Currency Exchange Risk
There is more than just a price-risk with currencies -
an overview of what need to be considered when dealing fx
In line with introducing more or less floating currency exchange rates a huge industry was born. The industry of managing these risks. Numberless
banks and other provider promise every day with new products that the risk can be held under control and on top, generating a cash-profit with it.
Can this be useful? What is the difference between hedging and speculation?
Strictly speaking, these problems exist already
since the moment when goods have been transferred across the
border in connection with monetary economic.
Precisely, with changing prices for goods and currencies. The
documented beginning of hedging prices are in the
18th / 19th century, when tulips from the netherlands widely
predermined before the harvest have been bought
for a fixed price. This was the birth of commodity forward
contracts. That means, goods for money for a
price where both counterparties try to eliminate the risk of changing
prices. Did they had success?
In the first view one could be tempted to reduce the risk on quality and quantity of the goods, which at the the end of the day define the price. But in
a deeper analysis all the following risks exist by buying and selling e.g. tulips:
Buyer
•
The seller, i.e. vendor, had been going insolvent int the
meantime and is unable to deliver.
•
Poor quality of tulips.
•
Less quantity as agreed, because the harvest was not
sufficient, problems with the delivery due to wreckage, fire,
theft etc.
•
Not enough cash to pay the tulips.
•
The own home currency (selling-currency) became
weaker and there must be paid now more units of home
currency per tulip-unit to pay the selling price.
•
Thank bank which leads the transaction is bankrupt and
can not pay the invoice-amount.
•
Tulips fade on the way to the Point of Sales (PoS), resp.
before they can be resold. That means, they loose value.
•
The sellers customer do not pay (in time).
Seller
•
The buyer cannot pay because of own or third party default
(see arguments on the left)
•
The tulips are not in ready-to-sale conditions at the time of
shipment (see also Inco-Terms) and the risk is with the
seller.
•
The agreed selling price does not cover the costs because
of inflation.
•
The selling currency is not the home currency -> see
argument on the left.
In this example it is assumed that cross border business is with different currencies as it is often the case. Above mentioned example exist still
today and they are key-risks in doing business. At least same like topics how to manage a decrease in the value of the goods, see also for
instance IAS 36.
These explanations shall monitor that currency-exchange risk is just one of many in the whole supply chain and the risk is mostly with the
buyer. In case the seller takes the risk, he has to bear the hedging costs and certainly he will include them in the final selling price.
But risks and gains are just hardly divisible twins. In consquence: it is not possible to elimnate always all risks! But it is possible to reduce
them down to a level which does not compromise the solvency of a company.
The Hedging of Currency Risks
Today the market offers an almost endless number of hedging instruments which
a) are offered mostly from Banks, and
b) have derivative character; i.e. they are derived from an underlying.
In this process the buyer of a hedging instrument should ask himself always following questions:
1. How does this product works and under which circumstances (triggers) happens what?
2. Who benefits and how much?
Are there all risks minimized or even increased? Keyword: to solve a problem (current risk on a specific cashflow) new problems / risks will
occur. And because nothing is free in the world - what Adam Smith already mentioned in his work “Wells of Nations”,
the second problem is often bigger than first!
It is common that regulating papers like IFRS, US/UK/Swiss Gaap, HGB and how they might all call are not very
wellcome in a companies business. They would make a brave accountant’s live just hard and build up borders where
it don’t need any. But one should consider that these rules are also made to protect the companies business and
certainly the protection of any other stakeholder. So, if the problematic hedge-accounting says that this or the oterh
hedging instrument is not designated to reduce a specific risk than it has the reason that somewhere else new risks will be produce. And often
larger than the original risk was!
Example
Underlying: you have receivables in EUR and buy an engine from the United Kingdom for 300'000 Pound Sterling (GBP), delivery is in 3 months,
payable at delivery. Exchange Rate EUR/GBP today is 0.8838 and forward outright 0.88338.
(For all undermentioned scenarios is the settlement risk always given, i.e. anything might go wrong with the payment, e.g. the bank is going
bankrupt, someone types 3'000'000 instead 300'000, the money will be paid to a wrong account or debited on a wrong account etc).
Conclusion
The best hedging of currenices is still only the match of payables and receivables in the same currency. But where a timing difference is
(what is quite often the case), the hedge need to be rolled by a Swap for example or a money market transaction. Nevertheless, this would lead
again to a new risk, the counterparty and settlement risk.
In any case it is a good hint to check the offered hedging products carefully whether they are designated to hedge an underlying. Otherwise it
could be possible, that at the end of the day there are more risks than without any hedge transaction.
Contact us, we would be glad to show you the possible opportunities!
Currency Exchange Risk
There is more than just a price-risk with currencies -
an overview of what need to be considered when dealing fx
In line with introducing more or less floating currency exchange rates a
huge industry was born. The industry of managing these risks.
Numberless banks and other provider promise every day with new
products that the risk can be held under control and on top, generating
a cash-profit with it. Can this be useful? What is the difference
between hedging and speculation?
Strictly speaking, these problems exist already since the moment
when goods have been transferred across the border in connection
with monetary economic. Precisely, with changing prices for goods and
currencies. The documented beginning of hedging prices are in the
18th / 19th century, when tulips from the netherlands widely
predermined before the harvest have been bought for a fixed price.
This was the birth of commodity forward contracts. That means,
goods for money for a price where both counterparties try to eliminate
the risk of changing prices. Did they had success?
In the first view one could be tempted to reduce
the risk on quality and quantity of the goods,
which at the the end of the day define the price.
But in a deeper analysis all the following risks
exist by buying and selling e.g. tulips:
Buyer
•
The seller, i.e. vendor, had been going insolvent int the
meantime and is unable to deliver.
•
Poor quality of tulips.
•
Less quantity as agreed, because the harvest was not sufficient,
problems with the delivery due to wreckage, fire, theft etc.
•
Not enough cash to pay the tulips.
•
The own home currency (selling-currency) became weaker
and there must be paid now more units of home currency per
tulip-unit to pay the selling price.
•
Thank bank which leads the transaction is bankrupt and can not
pay the invoice-amount.
•
Tulips fade on the way to the Point of Sales (PoS), resp. before
they can be resold. That means, they loose value.
•
The sellers customer do not pay (in time).
Seller
•
The buyer cannot pay because of own or third party default (see
arguments on the left)
•
The tulips are not in ready-to-sale conditions at the time of
shipment (see also Inco-Terms) and the risk is with the seller.
•
The agreed selling price does not cover the costs because of
inflation.
•
The selling currency is not the home currency -> see argument
on the left.
In this example it is assumed that cross border business is with
different currencies as it is often the case. Above mentioned example
exist still today and they are key-risks in doing business. At least same
like topics how to manage a decrease in the value of the goods, see
also for instance IAS 36.
These explanations shall monitor that currency-exchange risk is
just one of many in the whole supply chain and the risk is mostly with
the buyer. In case the seller takes the risk, he has to bear the hedging
costs and certainly he will include them in the final selling price.
But risks and gains are just hardly divisible twins. In consquence: it is
not possible to elimnate always all risks! But it is possible to
reduce them down to a level which does not compromise the
solvency of a company.
The Hedging of Currency Risks
Today the market offers an almost endless number of hedging
instruments which
a) are offered mostly from Banks, and
b) have derivative character; i.e. they are derived from an
underlying.
In this process the buyer of a hedging instrument should ask himself
always following questions:
1. How does this product works and under which circumstances
(triggers) happens what?
2. Who benefits and how much?
Are there all risks minimized or even increased? Keyword: to
solve a problem (current risk on a specific cashflow) new problems /
risks will occur. And because nothing is free in the world - what Adam
Smith already mentioned in his work “Wells of Nations”, the second
problem is often bigger than first!
It is common that regulating papers like IFRS, US/UK/Swiss Gaap,
HGB and how they might all call are not
very wellcome in a companies business.
They would make a brave accountant’s
live just hard and build up borders where it
don’t need any. But one should consider
that these rules are also made to protect
the companies business and certainly the
protection of any other stakeholder. So, if the problematic hedge-
accounting says that this or the oterh hedging instrument is not
designated to reduce a specific risk than it has the reason that
somewhere else new risks will be produce. And often larger than the
original risk was!
Example
Underlying: you have receivables in EUR and buy an engine from the
United Kingdom for 300'000 Pound Sterling (GBP), delivery is in 3
months, payable at delivery. Exchange Rate EUR/GBP today is 0.8838
and forward outright 0.88338.
(For all undermentioned scenarios is the settlement risk always given,
i.e. anything might go wrong with the payment, e.g. the bank is going
bankrupt, someone types 3'000'000 instead 300'000, the money will be
paid to a wrong account or debited on a wrong account etc).
A) Exchange just at delivery / maturity
Pro
The exchange rate might be better.
Contra
You enter into an exchange risk, the rate could be worser. Measured
with a probability of 90% the loss will be not more than EUR 31’000
(Value at Risk approach, historic values).
B) You change today
Pro
•
Interest gain 0,1% p.a. = EUR 84.-
•
Elimination of the risk that exchange rate will worsen.
•
Constant calculation
Contra
No more chance to achieve a better exchange rate.
C) You change in the future, but fix the rate today with a
Forward Foreign Exchanget Contract or a Future Contract
Pro
•
Elimination of the risk that the exchange rate will worsen.
•
Constant calculation.
Contra
•
Interest profit ./. bank costs, i.e. net = outright - 0.00042 costs
EUR 161.70
•
Often is a deposit necessary for 10% - 20% of the nominal
amount.
•
No more chance to achieve a better exchange rate.
D) You buy a Call GBP / Put EUR Option
Pro
•
Elimination of the risk that the exchange rate will worsen.
•
Constant calculation.
•
Benefit of possible better exchange rate at maturity.
Contra
•
Significant premium, usually to be paid in advance. Depending
on the risk between 2% and 5% of the nominial amount.
•
Compared to standardised methods often a non-transparent
high margin of the seller, i.e. your bank.
E) You sell a Call EUR / Put GBP Option. With the premium
you try to compensate an evtl. bad exchange rate
movement.
Pro
Getting a cash-premium which can be re-invested in financial- or
operational items.
Contra
•
The risk is not hedged, it is just compensated up to the
amount of the cash-premium. On top the risk intervall is
endless to the top and limited to 0 to the bottom (exchange rate
= 0)
•
Intensive monitoring is mandatory.
•
At least 10% - 20% deposit at the contract partner (bank) to
cover the existing risk.
Note: pure so called short-positions, as described above, are not
allowed to designate as a hedge in all common regulating policies, e.g.
IFRS or US-Gaap and the p&l is monitored 1:1 the p&L statement (i.o.
at least partially in equity).
F) Purchase of a mostly complex derivative instrument,
containing different parts of A) - E) above.
Pro
Often no direct costs, i.e. premium
Contra
•
Partially unlimited risk, especially if there are parts of E)
included.
•
Mostly not tracable content of the instrument.
•
High profit margin of the seller.
•
Often not adapted to the underlying.
Note: Als this solution is not qualified for hedge accounting.
G) Financing in the currency and for the time, in which the
engine has to be paid and amortized.
Pro
Exchange Risk is totally eliminated.
Contra
•
Evtl. higher interest rate as in the home currency + risk premium
of the bank.
•
Interest payment in foreign currency -> new currency exchange
risk.
Conclusion
The best hedging of currenices is still only the match of payables
and receivables in the same currency. But where a timing
difference is (what is quite often the case), the hedge need to be rolled
by a Swap for example or a money market transaction. Nevertheless,
this would lead again to a new risk, the counterparty and settlement
risk.
In any case it is a good hint to check the offered hedging products
carefully whether they are designated to hedge an underlying.
Otherwise it could be possible, that at the end of the day there are
more risks than without any hedge transaction.
Contact us, we would be glad to show you the possible
opportunities!
