By Wolfgang Koester
Both anecdotally (in conversations) and quantitatively (in the Q4 currency report), currency awareness is unquestionably on the rise. The number of companies reporting currency headwinds has risen dramatically over the past 5 years from 4% – to 44% in Q4 2015. That is a sign of increased impacts, but also a sign of increased currency awareness as a result of 5 quarters of sustained headwinds.
I’ve seen evidence of rising currency awareness in my conversations with leaders of multinational corporations— many of them now taking the first step to managing currency risk and understanding their entire portfolio of currency exposures. There’s an increased understanding of the fact that when a company doesn’t fully understand all of its exposures, any FX risk management actions (within policy or not) will be weak, based on incomplete information. Thus, the company can’t give good guidance about the impact of currency volatility on the financial statement and much less, effectively protect the company.
To really understand, a company needs to know three key things: 1) all of the currency pairs the company is exposed to; 2) where those exposures lie (revenue? expenses?); and 3) to what degree the company is exposed. With that picture, they develop a well-defined currency risk management policy and subsequently provide accurate guidance to the board, investors, and analysts.
FiREapps Chief Solutions Officer, Corey Edens, describes currency awareness as the following:
Being currency aware means having a continuous pulse on the foreign currencies that are resident in the assets and liabilities of the balance sheet, as well as the foreign currencies the firm is planning to do business in, in the future. With this information, the CFO can assess the risk that market movement of currencies will impair the firm’s net assets. Also, the CFO can determine how the P&L (revenue, margin, net income, EPS, EBITDA) and future net assets could be impacted as future transactions occur and make their journey through the balance sheet to an impact on cash.
3 Questions a Currency Aware Organization Can Answer
- How many currency pairs are you materially exposed to? Where multinationals used to face risk from a small handful of currency pairs, they are now impacted, potentially, by hundreds of currency pairs.
- Do you have full visibility into your international expenses? Most corporate leaders can easily explain their international revenue sources. But can you explain your revenue exposure, how much offset there is in expenses, and the potential impact on monetary assets and liabilities?
- To what extent do your revenues and expenses not offset but actually add to overall risk? It is easy to assume that revenues and expenses in a particular region or country overlap and offset each other. But that is often not the case. Yet companies like Yahoo! provide a good example of the benefits of denominating revenues and expenses so that they offset each other (hear from Yahoo! here: https://youtu.be/J8ucKlCCUuE).
A breakdown in currency correlations
Currency awareness is acutely important for multinational corporates now more than ever, as we are seeing a breakdown in correlations between many of the currencies which companies used to manage in a correlated manner. It used to be, for example, that emerging market currencies moved largely in the same direction; when the Brazilian real was down, so was the Argentine peso. The same was true for developed market currencies; when the Japanese yen was up against the U.S. dollar, so too was the British pound, for example.
The following chart shows the significant divergence between the British pound and the Japanese yen, vis-à-vis the U.S. dollar, beginning in late 2015:
SOURCE: Google Finance Tool
SOURCE: Google Finance Tool
As the charts above make clear, those old correlations simply do not hold anymore. There is a new phenomenon where, except for the U.S. dollar, G10 currencies are depreciating while lesser-developed countries’ currencies are appreciating (especially relative to the lows they had hit). That creates conditions where currency volatility is materially additive and disruptive for companies that approach currency risk management expecting old correlations to hold.
Companies that are managing through this breakdown in currency correlations are those that are currency aware. They know their exposures across the entire portfolio of currency pairs they do business in. They know the extent to which they’re exposed. They know how those exposures affect the balance sheet and cash flow. And based on that knowledge, they have a clearly defined policy for how to manage the currency risk.