Over the last few years almost all financial markets and asset classes have been volatile. Equities, Commodities, Interest Rates, and currencies. While the prices of residential properties and related volatility may not impact a business too much, wild swings in foreign exchange rates could have a direct impact on your business.
Foreign exchange movements had a huge impact at a recent client. The parent entity was headquartered in Europe and reported in Euros (EUR). The local entity had selected Euro’s as its functional currency, operated in Singapore and incurred local expenses in Singapore dollars (SGD) but invoiced customers in United States Dollars (USD) and also had sales and purchases in Japanese Yen (JPY). The client maintained bank accounts for all 4 currencies.
In order to naturally hedge their foreign exchange exposure, the client purchased from a Japanese supplier in JPY and sold that product in JPY as well. The margins on the Japanese product were healthy which meant that the client kept the profits in JPY which accumulated over time. The company had a healthy cash position in excess of operating requirements generated from historical earnings. For the past few years, the JPY remained strong even though it offered no real return in terms of interest rates. The rest of the leading global G7 currencies also offered little to no interest yield and the interest rate differential was insignificant. Since the JPY was stable or appreciating there was no real negative revaluation impact over the past few years on holding significant JPY balances.
All that changed as soon as the inflation print in the United States exceeded 8% and the federal reserve started to hike interest rates aggressively. The JPY started an aggressive downward move and went from around 110 to the USD to 150 to the USD in less than 6 months.
Such sudden movements generated a huge revaluation loss each month on the JPY monetary balances held, although the business remained stable in terms of sales volume and margin. Hindsight is always 20:20. What steps could the business have taken to manage this currency risk in real time?
The first step is to recognise the impact fluctuations in foreign exchange can have on your reported results. It is important to keep an eye on the macro environment and to understand what events could impact the foreign exchange rates.
Secondly, the company could have regularly converted the profits earned in JPY to either SGD (for local expenses) or into the functional currency EUR. JPY would still be required to pay the vendor for JPY purchases, but any cash balances generated from profits over and above the vendor payment needs in JPY, could be parked in EUR as a defensive play to reduce foreign exchange gains and losses since EUR is the functional and reporting currency.
Thirdly, the company could have converted more funds from SGD, EUR or JPY into USD as soon as the forward interest rates expectations started to increase for the USD. There is also a risk in this strategy as foreign exchange movements are relative. The SGD and the EUR also weakened against the USD but perhaps more gradually than the JPY. The federal reserve had clearly choreographed USD forward rate expectations and that could have been a trigger point to manage the cash balances more pro-actively.
It is also important to realise that the market’s expectations can also change abruptly. In the chart above, the JPY went from 150 to suddenly reverse course to 140 to the USD even though the USD offers a very high interest rate spread versus the JPY. The Japanese central bank has held course to keep interest rates ultra low. But the markets believe that the federal reserve will pivot and will pause or reverse interest rates soon, which put pressure on the USD to the downside. Whether this view actually plays out remains to be seen but the markets can move first on the rumour and not on facts.
Hedging is notoriously difficult. A 100% hedge can leave you equally exposed as a 0% hedge. Without a strong conviction on the future direction of any instrument, commodity or asset one tries to hedge, it would make sense to hedge a portion of the exposure to benefit from a trend movement or protect from an abrupt reversal.
It is also difficult to differentiate between a long term trend reversal and short term fluctuation. Prices seldom move in a straight line and ‘noise’ is very common in the markets based on events, headlines and current events.
Many companies do not have a dedicated treasury team or finance teams that are keeping track of macro movements. What options are available to smaller companies to manage their foreign exchange exposures more closely and make prudent cash management decisions to protect their PNL?