FX Challenges and Risks inhered within global operation
Multinationals (MNCs) operate in dozens of countries across different regions. Contracts between the MNC’s international customers, suppliers and group companies denominate in many currencies and are due at various dates (short-term to long-term). Therefore, if the value of a currency fluctuates against the company’s cost (or base) currency (as indicated below), there is potentially a loss to suffer. Most Corporate Treasuries will not, or rather, are not permitted to, leave such risk unaddressed. History has shown that unexpected fluctuations can have a severe impact on profits and consequent growth, or even threaten a company’s existence. Therefore, stakeholders (investors, The Board etc.) will always insist on setting up a comprehensive program to mitigate currency risk.
By Jiaxin Huang
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Back to basics – Illustrating the need for FX risk management
A Chinese exporter sells its product in value of USD 1,000 to its international customer. The cost of the product is CNY6,300. With an USDCNY rate of 6.5, the company stands to gain a profit of CNY 200. Suppose that the Chinese exporter does not perform any form of FX risk management. When the rate deteriorates to 6.2, the company sees its profit completely evaporate and even a loss of CNY 100 occurs. On the other hand, if USDCNY appreciates to 7, the exporter can earn as much as 3.5 times the originally projected profit. Therefore, leaving exposures unaddressed means huge uncertainty for business results.
| Base Case | |
| Sales | USD 1,000 |
| Costs | CNY6,300 |
| USD/CNY | 6.5 |
| Profit | CNY200 |
| Not hedge scenarios | |
| Scenarios | Profit |
| USD/CNY 6.2 | CNY-100 |
| USD/CNY 6.5 | CNY 200 |
| USD/CNY 7 | CNY 700 |
Certainty and predictability are tow of the advantage that companies (that manage their FX risk) have over “non-hedgers”. But besides this, hedging also allows for time to react to sudden changes. As illustrated in the case above, the Chinese exporter can hedge the FX sales contract to neutralize the risk as depicted below.
The two types of Foreign Exchange Risk
Transaction Risk
This is the case, when a company’s cost currency differs from the invoicing (receiving) currency. The risk of such transaction (exposure) can potentially lead to major losses. Treasury should always apply cash flow hedging programs by creating opposite cash flows to offset the exposure.
Translation Risk
Translation risk focuses on the change in value of foreign-held asset’s based on a change in exchange rate between the home and foreign currency. It can lead to what appears to be a financial loss that is not a result of a change in assets. It is revaluation of the assets based on exchange rate fluctuations. Treasury sometimes is being asked to address such risk (for Balance Sheet purposes).
Ways to manage the Foreign Exchange risk:
* Natural hedging (also known as currency flows matching): guided by Corporate Treasury, a company can diversify production facility, customer markets, or financing sources by using more foreign currencies. Treasury is tasked with identifying efficient offset of FX exposure. Sometimes this means borrowing the foreign currency although a higher credit premium may apply for local borrowing. And such borrowing does not hold a flexible term.
* Financial hedging: such as forward contracts or currency swaps, are often used in case natural hedge is not practical. However bear in mind that for exotic currencies, it may be difficulty for Treasury to find counterparties to trade the exposure against.
* Place (“outsource”) the FX risk to customers. Besides necessary hedging action taken by Treasury, it is also commonly seen that Treasury applies a FX risk premium to the commercial contract with customers.
The relevance of multi-entity multi-currency Cash Pool for FX risk management
In order to allow a more flexible way of managing currency risk, Treasury can setup a multi-currency Cash Pool to centralize the currency exposures without the need for any FX conversion whatsoever. In addition, if this Cash Pool is implemented as a – so called – notional overlay structure, all local currency positions are swept automatically into the Cash Pool without change of funds’ ownership .
Features of FX risk management in multi-entity multi-currency Cash Pool:
* Each entity does not bear additional FX risk, the deposits to or borrows with the Cash Pool are maintained in original currency, no physical conversion.
* Centralize all currency position by single transaction that the corporate fit FX risk strategy. One system, one platform, one procedure.
* Flexibility to create hedge exposure in most cost efficient way.
* No hedge accounting or ISDA required.
Managing foreign currency position in Cash Pool compared to currency swaps
As indicated, a notional multi-currency Cash Pool centralizes all group FX position without physical conversion. Treasury therefore has the option to square the foreign currencies’ positions in line with group FX strategy.
By contrast, the alternative, swapping currencies involves management cost and “unnecessary” premiums charged by the counterparty. Furthermore, exotic currencies can usually not be easily dealt, especially with market turmoil.
Next level liquidity management -synthetic hedging in a notional multi-currency Cash Pool
Hedging in a Cash Pool – also called “synthetic hedging”- can ease the operational hassle and significantly reduce the administrative workload. Synthetic hedging means buy and sell in two legs over the Cash Pool accounts. It works more or less the same way as a currency swap. However there is no specific term and excessive risk, as the settlement risk is with the Cash Pool provider/bank. No mark to market required as the second leg is not an obligation.
How does “synthetic hedging” exactly work?
1) Treasury starts with calculating of FX exposure, in balance sheet exposure, the net monetary assets for each foreign currency. By excluding payable from cash and receivable data, Treasury will have idea about FX risk level. As it only addresses on the translation risk in balance sheet (there is no specific term for such exposure) Treasury can design its strategy to hedge those exposures either to a. roll once the hedging deal is due or b. opt with multi-currency Cash Pool. There is no due date in Cash Pool as long as overall pool position is not negative.
2) Proactive hedge the foreign currency contract. In the Cash Pool, Treasury sells down foreign currency of USD with contract revenue against the cost currency. The FX rate is a spot rate, for example in the Chinese export case, USDCNY rate is 6.86. The company can fix the future USD inflow generate by the contract.
The carrying cost of synthetic hedging in Cash Pool
Unlike a real FX swap, the cost in above examples cannot be pre-determined. It is due to 1) the second leg can be done at any time, and spot rate will depend with market condition; 2) long and short position of two currencies are accrued interest income and expense daily (at a daily rate). This total interest difference also dependents on the period and market condition. In most case, FX premium weights more than interest difference. Therefore long higher interest currency and short low interest currency would not be wise to proceed without consider FX fluctuation.
Note of warning. Increasing interest rate of the USD and arbitrage of cross-currency interest rates
Creating short positions by means of synthetic hedges, in order to engage in arbitrage (so without an underlying real business case), is unadvisable.
Due to spiking Fed rates, the USD borrowing cost are increasing. Since Covid in 2020. SOFR (secured overnight financing rates) hiked multiple times, and by now stands at 5.06%
CNY is developing in an opposite way. Rate cuts to stimulate the economy. The China one-year LRP (Loan Prime Rate) shrank to 3.55%.For MNCs, even for Chinese companies, offshore operations are highly depending on USD liquidity. By the divergence of these two currency’s interest rates, it gets hard for companies to rely on (pure) USD borrowing on a continuous basis. They may need to consider to FX swap lower cost CNY liquidity for USD. This can be accomplished by a utilizing a standard notional multi-currency multi-entity Cash Pool in more flexible way as described above. Likewise we see Japanese companies rely on JPY liquidity to also support their need of USD or other foreign currency.
Cash Pool is usually considered to be a liquidity management platform rather than currency exposure management tool. With a sophisticated notional multi-currency multi-entity Cash Pool setup, it definitely brings potential to take Treasury to next level. It provides the flexibility, transparency, cost efficiency as well as the control for the organization. The strategical use of a Cash Pool to replace traditional FX hedge is also considered to be “priceless”, since it is less rigid and less expensive as a real hedge transaction. Furthermore, there is far less administration and complexity compared to other forms of FX risk management.
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Featured image: Lijiang Landscape (Photo: Jiaxin Huang)
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