You’ve probably heard the phrase, “What she doesn’t know won’t hurt her.” Well, that doesn’t necessarily hold true in the realm of global socio-political-economic phenomena, like what happened over the weekend.
A Brief Recap
After several months of heated debate, the United Kingdom decided to exit the European Union. The vote was not uniform, with pockets of support and resistance throughout the country. The corporate sector, frustrated with increasing regulatory demands from Brussels, lobbied strongly to leave. Scotland, recipients of a substantial amount in EU subsidies, voted to remain. The media focused heavily on the “patriotic independence” rhetoric of Leave campaigner, Nigel Farage. Social media is already buzzing with tongue-in-cheek speculation about the spill-over effect. Will Brexit be followed by Grexit? Departugal? Italeave? Czechout? Oustria? How about campaigns to stay, like Remainia?
The British pound plummeted close to $1.33, its lowest level in more than 30 years, as the results of the referendum became clear. It's now down around 6% near $1.36. The euro also fell heavily.
Some investors are already concerned about cash drying up in global financial markets. “Britons delivered a bombshell to the markets,” says Chris Gaffney, president at EverBank World Markets, a firm headquartered in Florida. “This is the biggest risk to markets right now -- a possible lack of liquidity like we got during the Lehman crisis.”
Some pundits are saying that the UK’s move is “uncharted territory”, despite the centuries of independence that precede the existence of the EU. Nevertheless, the economics of the next two years will certainly be impacted. EU officials have said that the UK’s exit negotiations will be “less than amicable,” implying that they will “stick it to ‘em” at every opportunity. On top of that, the already-weak economy in the UK has already caused concern.
Bringing It Home
The question remains, “How does that affect my business here in the US?” The fact is, markets are global, even if your company or its products are not. Sales depend on demand for your products and services. And demand has a ripple effect around the world, a kind of economic circle-of-life. Success of a company in Europe creates demand for new investment. New investment creates demand for more products and services. To meet the demand of the marketplace, companies everywhere hire workers and outsource. More employment raises the level of consumer spending and creates more demand. The opposite also happens. It doesn’t happen overnight, but companies experience joy or pain based on the fortunes of their global counterparts.
The problem is… we don’t know what it’s going to look like.
Predicting the Future
Currency exchange rates will rise and fall with participants’ perceptions about a country’s future economic prospects. Unfortunately, even the best prognosticators can’t get it right all the time, as evidenced by the recent predictions about the UK vote. A lot of people were wrong. Uncertainty about future currency exchange rates makes it difficult to manage earnings. By way of an example, imagine a US company with revenue of $200 million and a 10% net margin. If a third of the company’s revenue is generated in the EU, just a 10% change in the value of the Euro (we’re already down 4% since December of last year) would cause that company’s earnings to decline by 30%!
Where is the Smart Money?
Everyone wants to know what the really intelligent, savvy, insightful managers are doing. What bets are they making? What actions are they taking for their companies that might inform what other companies ought to do? The answer is that really smart managers refuse to speculate on the direction of currency exchange rates. They’re too smart for that. It’s true that the structure of their businesses imply a certain market view, as in the above example. The US company is positioned to earn more as the dollar weakens and earn less as the dollar strengthens: de facto betting on the dollar weakening. But smart managers know that the way to avoid those large gambles is to become risk-neutral.
Managing currency risk is not a one-and-done activity. It requires an understanding of a company’s business, the ability to quantify the impact of currency exposure, access to tools, a calculation of cost, and measurement of success/failure. Effective risk management is a progressive process, as the figure below illustrates.
Understand Your Business
Understanding the origin and impact of currency exposure requires examining the details of your company’s supply chain and revenue cycle to uncover the sources of currency exposure. Often exposure shows up in multiple places (balance sheet, income statement, cash flow), so be careful to leave no stone unturned.
Quantify Your Risk
Once identified, it is imperative to quantify the risk. How much risk does my company actually have? What is the dollar impact on my revenue? Margin? Earnings? Equity?
The Right Tools
While important, the utility of tools alone is often overestimated. Some tools require a PhD in mathematics, sophisticated models, and more market savvy than a derivatives trader on Wall Street. It is more important that you use the right tools, and use them correctly. Many dealer banks will pitch a couple of “one-and-done” strategies based on a casual glance at your financials, but they don’t have time to consider all the angles that fit your unique criteria based on the nature and magnitude of your business and your exposure. And the banks certainly won’t calculate the cost for you! That is theirs to know and yours to find out. Buyer beware.
Calculate the Cost
It’s important to compare the cost of managing the exposure to the exposure itself. How else can you reasonably decide whether to mitigate the risk or live with it?
While it’s true that the cost of hedging is typically a fraction of the exposure, smart managers not only count the cost, but also present the comparison along with their recommendation. Board members and senior management appreciate a well-thought out plan and communication builds trust.
Finally, every complete currency risk management program uses criteria to evaluate success. When a stakeholder asks, “How did that work out?” a manager must be able to answer. Smart managers decide beforehand how to measure success. With a plan in place, whatever the benchmark, the program can then be evaluated, modified, and explained, along with their company’s financial performance.
The Bottom Line
Managing your currency exposure in the wake of tumultuous events is not for the faint of heart. Small to midsize companies are already stretched, and busy managers don’t have the resources to address every element of financial risk that inevitably surfaces in the course of the business cycle, let alone deal with the looming uncertainties of the future.
By implementing a sound framework for managing financial risk, it is possible to overcome the challenge of uncertain and volatile markets in today’s global economy.