exchange rate changing between the transaction date and the subsequent settlement date on an individual transaction.
  
• It is the gain or loss arising on conversion.
  
• Associated with exports/imports.
  
• Hedge using a variety of financial products/methods.

Economic risk

• Includes the longer-term effects of changes in exchange rates on the market value of a company (PV of future cash flows).
  
• Looks at how changes in exchange rates affect competitiveness, directly or indirectly.
  
• Reduce by geographic diversification.

Translation risk

• How changes in exchange rates affect the translated value of foreign assets and liabilities (e.g. foreign subsidiaries).
  
• Can hedge by borrowing in local currency to fund investment.
  
• Gains/losses usually unrealised so many firms do not hedge.

HEDGING TRANSACTION RISK - INTERNAL TECHNIQUES
Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds. Internal techniques include the following:

Invoice in home currency

• One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.
  
• However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.
  
• Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.

Leading and lagging

• If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.
  
• If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.
  
• The problem lies in guessing which way the exchange rate will move.

Decide to do nothing?

• The company would ‘win some, lose some’.
  
• Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
  
• In the short run, however, losses may be significant.
  
• One additional advantage of this policy is the savings in transaction costs.

EXTERNAL TECHNIQUES

Spot contracts
Put simply, a spot contract lets you convert currency either right away or with minimal notice. It can allow you to make a foreign exchange payment the same day.

Forward contracts
Add certainty to your international transactions by securing the price of future foreign currency. Forward contracts let you lock in your rate today and pay at a later date. Fix the price up to three years in advance.

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