This year, events have conspired to bring about an unprecedented level of currency fluctuation, with Brexit then Trump sending foreign exchange markets into turmoil and currency shifts causing a significant impact on company profits.
As of October, the pound had lost more than 15% of its value since the start of the year. This is unlikely to stop come December 31st, with the Italian referendum and French election potentially sparking further instability. This presents a major challenge to CFOs. Sam Hartwell, CFO of nonprofit KickStart, argues that it is in fact the greatest challenge of the next year, saying, ‘Currency fluctuation amid ongoing volatility in Forex Exchange creates a lot of challenges related to pricing and maintaining margins for companies operating in emerging markets.’
A CFO whose organization is involved in international trade has to be concerned with any potential changes in the value of trading partners’ currencies. In order to deal with the threat of currency devaluations it is vital that CFOs are nimble, and they need a strategy for providing strong foundations for FX risk management.
This means identifying threats ahead of time and implementing a system of rolling forecasts, which can be constantly updated to reflect potential threats and other changes to circumstances. It means understanding all exposures. It used be that when the US dollar rose, a situation that no longer exists as currency volatility is now non-correlated. If a CFO doesn’t know his Euro risk, he can’t manage expectations with his CEO and board around how the company should expect to be impacted by the Euro fall.
CFOs should also be careful to avoid long payment terms when selling, while conversely trying to get the longest possible credit terms when buying. They should also avoid advance payments so as to wait for currency to get less expensive.
The most important thing CFOs need to do is introduce and maintain a complex balance of hedges. As one currency devalues, another will rise, and CFOs need to realize the opportunities inherent in having a balanced portfolio. There are two types of foreign currency risk – transaction risk, an exchange rate changing between the transaction date and the subsequent settlement date, and translation risk, the risk that a company's equities, assets, liabilities or income will change in value because of exchange rate changes.
Equally, while it is vital to hedge properly, it is also important not to over hedge. CFOs have to understand the underlying risks of foreign exchange rates and how to measure them before selecting a hedging strategy, as it can end up proving unnecessarily costly. The decision to hedge should be considered in relation to the potential impact of net asset value translation on the capital base of the company, and it is not worthwhile to do if the cost of borrowing foreign currency debt amounts to more than the borrowing in the group’s consolidation currency.
Finally, CFOs need to be in a strong position when it comes to understanding the risks to currency valuation so they can plan accordingly, and at the moment many are not. In Deloitte’s 2016 Global FX survey, 56% of respondents said that ‘lack of visibility and reliability of FX forecasts is the biggest challenge in managing FX risk.’ The better a finance department is at spotting FX risk, the more chance their hedges will be balanced. It has been a challenge to see FX risks this year, with Brexit and Trump in particular considered highly unlikely by many. Next year, CFOs need to do a better job of foreseeing the unforeseeable.