Risks of the business the company is in and spends most of its time on.
Unavoidable risks that it can’t do much about.
Risks related to the business that can be managed with a well designed ‘set it and forget’ routine.
The risk of volatile exchange or interest rates wiping out the margins of planned sales and purchases, or the budget overall, are in the last category.
Many companies don’t manage these risks because they don’t appreciate how big they are or that there are practical and cost-effective ways to manage them.
A purchase or sale in another currency creates a measurable exchange rate risk. Existing or planned debt creates an interest rate exposure. They may or may not be significant. There might be large exposures one way that are offset by ‘mirror image’ exposures in another part of the business. Unless they’re added up you can’t know for sure.
If a company buys or sells in other currencies or has debt and tells you they don’t speculate on exchange or interest rates, they’re simply mistaken. The company has an open position and should, within reason, know how big it is. Here’s what any company should answer when asked if they speculate:
“The company has exposures to other currencies and/or interest rates so yes we are always speculating to some degree. We know when these exposures arise, when they are contingent and when they are unavoidable. The company has a policy, based on our assumptions about effectiveness and transaction costs of hedging, that says how large the exposure can be before it must be actively managed. When an exposure becomes large, based on the company’s circumstances at the time, management makes a decision about whether the risk (speculation) is acceptable, whether it should be hedged and if so, how the hedging should be done.”
Can your company say that? Here are the steps that need to be taken for managing currency risk:
Estimate the company’s net position (long or short and by how much) for each currency.
What exchange rate creates an unacceptable loss?
What kind of hedge makes the most sense–forward contracts, options, or swaps–and what’s the cost?
Make a decision. If the decision is not to hedge, it means the company is a speculator but happy with the position that it has.
This is commonsense and with a some training can be done in-house. In more complex situations you can ask your banker for data on historical volatilities in order to better quantify the value at risk. Any bank’s treasury group has this information and can help with the calculations.
If you need help figuring out the right questions to ask, give us a call.
Believe it or not, there are large and sophisticated companies that will insist they don’t speculate. If you’ve read this far I’m sure your company is not one of them!