If life were a game, it would be titled … "Risk." So, too, would the game of business, conducted on the international stage. Though some of us love to take risks, many of us don’t. Risk tends to be anathema to C-level executives, especially CFOs and COOs — as unknowns take all the wind out of corporate sails all too often.
In the past decade, we’ve seen seismic shifts across economic landscapes. The Great Recession taught us (or should have) that unforeseen events — suddenly present, front and center — can be terribly destructive to profits and balance sheets (and even livelihoods!). Mulling an international stage fraught with geopolitical risk (trade wars, Brexit, sabre rattling over nuclear arms, and the vagaries of currency fluctuations and interest rate gyrations), it’s no wonder that this week’s Beyond the Buzzword focuses on hedging.
One would be forgiven for thinking that hedging is the purview of hedge funds, since it’s in the name. However, in a much more day-to-day and payments-related sense, hedging is not limited to Wall Street or any number of movies and TV shows. Hedging, of foreign exchange exposure and for firms operating across borders, can be a useful and profitable tool.
In an interview with PYMNTS’ Karen Webster, COO Mark Frey of Cambridge Global Payments said that, to find out what makes an effective hedging strategy, it is instructive to find out what hedging is not. There are myths held by the business community, he said, that hedging must involve large complicated financial transactions that swap one form of risk for another form of risk. The view is that it's like gambling, but that’s not the truth.
“When currency risk management or hedging is done well,” he said, “it's really all about taking something that is, ultimately, out of a firm’s control with what happens, with respect to international foreign exchange markets” and making sure certain events do not have a material negative impact on a company’s business.
Frey told Webster, “In many firms, when they think of hedging, they simply determine what their cash flows are and then step into the market, and they execute a series of transactions. Those transactions may be well-intentioned in terms of managing foreign exchange risk,” but they can be fruitless when it comes to insulating firms against risk.
In risk management, process and insight are paramount, he added. Executives must know what is the risk that is inherent in the business, and what are the costs that can be incurred if the currency markets move in opposite directions by, say, 10 percent.
“Where we see [Cambridge] customers get into trouble is that … they haven’t done that work on the front end,” Frey said. This is especially important in the case of enterprises operating internationally that rely on imports and exports, which, in turn, can impact foreign currency accounts receivables. Risk professionals must look at cash in and out from corporate coffers, said Frey. They must know their balance sheets intimately — and where, say, debt or operating plants might be exposed to foreign denominations.
Against that backdrop, and in terms of process, stress test those assets against market volatility, he said. Stress tests let executives find out where the impact can be significant to operating performance. Take, for example, the firm that is importing goods and services from Europe — and paying for them in Euros. Frey said the company straddling borders may operate in a market that is competitive and where there is not much ability to impact pricing domestically (in the U.S.). So, it must think about how it can hedge its input pricing over time frames that stretch across several months.
To manage profit predictably, executives must fix their cost basis domestically, then figure out what is a fair and appropriate margin. Thus, in its simplest and most effective hedging activity, a forward contact that locks in an exchange rate can be an effective management tool.
As for the technological tools that can help (look past the nomenclature of volatility, implied future volatility), computer-driven risk simulation models help determine risk within a certain confidence interval. Using just rules of thumb will not help in a globalized operating environment, Frey said. Building in a buffer of 5 percent when assessing exposure to market moves is not enough when looking back at a decade where currencies have moved 20 percent or more in a year.
“I think it is reasonable to expect that volatility is going to increase in the coming periods,” he said.