Politics, Uncertainty, FX

By Anne Friberg

Are you looking at a world of unpredictable political events and wondering what choppy FX markets will do to your financial results next quarter and beyond? Good question.

As of late 2016 FX volatility had nearly doubled since the US Federal Reserve concluded the last round of asset purchases under QE3 in 2014, according to the JPMorgan Global FX Volatility Index. And just between June 2016 and March 2017, the British pound plunged in the wake of the Brexit vote; the Mexican peso took a dive after the Trump presidential victory; and the euro held its breath until the Dutch elections and then gave a sigh of relief. All three are high-exposure currencies for most multinational corporations.

In early March, I had the pleasure of moderating a panel entitled “Focus on FX: The Problem of Politics,” at the EuroFinance in San Francisco, a conference that emphasizes treasury’s role in companies navigating rapid international growth. In a discussion with panelists Priti Kartik, global treasurer at Logitech; Wolfgang Koester, CEO of FiREapps; and Helen Kane, president of HedgeTrackers, the conversation touched on how corporate treasurers think about FX risk and the objectives and performance of the hedge program, especially considering several large FX “shocks” in recent years.

How Much Shock Can You Absorb?

With the Trump administration’s policy goals now on the Congress’s agenda, more contentious European election events coming (France), and an otherwise “uncertain” world, we are probably looking at a lot of potential FX volatility in the coming year. As noted above and highlighted in the nearby chart, the occasional nature of big FX moves is a thing of the past. Upsets in the currency markets are not just a black swan anymore; it is a much more frequent event than people think when they look forward. You might define a currency shock differently, but Mr. Koester argues that there have been 10 currency “surprises” in 11 quarters between Q2-2014 and Q4-2016. Even if you are not directly exposed to some of them, there may be knock-on effects on those you are. Is your FX program prepared for roughly one surprise per quarter, and how do you know?

What Are You Protecting?

Dealing with FX volatility is what a good FX risk program is designed to do. To do it right, you need to know how your exposures arise, how big they are and how to mitigate them. How you mitigate them depends on what the true objective is, which—as I often hear in my role as facilitator of the two NeuGroups for MNC FX risk managers (FXMPG 1 and 2)—usually depends on what performing metric matters most to management.

As treasurer of Logitech, Ms. Kartik takes into account Logitech’s goal of minimizing volatility from exchange rates in the income statement. This is an overall goal shared by many, but the key metric may vary by company and it may drive the actual hedge approach to different solutions at different companies. The key metric for Logitech is the FX impact on OI&E and COGS (other income and expense and cost of goods sold), i.e., the impact on profit margins. For many high-growth companies it may be revenue growth, for example, while many established and publicly traded companies focus on earnings per share. For tracking,

Logitech looks at the FX impact both with and without hedges. Another metric in increasing use is to look at “constant currency,” i.e., tracking performance of the key metric using the same FX rates for the two periods you are comparing to strip out the FX impact from the business performance. For those focused on EPS, many FX managers say the real guard rail of their FX programs is plus/minus one cent of quarterly EPS attributed to FX (another metric also used by Logitech). Or put another way: If you don’t get any questions about FX on the quarterly earnings call, you’ve done your job.

What Are Your Exposures?

Exposure identification and ongoing monitoring is one of the things that growing and complex businesses note as particularly challenging. Even with robust accounting systems, treasury often has to manually manipulate the data to get at the true exposures that need to be hedged—which then becomes a regularly occurring and time-consuming process. The more this process can be streamlined and automated, the better the chances for consistently on-target hedge results, and both ERP and specialty third-party providers are working hard on these offerings. For those hedging balance sheet—often a monthly exercise with hedge costs that add up— balance-sheet exposure-aggregation tools may help with accuracy in exposure consolidation and netting, reduction of notional hedge amounts, and produce savings from transaction costs, efficiency and error reduction, as Mr. Koester highlighted.

What Not to Hedge?

As with everything, there are limits to what you can do to protect yourself—and not only because of wilder-than-anticipated FX swings. The cost/benefit equation of hedging all exposures is negative: Ms. Kartik said that hedging the top 5-6 currencies “gets us 80-85% there” and after that you’re dealing with diminishing returns on the cost and effort of tracking and transacting. And generally speaking, some exposures may be so variable or uncertain that you run the risk of over-hedging them, which is both cost-inefficient and a hedge-accounting no-no.

Is Hedge Accounting Helping or Hurting?

Speaking of hedge accounting, its very nature introduces inefficiency into the hedge program, often due to the functional currency of foreign affiliates preventing treasury from hedging the exposure they actually would like to hedge. Revenue hedging for Logitech is not possible because its affiliates are local-currency functional, for example. So, you end up making sub-optimal hedge decisions.

Outlook—Sometimes regulatory Changes are Opportunities

Regulatory changes are often looked at as something that can only bring bad news, but not only are the proposed FASB changes likely to make hedge accounting easier to achieve and maintain, the silver lining of the OECD BEPS (base erosion, profit shifting) initiative is that the change in facts and circumstances from reorganization (from commissionaire to buy-sell entities, for example), will provide an opportunity to change functional currency, if you are willing to absorb the cost of financial restatements and overhaul of your ERP, that is. So, there’s that.