First the ruble, then the franc

First the ruble, then the franc

To more than one German or Austrian mayor, reading the morning papers on January 16, 2015 must have felt like Ash Wednesday to a Carnival reveler — a sobering experience. The day before, the Swiss National Bank's announcement that it would no longer defend an exchange rate floor of 1.20 Swiss francs per euro had triggered a veritable avalanche in forex markets. In the aftermath, Swiss franc-denominated loans taken out years before to take advantage of low interest rates left a trail of destruction in municipal finances. What's unsettling about the story is that some municipalities had apparently been unaware of the FX risks of the loans until things turned ugly — attracting suitably unpleasant inquiries from the media.

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Although industrial and commercial enterprises generally hedge transaction risks against exchange rate fluctuations, the unexpected unhitching of the franc did not leave them unscathed either. Particularly for businesses with production in Switzerland and a high percentage of exports to the eurozone, a long-term strong franc is a drag on profitability and brings forex management to the center of the CFO's attention. Questions about translation risks and economic risk also play a role.

As the examples show, to avoid surprises, remain informed and retain freedom of action at all times, it's high time companies took a magnifying glass to their existing currency management processes and strategies.

The first point of scrutiny should be the mechanism for determining exposure, a cornerstone of currency management whose quality must be assured. From (correct, timely, complete) reporting by remote units through back-testing of time sequences to (error-free, methodologically consistent) aggregation, the process must be precisely and effectively structured. It is essential for both direct and indirect effects to be considered across the entire value chain. It is not uncommon, for example, for forex risks on the purchasing side to be hedged even as their effects are swamped by those on selling prices. By practicing one-sided hedging a company may be increasing its risk, not reducing it, relative to the competition.

Risk appetite and risk capacity should also be reviewed and adjusted if necessary when deciding whether to assume the costs of hedging. Concurrently, the risk measures employed should be examined for their suitability and perhaps replaced by more sophisticated methods (such as CFaR) before making changes to the hedging strategy or hedging instruments used. As we noted in a previous article in this newsletter, the considerable increased volatility of the ruble, for example, was an early warning sign of further potential changes. Organizations that have avoided hedging until now because of the considerable interest costs involved (and the consequent empirical advantage of settling at the spot exchange rate) could likewise, given appropriate risk monitoring using this market indicator, have implemented situational hedging and in many cases avoided substantial losses from unsecured positions.

One thing to consider in relation to hedging instruments is how well they fit the organization's particular risk profile. Increasing use of options can become costly if a strike price is not chosen based on careful analysis so that the sum of option premiums is less than the opportunity cost of alternative hedging via forward transactions. 

Given its importance as the basis for decision-making and capital market communications, careful scrutiny of management reporting also plays an important role. Currency management should not be viewed in isolation; instead, interdependencies with liquidity management and corporate finance, for example (such as hedging of translation risks in the context of debt covenant management) must be discernible.

Properly structured, currency management enhances planning certainty within the risk horizon, reduces the likelihood of extreme impacts on profit and provides support for capital market communication — in brief, it can help prevent a sober awakening.

Source: KPMG Corporate Treasury News, Edition 40, February 2015

Author: Johannes Goebel, Manager,

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