The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.
The foreign exchange markets can be very unpredictable at times, especially when conflicting news from different areas happen on the same day as on Monday, April 18.
The day started with Irish debt being downgraded to junk. The response was what one would expect. The euro was sold off and fell three-quarters of a cent. Six hours later, S&P announced it was putting the U.S. under a revised rating status of negative against its AAA rating. In reality, this means that S&P is not likely to do anything to the U.S. rating for as much as two years, but we are under the spotlight due to our debt load. The market reaction was for the euro to rise three-quarters of a cent. The cost of insuring Greek and Irish sovereign debt sky-rocketed. This news overpowered the S&P announcement about U.S. debt and the euro fell again, this time by nearly two cents. These reactions to news bites are not unusual, but the magnitude of these moves emphasizes the volatility that is intrinsic in the currency markets these days.
In this situation the euro gyrated as described. The pound followed the euro almost tick-for-tick in percentage terms and the dollar was also under pressure. In an almost perfect storm of the markets reacting to which of the animals in the barnyard is the least smelly, the aptly named PIIGS of Europe today were joined by the U.S. If all of these currencies lost value who was gaining? Believe it or not — Japan. Yes, the country with the unresolved nuclear problems and the massive job of rebuilding after a massive series of earthquakes was the beneficiary. The reason: even though Japan's debt is 200 percent of its annual GDP, it has a trade surplus. One side of its books is in the black. If this doesn't make you nervous about trying to predict what to do about currency exposures, then I am surprised.
Such unpredictability of currency movements and the problem of trying to work out how to negate the risk associated with doing business overseas seems extremely complex. Trying to work out which way the markets are looking at and interpreting news, and how it should affect the value of currencies seems to change from day to day.
Even the moderately understandable mantra of one day being a risk-on day means assets of higher risk go up in value as risks seem less daunting. Then the next day, risk appetite reverses, risk aversion kicks in, and money flows to the safest assets, (typically government bonds) due to some negative news. Most incidences of market movements are covered in one of these scenarios.
Yesterday the Dow ended down 140 points and commodities fell as one would expect on a risk-averse day as they are deemed to be higher risk assets. The currencies fought it out and the unlikely yen was the winner, ending up against the 16 other largest currencies. This takes us back to the question of how you negate the risk of doing business overseas in such unpredictable circumstances.
It is actually very simple. Whenever you attach a value to something you sell or buy in a foreign currency, that value should be hedged. If this is done when the transaction happens, in dollar terms the value is known. If this creates a problem, then the issue is probably that an unrealistic value was expected. This itself means that an expected value was not hedged when the assumed value was determined.
If you don't try and guess what the markets are going to do and just hedge against the real value of your transaction, you will not have any unexpected surprises. This does not cover such things as predictability, reporting accuracy and timing, but you can use a mixture of strategies that will help negate a very high proportion of these factors and enable you to be well-hedged against any currency movements.
These crazy markets should not be an impediment to your overseas business, and pricing in U.S. dollars is not the answer. If the dollar should rise in value against the euro and you sell in dollars, it will cost your counterparty more euros to pay you. They may not have the ability to pay the higher price!
Tomorrow the news will do what to the currency markets? If you hedged at the dollar value, you know it doesn't matter.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.