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For Corporates
This is the home page for our corporate resources information and includes information that is relevant to both exporters and importers. It is designed to help corporate treasuries understand issues that face them in their currency risk management. OverviewForeign exchange management internal policyStrategic Planning IssuesObjective of Risk ManagementStrategies for Foreign ExchangeOverviewThe days of corporate treasuries being aggressive profit centres are long gone although there are a few that still survive. These days Corporates are far more conservative with foreign exchange risk management and have reasonably well defined guidelines for the management of forex risk. At a minimum Corporates should have a foreign exchange policy which spells out exactly what should be done with the foreign exchange risks they face. Quite often this policy is developed in tandem with an exposure measurement process. For Corporates with minimal risk exposure measurement may be a very simple process of forecasting what the cash receipts or payments are likely to be for a given period. For other companies who purchase or sell products in Australian dollars but where the underlying product is priced in USD on world markets then the risks are less obvious but just as real.Foreign Exchange PolicyA good foreign exchange policy is critical to the sound risk management of any corporate treasury. Without a policy decisions are made ad-hoc and generally without any consistency and accountability. It's important for treasury personnel to know what benchmarks they are aiming for and it's important for senior management or the board to be confident that the risks of the business are being managed consistently and in accordance with overall corporate strategy.Strategic Planning - Making Rational DecisionsThe recognition of the financial risks associated with foreign exchange mean some decisions need to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile markets so that emotions are dispensed with and previous careful planning is relied upon. This approach helps eliminate the panic factor as all outcomes have been considered including 'worst case scenarios' which could result from either action or inaction. However even though the worst case scenarios are considered and plans ensure that even the 'worst case scenarios' are acceptable (although not desirable), the pre-planning focuses on achieving the best result.The use and acceptance of risk management as a key management issue is evidenced by the proliferation of risk management tools, the extraordinary volume of literature that is published on the subject and the focusing of academic attention towards improving risk management techniques. Active risk management is a common characteristic in by far the majority of major corporations the world over. Not to manage financial risk is seen to be negligent as a company's management team is responsible for managing all the variables that ultimately effect the profitability of the company. The Objectives of Risk Management
Strategies for Foreign ExchangeHaving accepted the fact that foreign exchange exposures exist, it is necessary to formulate a strategy to deal with the exposure. Without strategies it becomes very difficult to make decisions of when to purchase or sell foreign exchange. The absence of a strategy often has the effect of mismanagement of an exposure because typically people are only jolted into action when something goes wrong.There are a number of alternative strategies that can be employed when managing foreign exchange risk: a) Do nothing - undertake currency transactions as they arise. b) Hedge known future obligations - this is the strategy that by default most smaller Corporates uses. c) Use the time between the recognition of the foreign exchange exposure and the time that the foreign currency will be needed, to achieve the lowest price of the foreign currency. This can normally be most effectively achieved by a predetermined strategy that sets levels and trigger points to achieve purchasing targets. Both strategy (a) and (b) are commonly used as they are the easiest. They require no additional decision making, they are administratively simple, and they have been the status quo for so long that some market participants aren't even aware that alternatives are available. However these two strategies have serious flaws the first is that they can carry a very high level of risk to the cash flows of the company. The reason that the risks are so high with these strategies is that they are extreme positions. To hedge every exposure means removing any chance that the market may move beneficially for the company, whilst its competitors may still enjoy the benefits of these price movements, in doing so the cash flows are at risk as competitors may lower selling prices and hence the profit margin is reduced because of diminished revenues as a direct result of hedging. To not cover any foreign exchange exposures leaves the company equally vulnerable to adverse movements in the exchange rate that could result in cost blowouts, and since cost increases are equally as harmful to margins as revenue decreases they also have explosive potential to undermine the profitability of the whole company. The approach that appeals to people who believe in the management of the variables that affect the profitability of business is called "Foreign Exchange Management". This approach means making decisions and means taking control of a large risk area that affects a corporation. It can take any number of forms from very rigid strategies that ensure conservatism and ease of administration to more complex strategies which attempt to maximise results by taking on additional risk. OzForex actively encourages contingency planning where decisions are made in advance. It is important that Treasury personnel agree to the risk management approach and have it ratified at CFO/Board level. Examples of Strategies1) Scaled in Selling: This is a very simple strategy which is also particularly successful. It normally involves the estimation of a range that the relevant currency will trade in over the period of the exposure. In the case where an importer needs to purchase USDs we seek to buy the USD when the A$/USD exchange rate is at it's highest. Assuming that the current exchange rate is .6300 and we feel that the A$/USD is likely to trade between .6250 and .6600 during the life of that exposure. In this case we would set up a strategy such as the following:In this way an average rate of .6500 is achieved instead of the prevailing spot rate of .6300. However if the view turns out to be incorrect then the worst case trigger is touched and the exposure is covered at .6245 just outside the expected range. This is only 55pts worse than covering at the then spot rate. If the best case is achieved then you have done better by 200pts.At .6400 we purchase 20% of requirements 2) Taking out 'Insurance": This type of strategy employs foreign exchange options which are widely used products. Let's look at the case of a corporate who suffers when the A$ loses value. If that corporate were to buy an option that would protect them from downward movements in the A$ but still left them with the opportunity to benefit if the A$ were to gain strength then this would appear to be a good safe strategy, and in fact it is. Options are just like insurance they protect against worst case scenarios whilst still leaving room to benefit when things are favourable. 3) Working an Exposure: This is a fairly aggressive strategy where the business unit hedges and unhedges the exposure in order to take advantage of a market that is range trading and seems to have no real direction. For example if the business unit hedges the exposure at .6500 and the A$/USD rate subsequently falls to .6300 the business unit could take a profit of 200 pts. Assuming that the rates were just range trading and went back up the business unit could put on the hedge again at .6500 and because of the 200 pt profit achieve an average rate of .6700. This may happen a number of times and extraordinary effective rates of exchange may be achieved. This may sound risky but a worst case plan can easily guard against the situation where the A$ starts to depreciate rapidly, for example the exposure is fully covered if breaks lower than .6250, N.B.- at this time the corporate may already have 400 pts up it's sleeve ! The number of different strategies available are only limited by the imagination and the skill of the planner. It is not difficult to formulate these strategies with the right advice and it is certainly not difficult to implement them.
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