Rethinking currency risk management amid $22.52bn FX headwinds

North American and European CFOs lost $22.52 billion in the first quarter of 2023 due to FX volatility and fluctuating exchange rates, Kyriba research finds.

Although the FX-led loss fell below the previous quarter’s $30.22 billion headwinds, it was a 36.78% year-on-year increase compared to the $16.46 billion recorded in Q1 of 2022, and a 136.05% increase from Q1 of 2021.

Andy Gage, senior vice president of FX solutions and advisory services at Kyriba, notes, “while $22.52bn is a step down from what we saw at the end of last year, it is still largely way out and very high compared to what we have seen in 2020 and 2021.”

Global events drive currency risks

The global economy has undergone several stressful events in the last couple of years, including the pandemic that eventually snowballed into supercharged inflation and interest rates. The Russian invasion of Ukraine further aggravated the situation, leading to more uncertainty and volatility.

The strengthening US dollar over the years has added to these challenges. Over the past 10 years, the value of the US dollar against the UK Pound has appreciated, peaking at 0.932256 in the second half of last year.

Gage explains that the combination of these developments has fuelled volatility in the market and pushed CFOs to establish mitigating measures to manage currency risks.

“2022 was a very challenging year for multinationals, predominantly in North America, due to a complex combination of factors,” he tells The CFO.

“One was a very strong dollar that grew in strength through the year which created some unprecedented headwinds going into through most of last year. In combination with that, central banks also started intervening, with the Fed increasing interest rates to combat inflation. That added to volatility.”

Gage notes that when interest rates increase, it creates an opportunity for FX investors to benefit from the differentials; as a result they move funds around to take advantage of the variances. However, such a move impacts the cost of hedging.

“When the interest rates rise, the interest rate differentials between two currencies are embedded in the cost of derivatives,” says Gage. “For many US corporates, that was a real problem. In some cases, we saw hedging costs quadruple depending upon which way they are trading.”

FX challenges shifts across the Atlantic to Europe

While the overall negative currency impact decreased in the first quarter of the year, Kyriba’s data indicates a sign of shifting fortunes for North American and European companies.

North American companies suffered a $21.24 billion headwind, down from $28.94bn in Q4 2022. In contrast, European companies’ headwind remained constant at $1.28 billion, albeit lower than $4.03 billion in Q3 of 2022.

However, in a continuing sign of a potential transatlantic shift in market conditions, European companies reported a fall in tailwinds to $0.61 billion (from $1.40 billion). That is a far cry from the third quarter of 2022 when European companies witnessed a massive tailwind of $16.78 billion.

In contrast, the North American companies reported a slight uptick in tailwinds from $0.59 billion to $0.66 billion in Q1 of 2023.

Gage believes the recent depreciation of the US dollar will lead to significant dropdowns in the headwinds for US companies in Q2. In contrast, CFOs in Europe and the UK will experience the opposite as their respective currencies appreciate in value.

“We are seeing the beginning as the dollar starts to tail down and the euro and pound regain their strength. So, we will see the headwinds start to move up significantly, and those tailwinds that [UK and Europe businesses] were benefiting from last year will certainly trend downward significantly to becoming almost irrelevant,” says Gage.

Rethinking FX risk management

Although Gage predicts a shift in fortunes for the American CFOs and their European counterparts, he maintains that challenges remain for businesses on both sides of the Atlantic.

After all, the volatile market conditions will not dissipate overnight. Therefore, CFOs will need to plan accordingly.

Gage also notes that past risk management solutions of businesses are likely to become obsolete and no longer best practice in the current market conditions as they were established at a time of low-interest rates.

“A lot of the risk management programs that were conceptualised over the last five to 10 years were done in a low to no-interest rate environment. Now, those currency impacts are much more profound, and the cost of hedging is really stepping up,” he explains.

According to Gage, CFOs have already begun adapting their risk management programs to tackle the current volatile markets.

“Last year was such a damaging year in terms of how currencies impacted results throughout the income statement. We are seeing CFOs mandate their treasury teams to rethink their risk management programs,” he says.

“The CFO is asking the treasury team to work cross-functionally as well as within their own functional responsibility to understand how they can manage that risk while being cost-effective.”

CFOs strategies in mitigating FX risks

Gage states that businesses from both continents can deploy similar strategies to mitigate the negative impact of FX volatility.

He notes CFOs are utilising the internal analysis to better understand their portfolio and exposure. This enables them to identify areas where they need to take proactive steps to reduce their risks.

Using analytics, CFOs can get a better understanding of how currency fluctuations impact their financial results.

CFOs can leverage this information to explore various approaches to reduce exposure organically. For instance, firms could negotiate contracts with suppliers’ customers, or reclassify their intercompany loans to be long-term instead of short-term.

While internal actions can contribute to reduced risks, Gage points out that some firms will require more actions like hedging in order to mitigate FX risks.

Gage notes that companies are actively fine-tuning their hedging programs, with CFOs opting for correlated Value at Risk (VaR) analysis on both sides of the Atlantic to reduce risk and minimise costs.

When actioning correlated VaR analysis, companies analyse the correlation between two currencies. If both currencies are aligned in their direction of movement, companies hedge the cheaper of the two currencies, effectively reducing hedging costs and minimising risk.

Technology adoption

Although companies have deployed correlated VaR analysis strategies before, Gage highlights that technology adoption has made it easier and quicker for firms to analyse the correlation between two currencies.

In the past, businesses relied on banks to perform periodic analysis of currency correlation. However, the findings were only relevant for a short time as the correlation continuously changes.

As Gage puts it, “if you see a spike in volatility, some of those correlations that businesses were benefiting from in the past may break down.”

With technology, firms can circumvent the time limit issue by running the analysis whenever they prefer to make the results timelier and more relevant.

“We are starting to see companies wanting to have access to technology. They can run correlation analysis and cost analysis on the fly to make those changes and be more focused on the overall portfolio risk and trying to hedge that in the most cost-effective way.”

Comments are closed.