Strategy & Operations » How can corporates hedge against currency risk?

How can corporates hedge against currency risk?

The pressure on corporates to manage FX risk is intensifying, with the US Federal Reserve and other central banks continuing to hike interest rates to rein in inflation. Eric Huttman, CEO of MillTechFX, urges CFOs to review their FX risk management policies and take steps to mitigate against heightened currency risk

Currency volatility has become one the dominant macroeconomic trends of the year. The Wall Street Journal Dollar Index, which measures the US dollar against a basket of 16 major currencies, has surged repeatedly over the past nine months and reached a new 20-year high as of September 23.

The rise of the greenback has in parallel witnessed the depreciation of other major currencies such as the euro and the pound, which recently fell to a 20-year low and 37-year low respectively.

Corporates subsequently find themselves in a highly volatile climate. According to the July 2022 Kyriba Currency Impact Report, global foreign exchange (FX) impacts surged to $24bn in Q1

2022 while North American companies reported a 200%+ increase in currency headwinds.

With growing headwinds set to persist throughout the rest of 2022 and beyond, now is the time to examine the challenges that CFOs face when it comes to FX risk management and what steps companies can take to hedge against heightened currency risk.

FX risk management – a growing priority

Throughout 2022, CFOs had to adjust their priorities rapidly to reflect the changing economic environment in which their firms operated, withj FX risk management becoming  a top priority according to a recent survey by the European Association of Corporate Treasurers.

PwC’s recent Global Treasury Survey 2021 found that inaccurate forecasting and poor visibility were some of the biggest challenges facing treasury teams. This made the task of FX risk management like hitting a fast-moving target. This was compounded by the supply chain crisis and treasury teams had to quickly adjust against a backdrop of working from home due to lockdown restrictions.

These issues had a direct impact on many businesses profitability with HSBC’s latest corporate risk management survey finding that 57% of CFOs (rising to 77% in EMEA) say they suffered lower earnings in the past two years due to significant levels of unhedged FX risk.

FX isn’t plain sailing

Corporates continue to overpay for their FX requirements and suffer from a lack of transparency.

The FX market is the largest financial market with a daily trading volume of $6.6trn . A growing proportion of this volume comes from corporates.  But despite their increased participation, many businesses can often be treated like second-class citizens in what remains a frustratingly opaque and often unfair market.

The first problem is the lack of transparency, especially when it comes to pricing. Transaction costs (which are very real costs to a business) are hidden in the FX spread, typically calculated as the difference between the traded rate at the point of execution and the mid-market rate at that time. This is something that is easy to calculate through Transaction Cost Analysis, but all too often firms don’t even know this is possible.

In addition, unless they are very large, corporates can have limited choice on which and how many counterparties they trade with. They tend to work with only a small number of banks for their FX because of the operational complexity of setting up multiple banking relationships. This makes it harder for them to compare prices in the market because they have fewer access points and a smaller number of liquidity providers.

The second big problem is that brokers and banks give different rates for different clients depending on the type of client that they are. The most competitive rates (IE those with the lowest spreads) are typically reserved for those with the largest trading volumes.

This is not a secret. The European Central Bank produced a report in 2019 that found that banks were overcharging their smaller corporate customers for FX services with hedging rates as much as 25 times higher than for their larger and more sophisticated clients. The report’s author likened it to walking into a user car dealership and paying £50,000 for a car that others can buy for £5,000.

The lack of transparency, limited number of counterparties and discriminatory pricing all increases the difficulty for corporates to achieve, let alone demonstrate best execution.

What can corporates do to improve their FX strategies?

Streaming giant Netflix is the latest big name to highlight the need for an effective hedging strategy, outlining that it did not use FX derivatives to hedge volatility exposure and that revenues would have been approximately “$619m higher” had exchange rates remained consistent with those of 2021.

Fortunately, there are several steps that firms can take to improve their FX risk management infrastructure. These include:

  • The use of Transaction Cost Analysis (TCA) – TCA was specifically created to highlight hidden costs and enables firms to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.
  • Compare the market – having the ability to put trades up for competition is central to ensuring access to the best price – which is key to effective hedging. However, many treasurers are hampered by their inability to access Tier 1 FX liquidity, meaning they often rely on a single bank or broker to meet their hedging requirements. A new generation of fintechs is tackling this problem, enabling treasurers to access rates from multiple banks whilst reducing the operational burden associated with this kind of market access.
  • Margin-free hedging – Liquidity and funding requirements are one of the biggest challenges faced by corporate treasurers today. Businesses should explore ways to eliminate unforeseen demands on free cash flow, and one such demand might arise from financial risk management. CFOs should explore hedging solutions that are initial or variation margin free and don’t pose a threat to free cashflow.
  • Outsourcing – There is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities, but when using the right partner can actually improve transparency and execution quality. Outsourcing can enable firms to dedicate more time to core business matters, which is all the more important amidst inflationary and volatility pressures.

Moving away from the traditional single bank-based approach, and instead harnessing solutions that offer greater transparency and execution quality, will be key to mitigating the risk and uncertainty brought by ongoing currency volatility.

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