Volatile times are here to stay. As FiREapps reported in the 2015 Q1 Corporate Earnings Currency Impact Report, at the height of the European debt crisis, many people thought currency volatility was the worst it would ever be. Yet less than three years later, volatility has surpassed the height of the euro crisis—as have the negative impacts on U.S.-based multinationals.
With such high currency volatility, the cost of derivative-based hedging is rising in many cases, making efficiently managing currency risk more important than ever. Treasury teams have to look for the most efficient methods of hedging—which may mean expanding their strategy.
In times like these, companies should:
- Always manage the expectations of the board, investors, and analysts to the point of no surprises.
- Take advantage of or create natural offsets (eliminating unnecessary exposures) and opportunities for operational hedging (e.g., organic exposure elimination, intercompany settlements, and cash conversions).
- Perform an analysis of their entire portfolio of currency pairs to prioritize management strategy and achieve the optimal balance of cost/benefit while efficiently reducing risk.
Operational hedging is not a new concept, but it is more important now than ever. Given that volatility is here to stay, and companies are more exposed, it is essential to find the most efficient ways to manage currency exposure.
How Yahoo! eliminated over 50 percent of its FX exposure
Yahoo! is one example of a company that was able to dramatically increase the efficiency of its currency risk management program by taking advantage of opportunities for operational hedging before turning to derivative-based solutions. As Amanda Butler, CTP, then-senior manager of corporate treasury, explained, “Before late 2008, Yahoo! took an economic view of foreign exchange and didn’t have an active FX management program. Then the company took a $13 million loss in the third quarter of 2008 and another $13 million loss that October. So we engaged FiREapps to find out what our exposures were. We realized that over 70 percent of our exposures were intercompany transactions.”
Over the course of three years, Yahoo! developed a risk management program that starts with aggregating (in a timely fashion) all relevant exposure data, analyzing it in an institutional setting, and then identifying the smartest opportunities to eliminate exposures based on size and risk.
Once Yahoo! had up-to date insight into its exposures and the underlying drivers, it saw strategic opportunities to streamline corporate structure and eliminate exposure. Yahoo! centralized the intercompany settlement process globally within treasury and targeted specific balances to settle. It created an in-house currency bank and developed a streamlined process through the in-house bank and netting center to settle transactions, and automated accounting processes to clear the settled balances. At the end of that evolution, Yahoo! had organically eliminated over half of its FX exposure.
In 2011, Yahoo! started its balance sheet hedging program. “After all of the operational hedging initiatives that had happened over the previous three years, what we were left with were our core currency exposures,” Butler said. “Now we use derivatives to hedge very strategic positions -- and we get big bang for our buck on those hedges.” In other words, by first taking advantage of operational hedging opportunities, then looking to derivative-based hedging, Yahoo! created a very efficient currency risk management program.
Taking advantage of natural offsets and opportunities for operational hedging
The key to taking advantage of natural offsets and opportunities for operational hedging is having full, on-demand visibility into how currencies are flowing through cash flow and sitting on the balance sheet.
As Brent Callinicos, former vice president, treasurer and chief accountant at Google noted, “A lot of large moves in very small currencies can hurt you as much as small moves in very large currencies in terms of your exposure to those currencies. When currencies move as much as they have, as it turns out a lot of those small currencies will add up to a large amount.” So a portfolio approach where you have a comprehensive view of all of your currency exposures is necessary to manage expectations to the point of no surprises; and manage currency risks in the most efficient and effective manner.
Confidence that you have full, on-demand visibility into all of your exposures precedes any decision-making; once you have that visibility, you’ll be able to see natural offsets and opportunities for internal hedging. Then you’ll be able to make the most informed decision, whether that is internal actions only or external hedging as well.
When treasury teams use the most efficient method of hedging -- avoiding mis-hedging and by leveraging natural offsets and operational hedging opportunities -- they save the costs associated with potentially unnecessary transactions. That’s what Cabot, a specialty chemicals and performance materials company with global operations, did. After implementing a FX analytics platform, Cabot was able to eliminate 63 percent of its exposure through natural hedges and internal netting, which eliminated the need to externally hedge EUR and JPY exposures -- eliminating the associated transaction costs and realizing over $1 million in annual savings.
Wolfgang Koester is the CEO and co-founder of FiREapps.
A longer version of this article will appear in the September edition AFP Exchange.