Is your risk comfortable?

“Just how far forward should my com-
pany’s foreign exchange (FX) risk management policy allow forward cover protection?”
Answer — “It depends, on many and varied factors.”
Or perhaps the more fundamental question: “Should we now be changing the FX policy in this area, purely as result of the company’s experiences of the past two years and the current stability of the NZ$/US$ exchange rate?”
Answer — “Not necessarily.”
For most exporting companies, common scenario would be that you’ve spent the past 12 months using up forward contracts (at contracts rates above 0.6000) entered in 1997/98 and vowing never to cover so far forward again! Perhaps also vowing never to be enticed into the seemingly attractive and “zero-cost” compressed ratio spread option contracts ever again!
Also contributing to some unhappy experiences has been reluctance and slowness to reduce forward cover amounts by closing-out contracts (at cash loss) when underlying export exposures were dramatically revised down. The result was nasty over-covered position and straitjacket in terms of future management flexibility.
The dangers in changing now to shorter forward cover horizon, are missing out converting receipts in the low 0.5000’s Kiwi spot rate and running second risk of being under-covered and losing out again if the NZ$ appreciates from current levels back to 0.6000. The reluctance to cover forward beyond 12 months may be poor financial decision (or non-decision) when looked back on in few years.
On the first question above — the length of cover — some perspectives on the “many and varied factors” are:
* All exporters are different and within one exporter there will be different types of foreign exchange risk. The maximum term of forward cover that FX policy allows depends on the exporting activity.
* When and how export product prices are set, the ability, extent and timing of price changes and whether there is any relationship or correlation to the NZ$/US$ exchange rate (eg certain commodities).
* The position of the product in the export market, what drives the buying demand, the type of customer, the sale/purchase contractual arrangements and who the competitors are (domestic producers or exporters from other countries). The home currency and product pricing policies of the competitors need to be considered as well.
* The quality (accuracy) and past track-record of the business-unit or export division in forecasting future export sales within the budget/annual plan period and beyond. Forecasting methodologies and communication of changes are matters that FX managers need to understand and be directly involved in. Sales forecast variability will determine exposure recognition, affecting percentage cover limits and time periods.
* Is the main objective of forward covering just to protect the profitability of the company over the time it takes to adjust the export business (costs, pricing, markets) when changes are forced by permanent and semi-permanent currency value re-alignments? If yes, this will determine the maximum term of cover.
* Cover for periods over 12 months is supported by the fact that exporters commit investments into overseas markets for long-term presence and returns. Export market and product development are multi-year investments. So is it wise to risk that investment with an FX policy that doesn’t provide some medium term protection and certainty in margins and profits? The FX variable certainly does not exist in isolation!
* What are the accounting, tax, cash flow and bank credit limit implications and restrictions of adopting longer-term forward cover regime? Take care that these factors don’t totally drive the policy risk framework; the export business or economic variables and drivers are more important.
* The design of your FX policy shouldn’t be copy of another company’s policy. It must be tailored from “bottom-up” analysis of each export business. Once designed, the foreign exchange risk control limits that determine percentage levels and the term of forward cover should be stress-tested under alternative future exchange rate scenarios. This provides invaluable financial information and tolerance limits to directors and shareholders as well.
Good risk analysis and policy design should give exporters of all sizes more comfort that managing the foreign exchange risk on portfolio basis with an element of controlled longer-term cover activity is both prudent and financially advantageous.
Roger Kerr is director of Deutsche Risk Management Advisory, Auckland