In Today’s financial environment money knows no boundary. Digital currencies such as “bitcoin” have been accepted by large institutional investors and emerging currencies as the Yuan is replacing the US Dollar for commercial transactions world wide. More international mobility of capital is providing benefits for firms, by allowing them more financial options but at the same time is adding complexity.
Companies should consider suitable and often innovative analysis for strategic finance.
1. THE VIEWPOINT OF AN EUROPEAN COMPANY
In Europe, the adoption of the single currency has created a very favorable environment for business transactions between some member countries. The crisis has forced most companies to export to markets outside the Eurozone and tackling issues related to the management of multi-currency environments.
The figure above shows that Euro has mostly fallen against the US Dollar since last year. The Euro’s depreciation has been attributed to the strength of the US economy combined with the slowness of may European countries in performing the necessary reinforcement of their economies. The US economy is considered dynamic and flexible; that contrasts with a view of Europe as a region with high taxation levels, labor rigidities and heavy bureaucracies.
1.1 Volatility
Last year, 1,000 USD were worth 750€, today they are at 890€. On one side we have the weakening of the Euro, which is good for exporting companies. They have receivables that will be paid in strong currency. But, on the other side, this is a crucial problem for importers. They don’t know exactly the value of the USD they have to pay at maturity of their invoices and if the downsizing trend of the Euro will persist, they will have to pay higher rates than today’s exchange price.
The Figure above show a key measure of risk in financial market: the volatility.
Volatility is a standard deviation that measures the variability of prices and their dispersion. It is an indicator of the potential price fluctuation.
The risk (or volatility) of the Euro/dollar price is on a broadly increasing trend.
The increased volatility of the Euro/Dollar fixing is a warning signal. If prices in the financial markets rise and fall greatly, this increases the uncertainty of what will be the prices set in the following days.
In a market where volatility is low, prices have no big swings and there are no surprises about future prices.
Conversely, if my company has a payment in foreign currency to be settled in a few months, as the euro/dollar fixing has become very volatile, the price I have pay at maturity is probably far from that of today.
1.2 Why so much volatility?
In the last few months, the Euro/Dollar fixing (in just one day) moved by +/-2% three times. On 22nd January the Euro weakened by -3%. On 18th of March the Euro appreciated by +2,3% and on 2nd of June by +2%. In the whole of 2014 it has never happened.
Current high level of volatility are mainly due to three factors:
1) the difficulties to assess the consequence of the political match between Greece and the Eurozone;
2) the lower global growth;
3) the misaligned monetary policy by the major central banks.
We are in presence of an explosive mix of macroeconomic conditions that captures the tensions in the financial markets and influences the choices of the operators, pushing to strong price fluctuations in one direction or the other. Often the volatility is associated with the feeling of fear, therefore, the volatility index is also known as the “fear index”.
2. THE SCENARIO BY THE END OF THE YEAR?
2.1 A practical example
A big challenge for corporates is forecasting market rates over the horizons, associated with business plans. In order to develop the necessary scenarios, eKuota applies its special developed proprietary econometric model.
The eKuota approach is now explained with a practical example, focused on foreign purchases.
How it is possible to calculate maximum shortfall in respect to the company’s target?
Let us imagine a practical case of a cash flow at risk due to foreign exchange risk.
Let us imagine that a European company buys commodities (such as copper or aluminum, etc.) or components in US dollars. The companies fixed fx rate for budget purposes, as at end of 2015, is 1.2 Euro/USD.
The company, for its USD denominated purchases, would like to calculate the risk associated to the fluctuations in the Euro/ USD exchange rate.
The company projected total purchases in USD, as at December 2015, are USD 100,000 assuming that its purchase projections will occur with certainty. Its only risk is therefore due to potential fluctuations in Euro/ USD exchange rates.
As shown in the following Figure the company has a budget-target represented by the green slash. The worst case scenario is represented by the red slash.
In the Table 1, we can see the exact amount at risk. The budget planned an amount of 89,940 Euro for purchases in US Dollars at a budget rate of 1.2 (Budget Cash flow).
In the worst scenario, shown in Table 1 the company may spend 107,618 Euro for its purchases: a difference of +29% on its budget.
This number means that with 99% confidence, fluctuations in the Euro/USD exchange rate untill the end of year will cause a cashflow shortfall of not more than 24,285 Euro.
Using this result, the company can assess whether this level of risk due to foreign exchange is acceptable. This information can be used when deciding whether or not to hedge the foreign exchange exposures or when reporting to directors or to shareholders, or when negotiating with banks.
3. CONCLUSIONS
For most national companies operating in international markets, we believe a prudent approach would be to allocate sufficient time and resources to analyze financial risk budget exposure.
In the current environment, mangers have the temptation to skip away from financial markets issues. Such approach might have sense for domestic companies not involved in foreign markets.
On the other hand, those companies active on the international markets should not compromise on assessing financial market risks with due level of complexity.
Ultimately, the objective of using a tools as the eKuota one, is to complement the existing strategic financial planning, making projection more robust, in an increasing uncertain and volatile environment.
The company’s ability to adapt to a changing environment is at the very heart of the company survival.
