Protection against the pitfalls of financial markets

Laura Oliva Financial risk management guide Leave a Comment

Financial markets can be dangerous, full of threats to businesses that come in the form of lower revenues in foreign currencies as well as an increased cost of commodities.

Some threats are obvious, such as the fluctuations of foreign currency sales and are; therefore, carefully controlled.

Other threats are part of the so-called generic “loss of competitiveness” that afflicts companies in distress. This threat is a hidden cost, even more insidious because it is often unknown, not understood, or even completely underestimated.

  1. HIDDEN COSTS

The risk (or threat) derives from the costs or lost revenues suffered by those companies that believe they are unlikely to be harmed because they only use their own currency in commercial transactions in spite of competing in global markets.

A company selling in foreign markets, while using its own currency, may have the illusion that it faces no financial risk. They feel that there is no need to use foreign currency accounts since they are only using their domestic currency, which leads them to think that the currencies fluctuations are an ignorable issue, which is very wrong and dangerous as significant risk comes from underestimation! The reality is that products sold in a foreign country are compared with products sold by local producers, with prices in local currency, and compared to the products of international manufacturers who have different currencies.

Each currency might undergo substantial value fluctuations and may be more or less expensive than others, depending on the international economic situation. Due to this, the price of the products in other currencies may be more or less expensive depending on the currency in which they are examined. Such a scenario might seem like a puzzle of complex financial tangles, but in reality, this is not an exaggeration but an everyday reality!

1.1 A practical example

Let us imagine a real world example. If a European company is selling its products in a country outside the Eurozone, it is subject to a financial risk that may present itself in lower profits due to the loss of competitiveness.

The fixed prices in Euros can be, depending on the moment, more or less competitive compared to the fixed prices in other currencies so that the firm might lose market shares along with customers, just because the Euro is too expensive compared to the currencies of their competitors. Conversely, if the Euro depreciates, the company will benefit from the positive effects. This example emphasizes that we need to get rid of the illusion that we are protected from fluctuations in the financial markets just because we do not use foreign currencies in our commercial transactions. Although hidden, the risks remain and we must know how to handle them if necessary.

  1. THE HIGH-RISK PURCHASES

So far, we have only dealt with international revenues, but we cannot forget purchases. Does the company buy from foreign suppliers? Does the company use commodities listed in financial markets (i.e. copper, aluminum, steel, etc.)?

If so, the company is exposed to financial risks, even if they do not use foreign currencies. Why? Because they bear the burden rather than the foreign manufacturers, who benefit from a price increase. The foreign suppliers have margins that depend on the costs denominated in their domestic currency. As an example, if the buying company requires payment in its own currency (Euro), it may incur an unexpected increase in costs, depending on the fluctuations of the Euro on the financial markets. Similarly, the purchase of commodities, whose prices are listed in international exchanges, involves an inherent currency risk. Let us examine a practical example regarding the price of copper.

Like the majority of commodities traded in international markets, copper is priced in the US Dollar. The decrease in the US Dollar’s value, with respect to the buyer’s currency, means that the purchaser will need to spend less of their own currency to buy any given amount of the commodity. As the product becomes less expensive, demand for the commodity rises, resulting in an increase in the price and vice versa.

A weak US Dollar may also disincentive producers from increasing output. The prospect of a lower profit margin acts as an incentive to decreasing the copper supply.

In other words, copper prices have a historically inverse correlation with the US Dollar. If the US Dollar appreciates, the price of copper decreases and vice versa.

2.1 The ranking of higher risks

Companies buying commodities are subject to the risks arising from fluctuations in commodity prices and also resulting from the changes in the currency values.

In 2016, all the prices of industrial raw materials increased; most with double-digit increase (zinc + 60%, steel + 47%, tin + 44%). In 2015, the prices collapsed; steel lost 55% and nickel lost over 41%. From this, we see how the variability of prices is very evident in recent years.

In addition to these fluctuations, we must also examine the variability in the foreign exchange market. The prices are in US Dollars and should be converted into the buyer’s currency. The US Dollar value is synthesized in the US$ Index (Figure 3). Since 2015, the US Dollar has strengthened and, even today, it has very high value against other major currencies. This means that we must add the additional cost of acquiring the US Dollars to the rising price of commodities.

  1. THREE PROTECTION TIPS

We will now describe three precautions to protect the company’s profitability.

  1. Financial risks are unavoidable – Consider the exposure to financial risks implicit in your revenues or purchases as unavoidable. But, the damage can be averted if addressed with transparency, coordinating the financial management, Sales teams, and the purchasing department.
  2. Supply chain and finance are crucial – The supply chain and the finance functions are now crucial for firms in all sectors that wish to cultivate new opportunities in global markets. In order to achieve synergistic results, the company must specify objectives and formulate strategies to target a specific goal and coordinate the various operations.
  3. Everything is measurable – In the financial markets, everything is measurable, often in real time. We can measure the success – or the potential loss – of international strategies for a company. This is key, valuable information: to know where is room for improvement; or where, instead, the company must protect or reduce its presence. This is crucial information; information that is now in the hands of all companies thanks to the FinTech technologies(1).

The world is evolving, and FinTech is the optimal choice for the most competitive companies that want to carry on their business and make it grow over time. This is the choice made by those companies, unwilling to passively face fluctuations or (financial, currency and speculative) storms, which will damage their performances and badly affect their turnover. Fluctuations and storms are independent factors that have nothing to do with how good the company is at managing its own business and how successful it is in international markets.

Surf rather than suffer!

(1): FinTech stands for financial technology. Fintech companies provide final services as well as services through the most advanced ICT technologies. The FinTech sector is on an exponential growth trend. In 2008, the world had a US$ 930 million turnover. That reached US$ 12 billion in 2014, with more than 4,000 active companies (Source: The Economist).

 

 

 

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About the Author
Laura Oliva

Laura Oliva

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Co-founder of eKuota. Degree in Corporate Finance from the Universita’ Luigi Bocconi in Milan, she has more than a decade of experience in capital markets. She was Head of Debt Capital Markets within the Allianz Group, she worked at a number of international investment banks. She was Global Product Specialist, Head of Structured Finance and ABS team, Head of Syndication and Credit Analyst. She managed and executed bond issues and loans syndication for major italian companies. She is a Fixed income and Securitization expert, she deals with financial analysis and financial markets. Co-Author of the AdviseOnly blog. Mom of three, born in Rimini now she lives happily in Milan.

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