In the first of a three-part series on risk management, Mark Beyer looks at the management of currency and interest rate risks.
THIS year’s unexpectedly strong rise in the value of the Australian dollar has been a wake-up call for the many Australian companies caught unawares.
From just US56.1 cents at the start of the year, the $A rose as high as US68.5 cents early this month before easing back to current levels around US65 cents.
Exporters who failed to hedge would have been severely burnt, as a rising $A equates to a fall in the buying power of their foreign currency receipts.
ANZ Investment Bank’s head of foreign exchange WA, David Sibley, said exporters appear to have been caught out by the speed and extent of the appreciation of the $A.
He said a lot of small and medium enterprises simply don’t hedge.
For companies that do want to manage their currency risk, a range of products is available.
Mr Sibley said he has noticed an increase in the use of bought options to hedge currency risk.
Options are like an insurance policy. Customers pay a premium to purchase the option, which can protect them from adverse currency movements but allows them to gain from favourable movements.
Jim Cunningham, managing director of Oakvale Capital, which operates an independent treasury service, recommends that businesses develop a risk management policy before they start looking at specific products.
“You should always have a written policy that sets out your risk management framework,” Mr Cunningham said.
“It’s a far more disciplined way to do it.”
He said many businesses mistakenly equated hedging with punting or taking a view on market movements.
Another common flaw was to implement a one-off hedge instead of having a rolling program that is regularly updated.
Mr Cunningham said a risk management policy should specify, among other things, the minimum and maximum hedging levels a business will employ.
He claimed most of Oakvale’s exporter clients had moved to the maximum level of hedging over the past year and were therefore insulated from the rising $A.
Oakvale did not adopt a view on the likely level of the currency, or of interest rates.
However it did focus on the likely direction of the currency (and rates) when providing advice to clients.
Mr Cunningham said Oakvale monitored the forecasts produced by a range of bank economists
“If you use them for the trends you generally get it pretty right. What they don’t get right are the levels.”
He said the risk management policy of each business should reflect their sensitivity to movements in currencies and interest rates.
This view was echoed by Mr Sibley, who said businesses were moving towards managing the effect of volatility on their business as a whole.
“Customers are moving to a more quantitative approach to managing risk that fits in with their budget and strategic business planning,” he said.
“They are treating risk in a total business sense rather than as a silo issue.”
Mr Sibley said ANZ worked with clients to help them measure risk by using tools such as ‘cash flow at risk’.
Similarly, businesses are quantifying the impact of interest rate movements and identifying the point at which high rates would start to have a material (negative) impact on the business. They can then adopt a hedging strategy to ensure this does not happen.
Mr Cunningham said the prospect of interest rates staying around current low levels for an extended period had reduced the amount of hedging by corporate borrowers.
Where companies were hedging, they were increasingly using options-based products such as interest rate caps.
However, in some cases, companies were prepared to lock-in long-term borrowing costs by using interest rate ‘swaps’.
For instance, the five-year swap rate was presently about 5.2 per cent per annum, which was extra-ordinarily low by historical standards.
Mr Cunningham said that while corporate borrowers were less active, Oakvale was seeing more activity on the investing side as companies sought to maximise returns on their liquid funds or working capital.
In particular, companies were seeking to achieve higher returns than were presently available from the bank bill market.
Mr Cunningham said companies could lift returns by investing in a range of short-dated securities, such as floating rate notes, mortgage backed securities and commercial paper.
Prior to investing, companies should formulate an investment policy that addressed issues like liquidity and credit risk.