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Managing Exchange Rate Volatility

John O'Rouke and Karen Dale Torre

Introduction


According to one study1, 59 percent of organizations are vulnerable to material fluctuations (+/- 5%) in net income owing to currency volatility, and that position is deteriorating. Continuing threats, such as the potential collapse of the Euro, along with hyperinflation in Japan, highlight the increasing complexity and difficulty of managing currency risk on a daily basis. The question for many organizations remains: how best to manage exchange rate volatility?

While traditional hedging techniques leverage financial instruments to offset short-term currency fluctuations, these tools may prove unsuitable for managing currency volatility in the longer term. At the same time, increased risk is pushing up the cost of traditional hedging techniques and limiting the availability of hedging products from financial institutions. So, how should businesses respond?

Operational Hedging


Those enterprises facing long-term exposure to currency fluctuations might consider adopting operational hedging strategies in order to mitigate their risk. Operational hedging introduces a greater degree of flexibility into an organization's supply chain, financial position, distribution channels, and market-facing activities. The aim is to create an agile and adaptable operation that can respond rapidly to currency fluctuations in such a way that any adverse currency movements—which would otherwise have an impact on costs and revenues—are offset, while ensuring the company's ability to compete is not impeded. However, organizations pursuing an operational hedging strategy need to have a variety of tools and techniques at their disposal in conjunction with a business model that is compatible with this type of strategy.

Mitigating the Risk


One of the most common alternatives to hedging is to mitigate the risk of currency fluctuations by sourcing materials, manufacturing products, and selling them within the same market. By buying and selling in the same currency the costs should remain broadly aligned. However, for global enterprises whose operations span multiple geographic locations, pursuing such a strategy may not be feasible, and setting up multiple manufacturing sites could be inefficient and problematic.

More sophisticated techniques include developing geographically agile supply chains and logistics frameworks to deliver the products or services. The greater the degree of flexibility, the more likely it is that the organization can hedge effectively. In doing so, organizations can capitalize on currency arbitrage opportunities as they arise and, for example, take advantage of the cheapest suppliers.

Globalized companies can also take advantage of strengthening currencies by concentrating their sales and marketing in these locations. However, in order to engage in this type of strategy it is important to ensure that operations and logistics are aligned to deliver in these locations and that the product is relevant to the local market. If the costs of getting the product to market outweigh the exchange gain, there may be little benefit in pursuing such a strategy in the short term.

On the other hand, large multinational organizations, such as Oracle-that are heavily diversified across product, markets, and currencies-are, in effect, invested in a basket of world currencies and for all practical purposes largely self-hedging. As a result, Oracle takes the view that it is only necessary to hedge on a very limited basis, such as intercompany trading.

Understanding Currency Impacts


Before a company can begin to contemplate reducing its exposure to currency risk, it needs to understand how it is affected by currency fluctuations. Moreover, significant and damaging currency movements can happen in an instant and are often unpredictable.

ERP technology and specialized treasury management systems can play a pivotal role in enabling organizations to quickly identify their exposure to currency risk, and can subsequently notify C-level management, who can then make appropriate decisions.

But many organizations fail to review currency conversion rates in a timely manner, with some only reviewing rates on an annual basis. As a result, capital projects, major product releases, or large customer contracts sealed some months earlier, may no longer be profitable or viable. Yet many companies fail to realize the impact until it is too late. Ensuring these kinds of activities are linked to real-time spot and forward rates, which can help give a more realistic insight into the true (currency-adjusted) cost or profitability of major initiatives and can inform timely decision-making, allows management to renegotiate a sales contract or re-phase a capital project.

Consider Oracle's treasury management solution, which can link to the FXL portal and provide real-time spot and forward rates from a number of banks. This information can then be run through scenario planning models and incorporated into budgets and forecasts to quickly identify the risk to an organization's margins.

Managing exchange rate volatility is a challenging and relentless task, and there is no one-size-fits-all solution. Organizations may need to adopt a variety of strategies to effectively hedge their business, and these are likely to vary according to industry, geographic location, and the nature of the enterprise itself. Unfortunately, many organizations spend too much time identifying the exposures, leaving management less time to figure out how they are going to respond. Having the right technology is paramount to informing C-level management of the exchange risks.

1 Foreign Exchange Exposure Management: SunGard AvantGard Insights 2010

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