The days of corporate treasuries being aggressive profit centres are long gone although there are a few that still survive. These days Corporates are far more conservative with foreign exchange risk management and have reasonably well defined guidelines for the management of forex risk.
At a minimum, Corporates should have a foreign exchange policy which spells out exactly what should be done with the foreign exchange risks they face.
Quite often this policy is developed in tandem with an exposure measurement process. For Corporates with minimal risk exposure, measurement may be a very simple process of forecasting what the cash receipts or payments are likely to be for a given period. For other companies who purchase or sell products in Australian Dollars but where the underlying product is priced in USD on world markets, the risks are less obvious - but just as real.
A good foreign exchange policy is critical to the sound risk management of any corporate treasury. Without a policy decisions are made ad-hoc and generally without any consistency and accountability. It's important for treasury personnel to know what benchmarks they are aiming for and it's important for senior management or the board to be confident that the risks of the business are being managed consistently and in accordance with overall corporate strategy.
The recognition of the financial risks associated with foreign exchange mean some decisions need to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile markets so that emotions are dispensed with and previous careful planning is relied upon. This approach helps eliminate the panic factor as all outcomes have been considered including 'worst case scenarios' which could result from either action or inaction. However even though the worst case scenarios are considered and plans ensure that even the 'worst case scenarios' are acceptable (although not desirable), the pre-planning focuses on achieving the best result.
The use and acceptance of risk management as a key management issue is evidenced by the proliferation of risk management tools, the extraordinary volume of literature that is published on the subject and the focusing of academic attention towards improving risk management techniques. Active risk management is a common characteristic in by far the majority of major corporations the world over. Not to manage financial risk is seen to be negligent as a company's management team is responsible for managing all the variables that ultimately effect the profitability of the company.
Having accepted the fact that foreign exchange exposures exist, it is necessary to formulate a strategy to deal with the exposure. Without strategies it becomes very difficult to make decisions of when to purchase or sell foreign exchange. The absence of a strategy often has the effect of mismanagement of an exposure because typically people are only jolted into action when something goes wrong!
There are a number of alternative strategies that can be employed when managing foreign exchange risk:
a) Do nothing - undertake currency transactions as they arise.
b) Hedge known future obligations - this is the strategy that by default most smaller Corporates use.
c) Use the time between the recognition of the foreign exchange exposure and the time that the foreign currency will be needed, to achieve the lowest price of the foreign currency. This can normally be most effectively achieved by a predetermined strategy that sets levels and trigger points to achieve purchasing targets.
Both strategy a) and b) are commonly used as they are the easiest. They require no additional decision making, they are administratively simple, and they have been the status quo for so long that some market participants aren't even aware that alternatives are available. However these two strategies have serious flaws - the first is that they can carry a very high level of risk to the cash flows of the company. The reason that the risks are so high with these strategies is that they are extreme positions.
To hedge every exposure means removing any chance that the market may move beneficially for the company, whilst its competitors may still enjoy the benefits of these price movements, in doing so the cash flows are at risk as competitors may lower selling prices and hence the profit margin is reduced because of diminished revenues as a direct result of hedging. To not cover any foreign exchange exposures leaves the company equally vulnerable to adverse movements in the exchange rate that could result in cost blowouts, and since cost increases are equally as harmful to margins as revenue decreases they also have explosive potential to undermine the profitability of the whole company.
The approach that appeals to people who believe in the management of the variables that affect the profitability of business is called "Foreign Exchange Management". This approach means making decisions and taking control of a large risk area that affects a corporation. It can take any number of forms from very rigid strategies that ensure conservatism and ease of administration to more complex strategies which attempt to maximise results by taking on additional risk.
NZForex actively encourages contingency planning where decisions are made in advance. It is important that Treasury personnel agree to the risk management approach and have it ratified at CFO/Board level.
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