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Forex for Finance Directors

Volatile currency markets have only added to the financial despair of companies trading across borders. This special report offers advice to Finance Directors on how to hedge against this volatility.
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Forex: All about risk management

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Written by David Stebbings, head of treasury advisory, PricewaterhouseCoopers LLP   
Thursday, 04 June 2009

Volatility in foreign exchange rates is a major concern for finance directors – a risk they can more effectively manage by following a three step process according to David Stebbings, head of treasury advisory at PricewaterhouseCoopers LLP.

The last year has highlighted the challenge that businesses and their finance directors face from exchange rate fluctuations. Sterling’s recent strength and then weakness against the US Dollar or the Euro can seriously affect the success of any business that has foreign currency flows. 

And following the trend towards outsourcing back office processes and manufacturing to low cost, offshore locations such as India and China, many more businesses are now exposed to  forex risk. 

However, finance directors can take steps to manage this risk more effectively. Rather than rethinking policy every time the FT reveals another major Sterling swing, a better approach is to establish more formal processes for regular forex risk assessment and review.

There are three steps to this process. Firstly, FDs need to understand their foreign exchange risk, its nature and volume. Secondly, they should consider any steps that can be taken “naturally” in the business to reduce any unacceptable risk.

Finally, and only where concern remains about the extent of forex risk, fully understood hedging measures should be considered.

Understanding forex risk


Assessing and understanding the impact on the business when exchange rates move is the essential starting point for risk management. The repercussions of forex volatility will affect cashflow, value of assets and profitability, as well as more importantly to many, the achievement of bonus-related targets.

Compliance with banking covenants could also be threatened. Many companies have recently been forced to take action to avoid breaching covenants at their year ends. This is a particular issue for EBITDA to debt covenants, given that EBITDA is measured at the average foreign exchange rate and debt at the year-end rate. 

Direct risks – such as a loss on a contract agreed in a foreign currency – are most obvious, but indirect risks exist too. For example, even if sales are made in sterling, a strengthening pound could lead to falling overseas sales.  Forex risk in tenders should also be considered where appropriate.

Understanding forex risk therefore requires a thorough analysis of all business flows and consideration of the sensitivities around them. This will involve liaising with sales teams, purchasing teams and all of those in the business with the power to affect cash flows so as to understand the full picture and enable a sensitivity analysis to be undertaken. Finance directors need to consider how big a rate fluctuation their business can tolerate without taking mitigating action.

Natural responses


If the forex risk analysis suggests the business is exposed, the first step in mitigating that risk is to identify ways that the business can be adjusted “naturally”. Natural hedging could include the repricing of products and services, passing on increased costs to suppliers or even, taking a longer-term viewpoint, relocating a factory.

For example, a European carpet manufacturer which generates 10% of its sales in the UK has formalised its “natural” response to forex movements. When the Euro moves adversely against Sterling, sales prices may be adjusted six months later.

Clearly there may be limitations on how far or how fast the business can respond particularly in the current business environment. If it is deemed that such changes are not possible finance directors may also consider how they report their forex risks to banks, analysts and investors. Ensuring transparency about the nature of the risks and the mitigating actions that are taken can help to set realistic expectations for future business performance.

Simple hedging


In my view, hedging through financial instruments should only be considered after a full forex risk assessment has been conducted and any natural steps taken to mitigate unacceptable risks.

Financial instruments need to be seen for what they are – tools for smoothing out the lumps and bumps of currency fluctuations and that defer the impact of forex rate changes, giving the business time to respond. However, they are no panacea and they do come with accounting implications, as well as direct and indirect costs. As a general rule when financial instruments are used, simplicity should always be preferred over complexity. If the hedging arrangement cannot be understood easily, it should be avoided.

Hedging may be a specialist Treasury area, but managing forex risk is not. Finance directors need to work together with their treasury and operational mangers to develop their own three-step process for reviewing and mitigating forex volatility risk.
 
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