Last May I made a presentation to a financial group in Denver
co-sponsored by the local KPMG office and the International
Business Department of the University of Colorado. Their write-up
of that presentation follows this introduction.
My overall view of currency exposure is essentially the same,
although I want to point out a couple of things that have changed
and become more important since last May. Volatility has picked up,
which means if a currency moves in a direction for even a short
period of time, the amount of time available to make decisions is
compressed.
The other change is with the currencies whose central banks are
now buying their own government bonds and other debt. This
quantitative easing, which is effectively printing money, has the
effect of immediately devaluing the currencies involved. The UK,
Japan and, more recently, the U.S. have all pursued this route.
This meant the British pound weakened first against the other
currencies; followed by the yen as carry trade re-establishment
selling and risk aversion buying dictated the direction of the
currencies. Finally, the U.S. dollar joined the pack. By lowering
interest rates only a ¼ percent last Thursday, the European
Central Bank left the door open to what they might do in the future
by saying they are considering other options. German Chancellor
Angela Merkel insists there will be no more stimulus measures.
Whatever the ECB decides will determine the value of the euro at
least in the short term.
The following article - featured in the Winter 2009 issue of
Global Forum Report from the Institute for International Business -
provides an overview of how to assess and reduce, if not negate,
foreign currency risk.
-Laurence Hayward
A "quantum shakeup" is how Laurence Hayward described what
has been happening in the global financial markets in the last 18
months. Addressing the conference co-sponsored by KPMG and the
University of Colorado Denver CIBER, Hayward said, "It's possible
to be 100 percent hedged against any foreign currency risk 100
percent of the time provided you do it right."
What does it take to do it right? "It's all a matter of timing and
understanding some of the things that drive currencies," Hayward
said. "The amount of time you spend on foreign exchange matters
should be proportionate to the company's exposure compared to
earnings and the maximum loss that could be caused by that
exposure."
Hayward acknowledged that the subject of foreign currency exposures
is complex and outside the comfort zone of most executives who are
not directly involved in finance. "I don't think it's reasonable
for me to expect people to do something they don't feel comfortable
with. So I take the education approach - educating people who want
to learn before they leap."
Defining Currency Risk
In broad terms, risk is exposure to anything with the potential to
produce negative numbers on your company's financial statement. In
international business, companies face the risk of one currency
changing in price against another. Consequently, the need to make
an investment that will reduce or hedge the risk. A perfect hedge
reduces the risk to nothing except for the cost of the hedge. "Risk
should always be negated," said Hayward.
Interest rate differentials need to be taken into account when
choosing a hedge. "When you're dealing in foreign currencies you've
got different interest rates for each one. And those interest rate
differentials have an effect on what you do when you are hedging.
Interest rates in the US are now about 2 percent below the euro;
just nine months ago we were 1 percent higher than euro rates
(figures are as of May 1, 2008).
"The only thing that creates risk on an exposure is leaving time
between when the exposure is known and when the hedge is put in
place. Many people fail to manage their currency exposures because
they don't understand what they should do," said Hayward.
"It helps for the company to define whether the currencies it is
exposed to are high or low risk and whether or not they are fixed
to the dollar. After that, company strategy should define which
hedging instruments can and cannot be used."
How the Market Moves
Markets are fickle, the psychology fragile, the eccentricities
many. "Markets trade and react on the difference between
expectations and what the reality turns out to be. The combination
of chart points, data releases, news, expectations and which way
the market leans in favor of one or more of these components will
dictate how it moves," said Hayward.
"Sometimes market participants try to be too clever and trade
against expectations. If the expectations are wrong they quickly
make adjustments, short covering or liquidating their positions."
That said, there are ways to sort through fast-changing data and
determine if market bias trends toward the bulls or the bears.
"Listen to the markets," said Hayward. "They will tell you things
you can use and learn from."
Sophisticated traders study history along with financial data and
current events to forecast trends and make judgments. "Looking at
history and how recent history has changed can guide you as to
where your investment is going and help you guess tomorrow's
best-case exchange rate."
Also, Hayward said, be especially observant of geopolitical risk
because political changes can signal instability in a country which
in turn could drag down investment returns.
"A lot of equity flows and investments have been going into China
and India. Their currencies haven't been active in the way
conventional currencies have been," said Hayward.
"The Chinese yuan is state controlled and the Indian market is a
very young market.You might think that the Indian rupee would be
strong because it is convertible, unlike the yuan. But the highly
volatile mentality of the domestic Indian investor has a huge
impact on their market, and that makes me wary of the currency."
As interest rates in the U.S. have come down, "there has been a
gradual slowdown in the amount of incoming cash flows which have
helped to fund the deficit here. This has some huge economic
implications," said Hayward, adding, "the funding of the U.S.
deficit is about foreign central banks like those of China and
Japan buying U.S. Treasuries."
For more information on U.S. cross border financial transactions
and other trade data, Hayward recommended the Treasury
International Capital system (TIC) website:
www.ustreas.gov/tic.
To further your education about foreign exchange, go to the website
of the Federal Reserve Bank of New York:
www.newyorkfed.org/education/fx/foreign.html.