The value of robust currency risk management is difficult to observe, let alone measure, in normal times. Yet risk management proves its worth in extreme circumstances, such as right now during the coronavirus pandemic. You can’t buy insurance if your car is already heading into the ditch. The same applies for FX hedging: You have to manage the risk even when it is not imminent, so that the hedge works when you actually need it. This article tries to shed light on the logic of systematic FX hedging, under normal conditions as well as in times of crisis.
Different types of risk
Setting up a business is risk taking almost by definition. For example, many companies are willing to bet that Russian customers will buy their products at a good price. Importing some specific goods from a supplier within the eurozone to the Nordics might be a lucrative proposition. However, the company cannot choose to only take on that specific risk alone, as such entrepreneurship will inevitably also expose it to some unwanted risks:
- Operational risks: Did somebody mix up the purchase orders; was the sales price calculated with correct figures; does the head accountant have a serious gambling problem?
- Hazard risks: Will the warehouse go up in flames; will the cargo sink into the Baltic Sea?
- Financial risks: Do we have enough cash; are customers going to pay their bills; is the rouble going to crash?
Operational and hazard risks fall into their own category, as you can only lose with them. By paying a premium, you can transfer a hazard risk to an insurance company. Due to the insurance company’s margin, your expected costs from the risk will go up in the long term, but you won’t go out of business due to an unexpectedly large cost in the short term. When it comes to operational risks, there is some art to the science, as too much cure could also kill the patient: A totally error-free purchase process may be too expensive, and you might not want to pay for an extra person just to monitor your head accountant.
Foreign exchange risk is a different beast, as you could also gain from the currency fluctuations. Some think that this makes it a zero-sum game: If the rates go up now, they will eventually come back down. For example the EURSEK rate fluctuated around nine for several years. Lately this law of nature has not worked. In this game of roulette, red has won now for six years in a row. It will take a while for the player to win the chips back, if she is still at the table when black starts winning again.
The benefits of systematic hedging
If you believe you are able to tell when a currency is strong or weak, it would be logical to only hedge currency revenues when that currency is strong, and costs when the currency is weak. The hedge result would thereby always be positive, assuming that the strong or weak rate will have corrected to its normal level by the time your hedges matured.
If you accept that you don’t know how the rates are going to move, you also have to accept that hedging won’t improve your margins in the long run. So why bother? For the same reason that not buying insurance can be considered reckless. You don’t want short term fluctuations to threaten your company’s long-term goals, or even your company’s future in general.
What’s more, finance theory books assert that the present value of future cash flows is larger, the less uncertainty they involve. This theory actually bears out in the entrepreneur’s bank account statement when she is selling her company. Investors pay more for a company with steady profits. Even if you are not selling, lenders are also willing to charge stable companies lower interest margins, compared to their equally well-capitalised and profitable peers with more volatile earnings.
What about costs?
Managing a two-way risk involves some surprising features. You might get paid to hedge your FX exposures. Wait, what? Well, for example, if your company is importing components from the US, the interest rate differential between dollars and euros (or kroner) means that you get to buy the dollars at a discount with forward contracts. If you are exporting to the US and selling dollars, the same phenomenon incurs an additional cost. The high interest rate level in Russia – a cost when hedging rouble revenues or assets – is often cited as an excuse to not hedge that currency risk:
“If the hedging cost is 7% annually, it makes no sense.”
“The rouble has been so stable for the last few years that hedging would have been a mistake.”
Comparing the spot rate with the effective rate achieved through hedging illustrates quite graphically how systematic hedging evens out the fluctuations – both the good and bad!
For a Finnish company exporting to Norway, or a Norwegian company importing goods from the eurozone, the interest rate differential between EUR and NOK results in a hedging cost. When we calculated how much these cumulative hedging costs – the insurance premium – would have been over time, we found that the changes in the spot rate have been such that hedging would in fact have improved long-term profitability!
Even with a 7-8% difference in EUR and RUB interest rates, the same costs for a EUR-based company hedging RUB revenues or assets against euros, the actual cost for risk mitigation would have been 0.65% total over eight years, instead of the expected 7-8% annually!
When looking at the above graphs, the natural reaction would be to think that there is no difference between hedging and not hedging. That is the very point we are trying to make. There is no difference in the long term. Hedging only evens out the severe effects of sudden rate movements, but doesn’t change the final outcome. The objective of systematic hedging is to reduce the uncertainty involved in the short-term cash flows and profitability forecasts, and provide time to react when mayhem ensues.
Moreover, if we drill down to the monthly level around 2014 year-end, the graphs tell a different story. The same volume of unhedged rouble revenues meant 20-40% less cash on the euro bank account within just a month or two. The effect of the crashing rouble rate was significantly less dramatic for a company running a systematic hedging program.
When we now look at how rates have moved during the corona outbreak, we can add one more major benefit from systematic hedging: If and when wild swings occur, you can sleep better at night:
For more, see Nordea’s Hedging Strategies 2019 Report, which surveyed over 100 medium-sized companies across the Nordics about their FX hedging practices. While the majority do hedge, there’s room for improvement, even without the resources of a large, multinational corporate.
And don’t miss this interview about the report’s main findings with Nordea Markets’ Tuomo Jääskeläinen, chief sales manager for FX Sales & Distribution: Mid-size companies can do more to manage their currency risk.
About the author:
Antti Aittola works on the Debt and Risk Solutions team and consults with Nordea’s clients on risk management and finance solutions. Before joining Nordea in 2012, Antti worked for a long time as a consultant in the Big4 companies, focusing on CFO function development projects.
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