Managing Volatility
Accurately predicting currency movements can make the difference between profit and loss for a multinational. Fortunately, help is at hand.
By Gordon Platt
Finance ministers and central bankers have a habit of substituting “volatility” for “levels” when it comes to what they perceive as out-of-line exchange rates. The Group of Seven industrialized nations, for example, warned in Istanbul in October, “Excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability.”
Actually, foreign exchange market volatility peaked late last year in the wake of the collapse of Lehman Brothers. The financial crisis temporarily reduced liquidity in the $3.2 trillion a day foreign exchange market, the world’s biggest market. However, FX volatility has been on a steadily declining trend since those dramatic days of last fall, when major currencies had some of their biggest single-day moves ever.
The big currency fluctuations may be behind us, but the FX market has a way of surprising the best of pundits. The currency market is ruled by Murphy’s Law: If something can go wrong, it will go wrong, and at the worst possible time. Just when banks are making a pretty penny by selling volatility options, betting against big moves, something happens. Sudden moves in the market are what the growing ranks of online FX traders live for and what corporate financial officers fear.
CFOs are increasingly turning to hedging to protect foreign-sourced earnings from potential currency-related disasters. At the very least they want to know what their FX exposures are, even if no sharks are apparent at the surface of the currently calm waters.
The benchmark three-month implied volatility embedded in option pricing for the euro is now around 11% and has been trending lower for the past six months, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman, based in New York. “Some European officials have commented recently about the undesirability of excess volatility in the currency market,” he notes. “If these concerns can be taken at face value, instead of some signal protesting the strength of the euro, then it behooves investors to take a look at currency volatility, even if one does not have option exposure,” he says. A review of the available data indicates that current implied volatility is benign and is not really a major problem, he points out.
In fact, one of the most lucrative trades in the FX market this year has been the “short volatility” strategy, whereby investors sell options that protect buyers against currency movements. This strategy, known as a straddle, involves the simultaneous purchase of a call option and sale of a put option. A call option is the right to buy a currency at a certain price, and a put option is the right to sell.
For whatever reason, sentiment toward the dollar is clearly negative, Chandler says. Based on the current spot market price and implied volatility in the options market, the odds are almost one in eight that the euro will rise to $1.60 by the end of 2009, and there is a more than one in four chance that this level will be seen by the end of the first quarter of 2010. “The extreme dollar bearishness by some forecasters appears to be based on a double-dip recession in the US and an earlier recovery in the eurozone and an earlier rate hike,” Chandler says. “Both of these scenarios seem exceptionally unlikely to materialize in the next three to six months,” he says.
Dennis Gartman, editor and publisher of the Virginia-based Gartman Letter advisory service, says, “Right now, everyone and their brother is dollar bearish.” With all of the dollars being printed, and with central banks diversifying their reserve holdings, the bearish story on the dollar is extraordinarily compelling, he says. But the dump-the-dollar trade is getting overcrowded, which could be an indication of a major dollar bottom, he adds.
Gartman compares the foreign exchange market to a boat. When all of the passengers move to one side, the boat begins to list heavily to that side, he says. It is only when some people fall overboard that the boat is able to regain its balance.
Other analysts are worried that since the global economic recovery got under way at the beginning of the second quarter of 2009, the dollar has been among the weakest of the major currencies and that this trend could continue. The latest data from the International Monetary Fund, when adjusted for currency valuations, show that central banks are increasingly reluctant to accumulate dollars, says Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital, based in New York. “Emerging market central banks appear much more aggressive than in the past in shifting out of the dollar into other Group of 10 currencies,” he says. “This makes it likely that dollar pressures will mount as, increasingly, the [dollar’s] buyers of last resort are reticent buyers,” he adds.
The IMF’s Composition of Official Foreign Exchange Reserves (Cofer) data for the second quarter of 2009 suggest not only that central banks are talking about diversifying their reserve holdings away from the dollar, but that they are also doing something about it, Englander says. The second quarter of this year was the only time that central banks have accumulated more than $100 billion of reserves in a quarter, and the dollar’s share of this accumulation has been less than 40%, he says. “This is also the only time the euro has accounted for more than 50% of the accumulation when central banks in aggregate have accumulated more than $80 billion,” he adds.
In the fourth quarter of 2008 and the first quarter of 2009, when central banks were drawing down their reserves, the drop in aggregate reserves was almost all in dollars, Englander says. The rebuilding of reserves since then has been primarily in currencies other than the dollar. “No one wants to be caught holding too many dollars, and this rising reluctance is increasing pressure on the dollar,” he says.
Mark Carney, governor of the Bank of Canada, warned in Istanbul in October that corporations should become accustomed to higher levels of FX volatility. He also said a strong Canadian dollar could derail the country’s economic recovery.
Understanding FX Risk
Accurately measuring and understanding FX exposure can improve the ability of corporate finance officials to manage currency volatility as an enterprise risk, says Wolfgang Koester, CEO of Fireapps. The Scottsdale, Arizona-based company developed the world’s first on-demand software to help corporations optimize FX processes.
In May 2009 Fireapps introduced a new version of its software, known as Enterprise, which helps multinational companies identify and resolve data-integrity issues with existing enterprise resource planning (ERP) systems.
“Most companies are unaware of the issues they have with their FX data,” Koester says. “But we have yet to find one without significant issues gathering, analyzing or making effective decisions about their foreign exchange exposures.” Those issues can make the difference between being profitable or not in a given quarter, he says.
Fireapps enables treasurers to aggregate FX transaction data from different sources and various accounting systems and identify inconsistencies. Once the data is validated, an overall exposure can be calculated. Companies then can use a combination of forward contracts and options to achieve the desired degree of certainty in managing their FX risks.
