The current levels of foreign exchange volatility represent a challenge that today’s younger CFOs have never seen before.
Currency risk has always been part of doing business globally, but most CFOs who are now at the financial helm of their companies haven’t managed this type of FX volatility—ever. The last time we saw major currency fluctuations of this sort was in the 1980s.
Recall in 1987, when the euro ranged between $1.06 and $1.29. Fast-forward three decades, and the euro was swinging again between $0.95 and $1.14, or up over 20%, in 2022.
For international companies, the negative impact of FX fluctuations can be significant. Foreign exchange exposure can affect virtually every level of financial statements. It generally comes in the form of translation impacts when consolidating international revenue to local dollars, or in the form of expenses in foreign currency-denominated payables.
“FX has a broad impact across the income statement,” notes Andy Gage, senior vice president of FX Solutions and Advisory Services at Kyriba, a cloud treasury and financial solutions provider. “It affects operating decisions, debt considerations and other strategic considerations central to how business is conducted.”
If not properly hedged, FX exposure can not only eat into profits but also change the competitive landscape for companies caught off-guard, according to Donald Lessard, MIT Sloan professor of International Management.
“In addition to the impact on the financials, companies also need to understand the potential impacts of a change in currency values on the competitive landscape and other aspects of business risk,” Lessard says. “My sense is that the financial management of foreign exchange is still myopic,” he adds, “and tends to focus mostly on contractual and translation exposures. This doesn’t really address the impact of changes in effective exchange rates on costs, prices, margins and cash flows.”
Despite these impacts, Chatham Financial estimates that only half of US multinationals are hedging their FX exposure. While it’s difficult to determine the opportunity cost of that, estimates show that FX volatility can impose a considerable financial burden.
According to Kyriba’s January 2023 Currency Impact Report (CIR), the combined pool of North American and European corporations reported more than $17 billion in tailwinds and about $47.2 billion in headwinds (i.e., a negative impact on corporate earnings) in the third quarter of 2022 due to FX fluctuations.
North American companies reported a 26.6% increase in FX headwinds compared with the previous quarter, Kyriba says, whereas European companies reported a 68% increase in FX-related headwinds. The fall in the value of the euro against the US dollar was to blame.
In the EU, the electronic-equipment instruments and components sector felt the greatest pain when it came to the negative impact of currency volatility. In the US, healthcare equipment and supplies were hardest hit, as of the third quarter of 2022.
For companies that chose not to hedge, year-over-year volatility could have eliminated margins entirely, explains Chatham Financial managing director Chris Towner.
“For example, if you were a UK business importing from the US and started the year at $1.35 GBP/USD, and you gave yourself a $1.30 budget rate, that would be a major concern when the pound went to $1.05,” Towner says. “That would’ve impacted profitability—or even, for some businesses, completely wiped out profitability because they would be required to pay 20% more in [pounds] sterling.”
These kinds of extremes have led to a lot more hedging requirements and a lot more hedging inquiries from corporates, says Towner. “While companies still tend to use plain-vanilla FX forward hedges, we’re starting to see companies combine more optionality and much more usage of participating forwards,” he adds. When the environment becomes more volatile, options provide more flexibility than straightforward contracts. The downside is that options are more expensive than regular contracts.
For some companies, FX hedging is the least feasible choice for managing currency risk. As Taswer Ahmad Khan, Middle East CFO of Güntner, explains, it can all depend on where your customers are.
Güntner, a manufacturer of refrigeration and heat-exchange products, is headquartered in Germany and Austria, with customers in the Middle East, Africa and India—and working with hedging instruments in countries across the Middle East and Africa is quite risky, says Khan, citing political volatility in those regions.
“One country improves, another goes down and then improves again, and the result is payment delays from our customers,” he says. “That’s one reason we don’t want to bind ourselves into an FX commitment when we’re not certain about the timing of that revenue.” As a result, Güntner Middle East has a wide, sweeping policy of selling only in euros, he adds: “We have kept it pretty straightforward, which is more secure for us.”
Other companies, like Qikiqtaaluk Corporation (QC), a diversified Canada-based resource company located in Nunavut, Northwest Territories, have a natural hedge. Ali Sarfaraz, QC’s corporate controller, says the company maintains all revenue inflows in USD and any multicurrency inputs are paid through their US dollar account—only converting to the weaker Canadian dollar when necessary, and at a gain.
It’s no secret that the strength of the US dollar has heightened currency volatility in many countries around the world. In 2023, most observers and analysts alike expect it to remain strong.
What To Keep In Mind
For international companies with exposure not only to USD, but to other world currencies, there are two things that they should keep top of mind when it comes to managing FX exposure, says Chatham’s Towner.
“First, it’s important for companies to have an FX policy or strategy that’s signed off by the board, that everyone bought into. Adhere to the strategy and take a disciplined approach—don’t be deterred by market moves,” he says.
“Second, whenever companies have an FX exposure, they should look at ways to offset that risk organically. What can they do internally or strategically to reduce their exposures? For example, can they do foreign currency debt swaps, before making any decisions to go to external FX markets?”
Kyriba’s Gage tends to agree.
“I’m a huge advocate of looking inside before you look outside to manage your FX risk,” Gage says. But you’ve got to have good analytics to understand where your exposures are coming from. “If you see that [data], then you should be compelled to ask questions like, ‘How can I work with the business to reduce those risks? What can be done differently? Can we rethink our supply chain?’ That’s the best practice even in periods of light volatility.”
Companies also need to be looking at how they’re accounting for transactions. “Make sure your business is really clean and precise in terms of accounting for foreign exchange transactions,” he says. “Make sure you’re netting your hedges so that you don’t have one business unit hedging Euros in one direction and another business unit hedging Euros in the opposite direction.”