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Risk Management

Warning: Hidden FX Risks May Lurk Here

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April 04, 2004

Dollar/euro shift and potential revaluation in China are putting MNC risk managers’ on high alert for invisible FX exposures.

FX risk managers are in agreement that it’s the tail risk, the five-percent /2SDV (standard deviation) away risk that really hurts (see IT, 3/22/04). Against the background of a tighter control environment (e.g., Sarbanes-Oxley) and continued FX market volatility, identifying those invisible risks is increasingly more important.

“The hardest part of the risk management is identifying the exposures and collecting the information. Once you know what it is, identifying the right strategies is relatively easy,” notes one experienced treasury practitioner.

For MNCs with complex offshore businesses, one area where such risks may lurk is the procurement process. And as the global sourcing and sales reach of US and European MNCs expands, the chances that a hidden supply-chain exposure would create an earning disruption is also growing.

Concentration vs. deconcentration risk

In the supply chain/procurement process area, FX risks arise in one of two ways:

(1) Risk of too much concentration; and

(2) Risk of too little concentration.

De-concentration risk: For example, procurement managers may insist that the process remain very decentralized, resulting in 10s of thousands of supplier relationships and contracts that are almost impossible for Treasury/FX to monitor for hidden or invisible FX impacts.

This highly fragmented approach creates massive control obstacles in general, but FX risk management hurdles in particular.

For example, it makes it very difficult to “superimpose” a currency risk management process in terms of:

(1) Collecting exposure information; and

(2) Hedging any expected procurement cost.

Since the underlying business process is not standardized, local managers can decide to initiate/terminate supply-chain links at various times over the year, and often there isn’t consistency in the contract language with regard to payment payment terms and currency of billing, etc.

Concentration risk: On the other hand, fully centralizing all supply relationship with a single vendor in a single country may appear to cut cost (more volume/better price), but can result in a massive (vs. diversified) FX exposure to a single currency pair; if that rate shifts (for example, relying heavily on Chinese production/sourcing) the cost benefits may quickly evaporate.

Hidden exposures

Data from the ERP or even contracts may not always expose the FX aspects of procurement. Here is a list of potential “hidden” risks:

1. US$-priced contract indexed to the local currency (LC). This is almost the same as a LC receivables converted at the prevailing spot rate.

2. Risk sharing agreements at 50/50. Those are hard to monitor and even harder to enforce and often result in an asymmetrical return.

3. US dollar pricing, renegotiated periodically This not really a dollar price, since vendors can adjust for FX shifts.

4. US dollar pricing taken by vendors who cannot afford the risk. Vendors may go out of business or have to renegotiate, i.e., FX risk morphs into credit or operational risk.

5. LC pricing by vendors which don’t have LC cost base. Vendors may have to renegotiate, even though it looks like it’s a local-currency base.

6. LC pricing impact in pegged currencies that cannot be hedged. In this case, the risk is identifiable, but not hedgeable.

There are also operational risks to consider: A (too) good price from an offshore supplier may result in bankruptcy for that supplier, and shortage of potentially mission-critical parts.

A checklist for getting better data

The first step toward better management of procurement exposures is getting reliable data on the extent of the risk—at least the aspects of supply chain risk that are “visible” (see box above).

While getting at the information is difficult, it is not impossible. Here are some suggestions from FX risk managers for improving the exposure information-collection process:

(1) Get global functional “champions,” i.e., identify a senior manager who is responsible for global procurement and leverage his/her process to instill risk awareness into the purchasing managers’ organization. It’s important to ensure that the champion has top-management backing; without support, his/her and treasury’s efforts would be quickly frustrated by intransigent local managers.

(2) Leverage existing IT investment. There are procurement/purchasing systems that the purchasing organization may already be using, which could be “tweaked” to supply treasury with hard to find data.

For example, some data-base queries may allow a search for the “currency” of the underlying transaction or add a field for “terms” in the screen that managers must fill out to get approval for a new vendor. It may simply be a matter of writing a query to the existing Oracle or SAP database.

(3) Look for “reservoirs” of existing data. Another suggestion is to look at other processes that require procurement to submit information about vendors. Some organizations, depending on their underlying business, may ask managers to go with preapproved vendors, and/or comply with industry rules (such as FDA regs). Such systems create some consistency of language and visibility into contracts. Another approach may be to contact a a central or regional legal department, which may have copies of all local contracts in its possession.

(4) Piggyback the planning process. Some companies require that each business submit expected costs, suppliers, etc as part of the annual planning/budgeting process. Treasury can potentially tap into that data, to gain insight into the procurement supply chain.

(5) Finally, survey regional GMs. If there is no ready-made process to “piggyback,” the backup is to ask regional business heads for their key relationships to get a handle on the bulk of the risk and focus on key overseas’ affiliates to identify significant risk factors.

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