Know the risks - and avoid the FX risk management traps
Corporate financial history is replete with examples of currency risk and trading management decisions that have backfired on companies.
Consider Toshihide Iguchi, a Japanese banking executive who turned a $70,000 in U.S. debt into a substantially larger debt of $1.1 billion, after making a bet on the U.S. fixed income market in 1983.
Examine the case of Nick Leeson, the so-called “Rogue Trader" whose unauthorized trading in derivatives led to the collapse of U.K.-based Barings Bank in the 1990's, with bank losses reaching 190 million in British pounds.
Or consider Japan-based Showa Shell Sekiyu and Brazil-based Sadia, who each lost more than $1 billion trading FX forward exchange contracts, in 1993 and 2008, respectively.
According to Wells Fargo's Foreign Exchange 2018 Risk Management Practices Survey,the biggest challenge in managing currency risk is market volatility, and knowing when to hedge in extremely choppy foreign currency markets.
Yet those risks aren't the only ways companies can find themselves on the negative end of a botched foreign currency risk scenario. Learn the lessons from those organizations who've been there before, and didn't – or couldn't – avoid the mistakes that led to their downfall.
And who aren't around to tell their tale today.
In this article, you'll learn:
History is abundant with mistakes made in foreign currency risk management.
The biggest mistakes are made when companies are reactive, and not proactive, in gauging currency risk.
Companies that take undue risks, and aren't aware they're making them, are most at risk for significant financial loss due to poor risk currency risk management.
4 Triggers that can lead to foreign currency disasters
What leads to poor corporate financial disasters when trying to leverage foreign currencies and securities? The fact is, some financial risk management mistakes are bigger than others, and the only optimal takeaways from such mistakes are that they're a lesson learned for other corporate currency risk management decision-makers.
Learn from these currency risk management mistakes, and avoid the fate of the companies listed above, who either collapsed or experienced near ruin from the experience:
Vague, murky FX policy objectives mean reacting. To create an efficient, mistake-free foreign currency management strategy, corporate financial decision-makers need crystal clear goals and objectives. Is your currency management and hedging strategy aimed at stabilizing your balance sheet? Is the goal to give more weight to corporate accounting outcomes over cash flow outcomes?
To avoid the mistakes of misguided FX risk management policy, the key is to be proactive, and not reactive, in aligning currency risk management objectives with accurate, measurable results that provide a blueprint for future risk management decisions.
Overusing complex derivatives limits defensive action. A common, but exceedingly risk-laden mistake in foreign currency risk management is the use (and overuse) of complicated FX hedging tools. Often, the reason for doing so is to curb currency hedging costs, as companies turn to a package of derivative instruments that leverage a knockout option to reduce hedging cost outlays. In doing so, corporate financial decision-makers sacrifice a much-needed defensive financial position when it's needed most.
Placing lopsided bets on currency flows are expensive. Companies that are overly influenced by the direction of currencies, are overly reliant on currency direction forecast, and apply FX risk management strategies that depend on those currency flows, are taking a high measure of risk. For instance, companies often pull the plug on currency hedging moves because of financial loss, just before the underlying exposure declines and as the hedges removed would have balanced out the losses with investment gains.
The idea in proper currency risk management is to balance out both sides of the risk management equation, and not just one side of it, based on currency directional forecasts.
Not having “situational awareness" creates blind spots. Companies who hedge their organization's local FX revenue risk exposure in the areas where they conduct business, without taking into consideration the unique needs of business partners, vendors, and potential clients/customers, are also taking a significant risk.
A corporate financial officer should know the ramifications of large, geographical FX revenue risk moves, and should know how business partners, clients and competitors may react. Executing FX risk management stress tests, and merging various “what if" scenarios into the equation, can provide a glimpse into how various entities in a company's business orbit will respond to a substantial currency.
If a company can't live with the potential outcomes of a large FX directional movement, for or against, then that company needs to reevaluate its overall currency risk management strategy.
History is abundant with examples of currency risk decisions gone awry
Markets will remain unpredictable and the importance of hedging incredibly valuable, but by re-evaluating the way financial risk is managed, painful currency management mistakes can be avoided.
Wells Fargo (2018) 2018 Risk Management Practices Survey
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