Managing Risk from Currency Fluctuations

Ethan Bailey Fx Leave a Comment

Every firm, whether international or regional, is competing on a global scale in a rapidly changing marketplace. This means that all companies must pay attention to policy changes and current events around the world and adjust their market strategies to protect their revenues accordingly. Profits are never secure, and even slight fluctuations in exchange rates or interest rates in foreign markets can cause expected profits to disappear without a moment’s notice. A smart and successful firm plans ahead to minimize these risks.

Figure: Performance of Currencies in Past Five Years

This table perfectly depicts the frenetic, volatile nature of currencies and the riskiness of basing one’s success on sheer chance. When currency shifts are the difference between staying above water and sinking, you cannot leave it up to luck or fate.

Even a firm that completes every transaction in its domestic currency is still exposed to risks from exchange rate shifts and foreign actions such as elections and monetary policy changes. No one can ignore these issues and still maintain control over their financial risks.

Four real-world market shocks affecting foreign exports:

  • Trump winning the Presidential election
  • Brexit and the most recent election
  • The effects of Switzerland unpegging the franc
  • Draghi and “Whatever It Takes”

Trump’s Election Effect on Mexico’s Peso

Trump ran on a populist ticket with promises of bringing production back to the USA, out-competing foreign competitors, and building a wall at the Mexican border. The outcome of the election resulted in an improved stock market and the depreciation of the Mexican peso from an exchange rate of 17.5 to 21.3 against the euro. The depreciation of the peso helps Mexico’s production become more competitive, which consequently hurts United States companies exporting to Mexico. This change of fortunes is important as Mexico was the United States’ 2nd largest goods export market in 2016.

In the end, the US dollar strengthened by 3.18% against the euro, making exports slightly less competitive, but we have yet to see the true effects of Trump’s protectionary policies for the American worker.

The Pound, Brexit and the Recent Tories’ Loss

Euro GBP FX - ekuota.com

Almost no one expected Brexit to occur. Immediately after the Brexit vote, the British pound depreciated from 0.79 to 0.85 to the euro less than a week later. The situation stabilized until May’s shocking loss in the most recent election. Since then, the pound has further depreciated from 0.85 to 0.88 due to uncertainty.

This drastic depreciation of the pound will help Britain’s exports and make British goods more competitive internationally, but for the foreign exporters who rely on British markets, this is terrible news. Their situation has changed so rapidly that their profits are no longer viable.

The Swiss Franc’s Dramatic Appreciation

Euro CHF FX -ekuota.com

In 2015, Switzerland’s Central Bank decided to remove the peg of the franc to 1.2 euros, which saw the value go up to parity, 1.00.  The franc then settled to around 1.1 against the euro.

This sporadic value change represents another opportunity for a forward thinking company to plan ahead to avoid market shocks from abroad, which can come from even one the most stable currencies.

Draghi and the Eurozone

Euro US Dollar FX - ekuota.com

In July of 2012, the strong euro was at 1.2 dollars before Draghi, the President of the European Central Bank, famously stated, “we will do whatever it takes” to save the euro. He accomplished his goal, and by June of 2014, the ECB began a policy of quantitative easing to improve investment/spending and the economy in general. This started the trend towards the euro weakening against the dollar, which improved the Eurozone and investing as well as putting upward pressure on inflation.

 What lessons do these four examples teach us?

Most importantly, these examples show how smart firms should prepare for a rapidly shifting marketplace. How do companies plan for unexpected election results or political actions? A company must first understand what causes these types of changes. Volatility and inflation are obvious risks, but the effects of interest rates can often be missed or even ignored.

Volatility

Every currency has a different risk, coming from its volatility. In the first table, many currencies depreciate rapidly one year and appreciate the next, constantly shifting between the two (ex. The rubble). The dramatic and rapid changes to the value of a currency is its volatility, and with the currencies volatility index, as seen below, eKuota is able to evaluate the level of risk coming from each currency’s volatility and use that information to optimize your coverage of each risk.

Figure: main currencies volatility

Currencies volatility - ekuota.com

 

As we can see, evaluating every currency in the same fashion would lead to poor decisions. In the picture above, the lower the number, the less volatility, and, therefore, the less risk. Since each currency brings a different risk to the table, you cannot ignore a currencies history and level of volatility when making strategic business choices. If you do, disastrous results should be expected.

Inflation

Inflation will lead to depreciation because it affects the demand for a currency. As inflation occurs in an economy, the exchange rate becomes harder and harder to manage for foreigners, so they become less likely to invest in your economy.

Interest Rates

Generally, higher interest rates will lead to a currency appreciating, but why does this occur? Higher interest rates lead to increased foreign investment, which increases the demand for the currency while maintaining supply, this creates upward pressure on the currency’s value.

How to hedge risks with a Forward Contract

Once you realize where the risk is coming from, it is much easier to cover. A firm can use eKuota’s calculators to evaluate their current level of risk coming from currency volatility and potentially choose to hedge their risk by using forward contracts. A forward contract is a deal made between two parties to exchange a good or service for a given price in the future and is used by firms to hedge in order to protect companies from fully experiencing market shocks and losing out on vital future profits by locking down exchange rates.

To forward with eKuota, a company simply enters into the eKuota calculator whether it is receivables or payables, the amount, the maturity, and the interest rates for the two currencies. The eKuota calculator will provide the forward price, which is the optimal price for minimizing the risk coming from currency volatility.

Forward algorithm - ekuota.com

The forward price does not magically appear, but is produced from information entered into the following equation:

S0 represents the spot price, which is what your firm would currently pay for the exchange, r and rf represent the domestic and foreign interest rates, respectively, and t is the amount of time before your forward contract matures. F0 is the forward price.

How does this apply to the real-world?

Let’s say you have to pay $100,000 to a producer in two months. You will know how much the exchange rate is today and what it would cost you if you paid right now, but what about in the future? You need to understand your risks. If today, the purchase would cost €93,000, but in the future, the purchase costs €114,000, you just lost money. Before you throw money down the drain, you must understand the probabilities of every scenario occurring. If the probability of this negative scenario occurring is 50%, you have medium risk. But if it is 80% or higher, your risks are too high to ignore. You must decide the maximum level of risk you are able to bear. After you determine the risk is too much to bear, what should you do now? You can choose to cover all the risk or some of it with a forward contract as we previously discussed.

The importance of this cannot be understated as this example demonstrates. Leaving your dealings to chance can cost you significantly in the future. When using eKuota, you can enter your information into our calculators and determine your level of exposure, enabling you to make well-informed decisions to cover your risks.

Summary

  • Measure your level of risk exposure to currency fluctuations with eKuota. Determine how much you are risking and the probabilities.
  • Decide the strategy of hedge (complete or partial)?
  • After having chosen your new business strategy, eKuota can provide you with the resources to stay updated on whether or not you are reaching your business goals.

 

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About the Author
Ethan Bailey

Ethan Bailey

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Graduated with a degree in Economics from the University of North Carolina in 2017. Currently he is a Financial Communications Analyst. Experience in Data Analytics using Stata, SAS, and SQL. Written Econometric research papers on the college wage premium as well as developing countries.

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