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Managing the Challenge of Increasing Foreign Exchange Rate Volatility

By Frances Coppola

After most developed economies adopted floating exchange rates in the 1990s, managing foreign exchange (FX) rate volatility became a key challenge for international business managers. Admittedly, flexible exchange rates are less likely to undergo sudden sharp depreciations: but constant exchange rate fluctuations nonetheless raise the risk that FX losses will affect companies' bottom line.

For many corporations, treasurers carry the responsibility of minimizing FX risks by deploying modern FX hedging products such as forward contracts and options within a comprehensive FX risk management strategy. In a recent survey by the management consultancy Deloitte, more than half (52 percent) of corporate treasurers surveyed identified FX volatility as their principal concern.1

 

Why Is Exchange Rate Volatility Increasing?

 

In the last few years, there has been considerable exchange rate volatility among commodity exporters such as Australia and Canada. Their exchange rates tend to respond to movements in the price of their principal exports, and commodity prices have been highly volatile. For example, when the U.S. dollar price of iron ore fell in 2015, the Australian dollar's exchange rate versus USD dropped in line with it.2

 

More recently, FX volatility for other major currencies, including the British pound sterling, the euro and USD, has risen due to economic uncertainty. FX markets respond to a range of indicators including central bank monetary policy signals, official and unofficial economic forecasts, and government policy announcements. For example, when the U.K.'s Chancellor of the Exchequer announced modest spending increases in November 2017, sterling's exchange rate rose against both the euro and USD.3 But a day later, disappointing business investment figures from the U.K.'s Office of National Statistics and a gloomy economic forecast from the Office for Budget Responsibility caused sterling to fall.4

 

In the U.S., uncertainty over the economic outlook and the path of Fed monetary policy has made the dollar's exchange rate more volatile. Because of the dollar's dominance in international markets, USD volatility tends to increase the volatility of other exchange rates, including those that are linked to commodity prices. For Australia, USD volatility has recently been a more significant driver of the AUD-USD exchange rate than commodity price movements.5

 

Measuring and Managing FX Risk in a Volatile World

 

When exchange rate volatility is high and the economic outlook uncertain, sophisticated tools such as Value-At-Risk (VaR), Earnings-At-Risk (EaR) and Cash-Flow-At-Risk (CFaR) models can help corporate treasurers manage FX risks more effectively.

 

EaR models calculate the amount by which business income could change if interest rates move.6 As we have discussed before, interest rate movements influence exchange rates, and vice versa. EaR can therefore also help treasurers to forecast the potential impact of exchange rate movements on business income.

 

VaR is the risk management measure of choice for financial institutions. It calculates the amount of business income that is at risk from all forms of market risk, including – but not limited to – interest rate and exchange rate movements. It estimates the maximum potential loss that could arise within a specified period.7

 

CFaR is a modified form of VaR that estimates the impact of market risks on cash flow within a specific period. It can help corporations predict and manage potential disruptions to cash flow arising from market movements.8

 

Sensitivity analysis and scenario planning can also be helpful when uncertainty is high.

 

However, three-quarters of corporate treasurers surveyed by Deloitte did not actively manage VaR, EaR or CFar, and fewer than half routinely performed sensitivity analysis. Although sophisticated risk management tools are widely available, the survey showed that 20 percent of risk management is still done on spreadsheets. Deloitte commented that businesses may want to increase investment in FX risk management technology to help them manage risks better in an uncertain world.9

 

The

Takeaway:

As economic uncertainty rises, international businesses may find adopting more sophisticated tools and practices helps them to manage business risks more effectively. Investing in modern FX risk management technology could prove cost-effective.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. 2017 Global Corporate Treasury Survey, Deloitte; https://www2.deloitte.com/au/en/pages/financial-services/articles/global-corporate-treasury-survey-2017.html
2. “Australia’s commodity currency at the end of the commodity supercycle,” FocusEconomics; https://www.focus-economics.com/blog/australia-commodity-currency-iron-ore-aud
3. “Pound Sterling’s Hammond Nudge Higher Tipped To Be Temporary,” Pound Sterling Live; https://www.poundsterlinglive.com/gbp-live-today/8059-bugdget-buys-time-for-gbp-to-eur-and-usd
4. “The Pound Extends Losses After Business Investment Falls, Economic Growth Steady,” Pound Sterling Live; https://www.poundsterlinglive.com/gbp-live-today/8053-pound-dips-ahead-of-uk-gdp-but-growth-seen-steady-upside-for-sterling
5. “AUDUSD Exchange Rate Fluctuates Amid Mixed US Data,, AUD News; https://www.audnews.com.au/aud-usd-exchange-rate-fluctuates-amid-mixed-us-data-7380
6. “What’s the difference between Earnings at Risk, Value at Risk, and EVE?,” Investopedia; https://www.investopedia.com/ask/answers/041415/whats-difference-between-ear-value-risk-var-and-eve.asp
7. “VaR and CFaR: two ways of measuring risk in the corporate world,” Treasury Management; https://www.treasury-management.com/article/4/224/1896/var-and-cfar-two-ways-of-measuring-risk-in-the-corporate-world.html
8. Ibid.
9. 2017 Global Corporate Treasury Survey, Deloitte; https://www2.deloitte.com/au/en/pages/financial-services/articles/global-corporate-treasury-survey-2017.html

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