Managing FX risk: The challenge of global payments

Mark Burrough, Vice President of J.P. Morgan Treasury Services, outlines how increasing globalization and cross-border trade has made foreign exchange risk management a high priority for US corporations.

Despite the financial crisis, growth in globalization, international trade and cross-border currency flow continues. As economic growth resumes, this trend will accelerate, further enhanced by international acquisitions, divestments and reconfigurations.

In a post-recessionary environment, the growth of international trade means that increasing exposure to foreign exchange (FX) risk has to be managed against a background of an increased pressure to realize returns, at the same time as the overall risk appetite is substantially reduced. No wonder that FX risk management has become a high priority and not simply a technical issue for corporations.

Risk reduction and transfer

Typically, corporate treasurers use a variety of hedging strategies to manage and control FX risk. Almost by definition, risk reduction and risk transfer can be achieved in effectively any scenario, but each solution carries a cost: counterparty risk acceptance has a price attached. So the simplest FX risk management strategy - static hedging - is to pay the cost of an appropriate derivative such as an option, swap or insurance contract, and lock in reduced risk. Beyond this approach, which treats the corporate treasury simply as a cost center, more dynamic strategies may involve active exploitation of arbitrage opportunities between currency rates.

Because exchange rate fluctuations have to be managed anyway, the opportunity to profit from the process can bring additional financial advantage. The downside may well be constrained risk reduction. In effect, in the typical FX management process of global treasuries, there is a three-way trade-off between risk, cost and profit. The solution to the trade-off will differ from company to company depending on its overall risk appetite.
However, in the new financial and economic landscape, CEOs are realizing that effective, and cost-effective, FX risk management involves much more than this.

Transparency and visibility

Let's take a step back. In order to manage FX risk it is necessary to locate and quantify it. This isn't necessarily as easy as it sounds in complex multinational corporations. The FX implications of any transactions and contractual obligations entered into at subsidiary level may be hidden within consolidated figures returned to global headquarters. Fortunately, several global banks now offer easy technology that allows multinationals to gain clear visibility of FX exposures without the costs associated with standardizing all their enterprise resource planning (ERP) systems - or even requiring them to be on the same version.

Once exposure is clearly quantified, the need for direct risk mitigation strategies can be controlled and reduced by operational strategies. These should be located within an overall corporate structure of risk management policy strategy and procedure that once again mirrors the strategic risk positioning of the corporation. For example, intra-group structures and relationships are a key source of potential risk, and hence of potential benefit if they are managed correctly. Where are balances kept and in which currencies? Do FX exposures match the respective trading risks? What is the financial relationship between subsidiaries and the global parent? How are they financed, by loans or by equity? In which currencies are they denominated? Effective reconfiguration of these relationships can lead to a more 'natural' and automatic hedged position, reducing exposure without direct financial cost.

Payment processes

Externally, however, it is the different contractual relationships with third parties - both customers and suppliers - that determine the nature and extent of FX exposure. Here, the payments process plays a key role. Every cross-border payment has foreign currency exposure risk. When engaging in global trade transactions, many organizations negotiate all agreements in one specific currency such as US dollars or Japanese yen rather than the local currency. They believe they are effectively eliminating exposure to FX rate volatility. This is a common misconception, as FX risk is inherent in all cross-border activity. Even in the absence of foreign currency cash flows, economic exposure to exchange rate movements is inevitable.

If the company's approach is to have a vendor invoice in its headquarters' local currency, the FX risk is in effect transferred to the vendor. That may seem effective, but as we know, risk transfer almost always carries a cost. Even if the exposure may be hidden it remains real: transferring exposure most likely means the company is overpaying.

Central ownership and expert support

Managing the overall risks in the most effective manner requires central co-ordination, even if it does not necessarily imply transfer of operational 'ownership'. Many multinational companies have global banking relationships with a large number of different banks. Often, this is a consequence of the global expansion process, where each local entity opens up a relationship with a local bank, in the absence of global oversight. Regional treasury management can't really address this issue: some sort of central influence is necessary.

Once a high-level coherent structure of responsibilities has been created, a central relationship with a sophisticated global bank can open up new approaches to cross-border payments and FX risk. Global treasurers don't have to be experts in foreign currency exposure management: all major banks provide that service. The FX 'desk' will provide advice on specific queries. Automated online tools are available to help develop programs and strategies that can then also be automated.

The trick is to centralize what is appropriate. In many instances, treasury activity is with business units. It is possible to leave the payments with the business units (they are most in touch with vendors/suppliers), but centralize everything beyond that. This allows information on cash flow timing and cash flow currency to flow to a centre where there are treasury skills that know how to analyze that information and make recommendations, or see a problem coming and deal with it.

Ensuring the correct tools and partners to afford flexibility

More flexible arrangements for payments, receipts and tracking and managing accounts allow stronger defense against dislocations in the market. As with risk transfer, conventional wisdom says you pay for flexibility and generally that is true. Although this may seem expensive, it can depend largely upon how the company is organized and who it partners with. Flexibility can flow from having good access and good information. If flexibility is part of day-to-day operations, it becomes less of a risk and brings benefits as well as costs. As an example, when doing business in other markets it is important to select a provider that can readily convert receipts and payments, provide detailed reporting, and deploy automated solutions to optimize liquidity in multiple currencies outside the time zone of their group treasurer.

Challenges of FX payments

Importers and exporters face several challenges when negotiating in local currencies.

Importers
· Inflated prices - local banks may charge the importer excess premiums to convert into their local currency. Also, the vendor will receive less local currency at conversion.
· Loss of control of exchange rate risk - if the home currency falls in value against the foreign currency, the cost of payments will increase.
· Risk of payment delays - home currency transfers sent internationally can take up to three to five business days to reach the vendor, while payments sent in the local currency in some cases can be delivered the same day.

Exporters
· Lost sales opportunities - an export firm's customers may choose a competitor's substitute product because it is priced in the local currency.
· Risk of payment delays - if the home currency strengthens significantly against the customer's local currency, the customer may be more inclined to wait for the exchange rate to improve in their favor before sending a payment.

Triennial Central Bank survey on the FX market

Conducted every three years since its introduction in 1989, the Triennial Central Bank survey provides comprehensive and internationally consistent information on the global structure and growth of the foreign exchange market. Results from 2010's survey show:

• Global FX exchange market turnover has increased by 20% since 2007, with average daily turnover up from $3.3 trillion to $4 trillion.
• Spot transactions represented 37% of the FX market turnover, a 48% growth on 2007 figures.
• Other FX instruments increased more modestly, at just 7%, with an average daily turnover of $2.5 trillion. Turnover in outright currency swaps was robust, but turnover in foreign exchange swaps was relatively flat.
• The FX market has become much more global in the past three years, with cross-border transactions accounting for 65% of all trading activity in 2010.
• The percentage share enjoyed by the US dollar continued to slow the decline first witnessed in 2001, and both the euro and the Japanese yen posted gains relative to 2007 figures.
• UK banks accounted for the 36.7% of all FX market turnover, way ahead of US banks (18%), Japanese banks (6%) and banks in Singapore and Switzerland (both 5%).

Profile

Mark Burrough is a vice president with J.P. Morgan Treasury Services. Based in Singapore, Burrough is part of the regional treasury services foreign exchange product management team responsible for the delivery of integrated cash management and foreign exchange solutions and services to the firm's corporate and institutional clients. He joined J.P. Morgan in 1998 and has held various positions spanning client services, liquidity and foreign exchange product management.