Managing currency risk has always been part of the cost of doing business globally. But this year companies that have been hit hard by the record volatility are scrambling to find more ways to hedge against the spike in those costs.
In the second quarter alone, U.S. companies sustained a USD $34.25 billion hit to earnings and as well as to assets, liabilities and cash flow from currency volatility, more than double the $14.55 billion from the year-earlier period, according to the latest Kyriba Currency Impact Report, a quarterly review of the reported effects of currencies on 1,200 North American and European companies.
Currency volatility can have many drivers. A currency shock occurs when an unanticipated event, such as a war, or a certain fiscal policy, causes money to suddenly flee to safer ground. “These things can happen but you just don’t know in what shape or form they're going to come in,” Chris Towner, Managing Director, FX & Impact Advisory at Chatham Financial, said in an interview.
At the same time, in this cycle, the U.S. dollar, a safe haven amid financial turmoil, has soared, with the U.S. Dollar Index – which tracks movement of the greenback with six major currencies – surging to the highest level in two decades.
In order to mitigate these risks, companies typically utilize a variety of hedging instruments that help offset swings, such as forward currency contracts, options and swaps. However, in 2022 many companies expanded beyond the contracts that have been the traditional hedging tools.
“This year, because of the increase in volatility, companies are looking more at optionality which acts like insurance,” Towner said.
For example, some small and mid-market companies are starting to use a hedging approach that has historically been used by larger companies known as a portfolio value at-risk strategy, said Andy Gage, senior vice president of FX Solutions and Advisory Services at San Diego-based Kyriba.
What that allows CFOs and treasurers to do, he said, is look at the entire basket or portfolio of currencies they have, and determine if some of those currencies have a tendency to behave in a similar fashion. They then selectively focus on specific currencies that are cheaper to hedge, he said.
Tackling organic exposure
“It’s becoming more important because they’re trying to manage risk in a very expensive hedging environment, he adds, so they have to try new techniques to stay within a hedging budget,“ Gage said.
For Pierce Kohls, CFO of TENTE Casters Inc. - North America, a unit of a German manufacturer, mitigating currency risk this year has had a lot to do with timing his hedges effectively.
“Seventy-five percent of our inventory comes directly from Germany, so that’s a big chunk of our supply chain and that’s all purchased in euros,” he said. When the majority of your cost of goods is in a foreign currency, he added, you want to watch that risk, understand the impacts, and then do anything you can do to mitigate those risks. Kohl hedges the euro with a 12 to 24-month forward currency contract, and only 50% of their exposure at a time.
“If I were buying euros for February 2024, I typically would buy half of my needs 18-24 months out, and the other half 12-18 months out. It’s all about knowing what my costs will be down the road in order to effectively budget and price my products,” Kohls said.
Another tactic that TENTE is using to mitigate currency risk is looking to shift the firm’s global operational strategy. It is now starting to focus on “making for your market,” Kohls said. Effectively, the firm is seeking to reduce the firm’s exposure to the euro by making more inventory locally rather than buying it from Europe. In 2023, TENTE U.S. will reduce its euro dependency by between 15% and 20%, he said.
“Those are some other things that you can obviously do to mitigate that risk and dependency on FX fluctuations,” Kohls said.
Gage also advocates looking inside a firm for strategic moves that can be taken to hedge against currency exposure. “We call this organic exposure elimination and the treasurer and the CFO should be working with the business to understand how they can reduce that exposure,” Gage said.
Finally, whatever hedging strategy CFOs execute, Towner cautions that the current volatility and uncertainty makes it hard for CFOs to get everything right. Given the uncertainty, he said it’s important to get the company’s board to sign off on the hedging plan so that there’s a shared responsibility.