The CFO's comprehensive guide to managing currency risk for 2017

The CFO's comprehensive guide to managing currency risk for 2017

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  Global Markets The CFO’scomprehensive guide to managing currency risk for 2017 December 2016
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  Introduction: Two political events,Brexit and the election of Donald Trump as US President, both previously considered unexpected outcomes, have now defined 2016. Political risk became a key driver of FX volatility and this looks set to continue in 2017. The purpose of this document is to identify & review the key issues for CFO’s managing the currency exposure from international trade in 2017. The focus is on key currency markets of Euro, Sterling and US Dollars. Authors: What you will learn: • The top 5 macro themes in Financial markets for 2017 • What’s driving FX opinion… the consensus & outlier views explained • Look ahead to the key dates, events & talking points for 2017 • What the currency options market is telling us now about 2017 • The 3 essential steps in building a currency risk strategy Ciaran Cash Corporate & Institutional Treasury Bank of Ireland Global Markets Vincent Crimmins Head of FX strategy Bank of Ireland Global Markets
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  1 It is shapingup to be a very interesting 2017 with a number of important questions looming. Is this the end of the great 30 year bond bull run? Are we seeing a rotation out of fixed income products and back into equity investments? Will fiscal policy take over the market driver mantle from monetary policy? On the political front, are we seeing a shift away from centrist, globalisation and integration friendly politics to populist, protectionist and isolationist policies? As a consequence, will free trade and global trade agreements be cast aside? Are we finally going to see the end of developed markets importing deflation from emerging markets and enter a reflationary period? There are many long term themes which seem to be on the verge of turning. All will have a bearing on FX volatility and direction in 2017. We have elaborated on our top 5 key themes below. Political Risk The votes for Brexit and Donald Trump as the 45th US President have raised concerns around upcoming political change, particularly in Europe where the political calendar is heavy next year. On the 4th December, the Austrian electorate decided against the far right candidate in their Presidential election re-run. The Italian constitutional referendum was also rejected leading to Prime Minister Renzis resignation. We now add the prospect of fresh Italian elections to a heavy European political calendar next year. The Netherlands hold national elections in March, France has its Presidential election in April and May and Germany will have an election by the 23rd October. Populist parties have been gaining support across Europe and should mainstream political parties lose control of government, the unpredictability of unknown quantities tends to unsettle markets. Some of the non-mainstream parties gaining support are openly anti-EU, which has raised concern from some quarters on the future of the EU. In the UK, the timing of when Article 50 is triggered remains unclear, as is the approach the UK Government will take with Europe (‘hard’ versus ‘soft’ exit). In the US, in the first quarter of next year discussions around the US debt ceiling will re-surface, which has caused gridlock on previous occasions. Monetary Policy Monetary policy is likely to continue as a key driver of markets in 2017. The ECB is expected to extend its Quantitative Easing (QE) program at its December meeting and likely to continue purchasing Euro area assets for most of next year. The Bank of England restarted its QE program this year and Japan has also been running a QE program. QE targets long term yields and while it was undoubtedly effective in reducing those yields, questions are now being asked about its continued effectiveness. By contrast, the Federal Reserve is likely to raise interest rates in December and its QE program ended some time ago. With developed market interest rates near zero it will be interesting to see how monetary policy evolves over the year, particularly with the expectation of increased activity in the fiscal policy space. Fiscal policy Since the beginning of the great financial crisis, monetary policy easing has been seen as the go to medicine to cure the ills of the global economy. However, after several years of deliberate fiscal austerity, there is now a growing chorus of political and financial leaders calling for a shift away from monetary policy and towards looser fiscal policy to generate spending and economic growth. The most notable political leader to heed such calls is the newly elected President Trump, who has suggested fiscal easing of some $1 trillion. Similar to its first- mover stance in terms of monetary policy, the US now looks like the first major economy to embark upon a policy mix of monetary tightening and fiscal easing. Such a mix has, in the past, been seen as supportive for the domestic currency. This mix is what fuelled the Dollar rally of the 1980’s and could drive further Dollar strength in 2017. Inflation As was the case with combatting ailing economic growth, monetary policy was the prescription to stem global deflationary forces. So anxious were central bankers to obtain a 2% inflation rate that they embarked upon a period of unprecedented asset purchases while also cutting rates into negative territory. Yet despite these measures, inflation has remained quite subdued. That said, several factors are beginning to align for inflationary forces to emerge in a ‘perfect storm’ type fashion. With rising energy and hard commodity prices coupled with significant public spending forecast in the US, Japan, China, and to a lesser extent Europe, the desperately sought after inflation mandate may finally be achieved in the year ahead. Trade The rise of the populist ideology has gathered significant pace post – the great financial crisis. Most notably, this year’s vote for Brexit and the election of Donald Trump are clear indicators that this pace is gathering strength. While there are arguably a plethora of economic impacts from these public decisions, none are more immediate and more obvious than the threat to international trade. Over the course of the Clinton and Obama eras two trade agreements have evolved – the North American Free Trade Agreement and the Trans Pacific Partnership. Similarly, the basic concept of the European Union was to allow the free movement of goods and people between member states. The recent outcomes in Britain and the US look to have both partially and fully jeopardised such agreements. In both cases new trade agreements may have to be drawn up, and the most likely outcome is a return of tariffs and embargoes and ultimately adverse effects for those economies that rely heavily on foreign trade. The top 5 Macro FX themes you need to know for 2017 By Vincent Crimmins, Head of FX strategy
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  EUR/GBP – Currentrange of opinion & rationale: Direction Range How might this happen? (High) Parity & Beyond EU: Positive election cycle in Europe leads to stronger more cohesive European Union EU: Stronger economic growth & inflation expectations above ECB forecasts force a change to the ECB’s current accommodative monetary policy stance UK: Brexit impacts confidence in the UK economy, ensuing UK current account crisis results in a further significant devaluation of the Pound UK: Economy fails to sustain current robust post-Brexit characteristics & Bank of England expand their QE program (Consensus) €/£ @ 0.88p UK: Consensus opinion has a slight upward bias to EUR/GBP as uncertainty surrounding the outcome to Brexit dominates market sentiment (Low) Sub £0.70p EU: Further shift towards populism & political parties with anti – EU Stance EU: Economic growth lurches lower resulting in further expansion of ECB accommodative policy UK: Successfully navigates Article 50 and secures beneficial trade agreements with key partners UK: No Brexit economic impact with Bank of England to row back additional monetary easing brought about in August EUR/USD – Current range of opinion & rationale: Direction Range How might this happen? (High) $1.20 & Beyond EU: Positive Euro scenarios as outlined in EUR/GBP table above US: President Trump protectionist policies backfire on US industry with spill over effect of rising unemployment US: Economy performs well but a slower global economy forces the Fed to row back future rate hike expectations US: Unforeseen asset bubble burst – akin to that which started the Global Financial Crisis – again the Fed and Treasury are forced to intervene US: The new US administration are unable to agree a solution on US debt ceiling next year, triggering a US technical default (Consensus) €/$ 1.05 – 1.00 EU: ECB to continue asset purchase QE program through 2017 US: Consensus view is for the Dollar to remain strong reflecting the expected upward trajectory of US interest rates (Low) €/$ $0.80 EU: Negative scenarios as outlined in EUR/GBP table above US: Economy overheats from the fiscal easing measures undertaken, the Fed are forced to hike rates faster than they or the market expect US: Non – US led financial or geo-political crisis sees the Dollar’s safe haven appeal increase rapidly What’s driving FX opinion? ... The consensus & outlier views explained By Vincent Crimmins, Head of FX strategy 2
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  Europe Political risk nowtakes centre stage with a number of key European elections scheduled in 2017. Will the same sentiments expressed by the UK and US Electorate carry through to European elections? What could this mean for the future of the European Union? United Kingdom British Prime Minister Theresa May has indicated a preference to have Article 50 triggered by the end of March 2017, despite the recent High Court defeat. An exact date has yet to be finalised, but this will likely be a key event for the UK next year. United States The inauguration of Donald Trump as the 45th President of the United States will take place on Friday, January 20th 2017, while the first 100 days will be marked on 30th April. The US debt ceiling is currently suspended until March 15th, thanks to the accord reached in October 2015. A solution will need to be found about how to accommodate the current debt and spending levels for after this date. A look ahead to the key dates, events & talking points for 2017 By Vincent Crimmins, Head of FX strategy 3 Election risks could weigh on the Euro in 2017 Scheduled and potential political events in Europe Source: Moody’s Investor Service SPAIN Parliamentary Elections (potential) HUNGARY Parliamentary Election: In or before Spring 2018 FRANCE Presidential Election: 23 April and 7 May (2nd round) 2017 NETHERLANDS Legislative Election: 15 March 2017 CZECH REPUBLIC Parliamentary Election: In or before October 2017 GERMANY Federal Elections: Between 23 August and 22 October 2017
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  EUR/GBP - Spotprobability & forward curve EUR/USD - Spot probability & forward curve Source: Market data Bloomberg 21/11/2016 Source: Market data Bloomberg 21/11/2016 0.740 0.940 0.765 0.965 0.790 0.990 0.815 1.040 1.015 0.840 1.065 0.865 1.090 0.890 1.115 0.915 1.140 0.940 1.165 0.965 1.215 1.190 1m 1m 3m 3m 6m Months EUR/GBPEUR/USD Months 6m 9m 9m 12m 12m 15% probability Euro to trade below here 15% probability Euro to trade below here 15% probability Euro to trade above here 15% probability Euro to trade above here 1 Std Deviation (Low) 1 Std Deviation (Low) 1 Std Deviation (High) 1 Std Deviation (High) 50% confidence 50% confidence 50% confidence 50% confidence €/£ Fwd curve €/$ Fwd curve FX implied volatility is essentially the markets’ current best guess on future FX price range & movement. It is the key component in the premium cost of currency options (the insurance market for currencies). Given its forward outlook, taking all relevant currency information available into account, implied volatility can also provide some valuable insights for FX risk managers. What the currency options market is telling us now about 2017 By Ciaran Cash, Senior Dealer Corporate Treasury sales As the outlook for currency risk becomes less volatile, the market will price a tighter range of outcomes ahead. Conversely, a more volatile risk outlook will see this probability range fan out as more extreme scenarios become more plausible. As of 21/11/2016: 50% of the potential spot outcomes in 2017 are currently expected to fall within the dashed lines (opposite). The range of outcomes falling within 1 standard deviation is illustrated between the solid lines across. 1 Potential range of spot outcomes: 4
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  EUR/GBP - 9mthVolatility smile EUR/USD - 9mth Volatility smile 10.00 8.00 10.50 9.00 11.00 10.00 11.50 11.00 12.00 12.00 12.50 13.00 13.50 13.00 14.00 14.00 14.50 15.00 15.00 16.00 5p 5p 45c 45c ATM ATM 25p 25p 25c 25c 15p 15p 35c 35c 35p 35p 15c 15c 10p 10p 40c 40c 30p 30p 20c 20c 20p 20p 30c 30c 40p 40p 10c 10c 45p 45p 5c 5c Range of EUR/GBP strike rates (expressed as delta) below & above current “at-the-money” level Range of EUR/USD strike rates (expressed as delta) below & above current “at-the-money” level EUR/GBP: Pre-US election the market was charging a higher premium to hedge sterling receivables for conversion back into Euro. With increased focus now on European political risks ahead, the probability of Euro negative tail risks in 2017 has increased. The more symmetrical chart across (today versus 8th Nov) reflects a more balanced EUR/ GBP directional risk outlook for 2017. EUR/USD: € put / $ call options protecting the buyer against EUR/USD continuing lower are currently in greater demand. This skew has become more exaggerated post the US election. This indicates greater market concern on the potential for continued Dollar strength / Euro weakness ahead. 2 Directional market bias: If the market perceives greater risk of the FX spot price moving in one direction over the other, it will charge a higher premium accordingly. The charts below illustrates the implied volatility for the range of FX option strike rates both above (right hand side) and below (left hand side) of the current “at-the-money” forward rate. ImpliedVolatility%ImpliedVolatility% 08 Nov 16 Current € put / £ call options hedge Euro downside risk < > € put / $ call options hedge Euro downside risk < > € call / £ put options hedge Euro upside risk € call / $ put options hedge Euro upside risk Volatility skew Volatility skew Implied vol is now more symetrical post US election. Vol curves illustrated below compare 8-Nov-16 V’s current Implied vol is skewed as the market currently demands a higher price to insure Euro downside risk versus an equivalent move higher 5 Source: Market data Bloomberg 21/11/2016 Source: Market data Bloomberg 21/11/2016
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  €/£ spot 9m€/£ risk reversal EUR/GBP – Spot & Risk reversal 0.650 -2.000 -1.000 0.000 1.000 2.000 3.000 4.000 0.675 0.700 0.725 0.750 0.775 0.800 0.850 0.825 0.875 0.900 0.925 0.950 0.975 Jan 15 Jan 16Apr 15 Apr 16Jul 15 Jul 16Oct 15 Oct 16 €/£Spot €/£RiskReversal The premium cost to hedge sterling receivables for conversion back into Euro, remains at a slight premium for 2017 but to a far lesser degree than pre- Brexit. Tail risks in both directions are now at similar levels of implied volatility. So while volatility remains elevated, the bias in terms of direction is more balanced now. 3 Risk reversal: The risk reversal can illustrate how the above market skew changes overtime. By subtracting the implied volatility of the put option from similar “out-of-the money” call option, this produces a value above or below zero. When the risk reversal value is above zero, call options are more expensive. This implies that more market participants are concerned about the underlying spot price moving higher. Looking back at EUR/GBP in 2016, the risk from Brexit first materialised in the options market with the risk reversal moving higher. The spot price soon followed but it was the risk reversal that first reflected changing market opinion on the balance of risks for Sterling. When the UK vote to leave the European Union 23rd June 2016 was confirmed, this risk materialised. EUR/GBP immediately traded higher to reflect the new paradigm and made another move higher in October in response to “Hard Brexit” rhetoric from the UK Government. (See chart below). Source: Market data Bloomberg 21/11/2016 6
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  Direct FX exposure:Indirect FX exposure: • Transaction exposure is the one most clearly identifiable and arises as result of a mismatch in currency denomination of your operating costs & revenue. • Translation exposure describes the impact on consolidated Company financials when foreign currency assets/liabilities are reported back into your domestic reporting currency. • In an open economy you are potentially exposed to appreciation of your domestic currency. This can attract new or increased competition in your home market from international suppliers operating from a lower cost base. Their weaker currency can improve their price competitiveness to challenge your market share and/or squeeze margins. • Companies with unpredictable & volatile currency exposure may have a higher cost of capital. Pricing: • Having thoroughly reviewed your price elasticity of demand, negotiate terms with your customers as to what extent and how often prices can reset to currency volatility. • By invoicing international sales in your domestic operating currency, this completely passes the FX exposure to your customers. This approach requires careful consideration as you lose control of pricing in your end market. How easily can you be displaced by competitors providing more convenient or favourable terms? Operational: • Transferring some or your entire operating cost base closer to your end market can create a natural currency hedge. • However it can take time to establish a new international operation and perhaps this is a long term solution for what may be transient problem (FX volatility). • The new international operation must have sufficient volume passing through to achieve the required economies of scale. Strategic FX hedging: • With any forward hedging program, you are in effect creating a business specific FX rate as an alternative to the wholesale FX market rate. How do you need this hedge rate to perform during spells of FX market volatility? • The range of hedging products & solutions available is extensive including FX forwards, currency options & structured derivatives. The focus should always be on achieving objective in all scenarios of FX volatility. Currency exposure can be complex and originate from a variety of sources. Effective risk management is a key strategic process that requires careful consideration every step of the way. This largely involves understanding your price elasticity of demand. (e.g. How sensitive is demand for your product or service to a change in price?) This will determine the extent to which you can pass through adverse currency adjustments to customers while also retaining your market share. Companies exporting to the UK from a Euro operating cost base are currently managing a 27% appreciation in the Euro against Sterling (year on year, Nov-2015 to Nov-2016. Source: Bloomberg). To what extent and how often can these businesses adjust their Sterling retail prices to offset currency volatility? FX rates are continuously moving targets and it is notoriously difficult to identify peak or trough turning points. If it’s not possible to increase prices, the alternative is an internal adjustment i.e. reducing your operating costs to offset a currency induced loss of competitiveness. This is clearly the more painful & challenging route but may be the only option. The 3 essential steps to building a currency risk strategy By Ciaran Cash, Senior Dealer Corporate Treasury sales 1 Identify the exposure: 3 Decide your hedging strategy: 2 Understand the risk: 7
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  Volatility reduction: A layeredapproach: Looking across at EUR/GBP probability & range of spot prices currently estimated for 2017. At a simple level if your objective is purely to minimise volatility in 2017, by hedging 50% of your annual exposure at today’s forward rate, you immediately reduce your 2017 volatility by 50% Using a layering strategy to average-in your effective rate for each business period you can address this issue. By continuously adding new layers of hedging at regular intervals over your risk horizon, you can create an averaged FX hedge rate to perform more like illustration (across). EUR/GBP – Spot probability & forward curve EUR/GBP – Historic layered hedging performance Two limitations of this strategy are the full year effective rate is influenced 50% by market conditions at a single point in time when the hedging transaction is completed. This rate may or may not be reflective of the year as a whole. It also introduces a rollover risk i.e. timing of the following year’s hedging transaction. This approach requires a systematic process which is effective at removing the high/lows in volatility. It also allows a business time to adjust and ascertain if market volatility is temporary or if a more structural currency adjustment is underway. Structured products: There are a vast range of hedging products and solutions available to create a desired hedge performance. Structured products combine two or more currency options or financial instruments. In many cases these solutions can be tailored to limit FX volatility within a pre-defined tolerance range of outcomes. When reviewing these structured solutions, the focus should always be on the end product achieving your desired business objectives in all scenarios of FX volatility. Historic EUR/GBP Spot Layered Hedge performance Source: Market data Bloomberg 21/11/2016 Source: Market data Bloomberg 21/11/2016 0.775 0.800 0.6 0.825 0.65 0.850 0.7 0.875 0.75 0.900 0.8 0.925 0.85 0.950 0.9 0.975 0.95 1.000 1 1m 3m 6m Sep 06 Sep 07 Sep 08 Sep 09 Sep 10 Sep 11 Sep 12 Sep 13 Sep 14 Months EUR/GBPEUR/GBP 9m 12m 15% probability Euro to trade below here 15% probability Euro to trade above here 1 Std Deviation (Low) 1 Std Deviation (High) 50% confidence 50% confidence €/£ Fwd curve Sample approaches to FX hedging 8
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  DISCLAIMER This document hasbeen prepared by Bank of Ireland Global Markets (“BoI” or the “Bank”). This document is for informational purposes only and BoI is not soliciting any action based upon it. Any information contained herein is believed by the Bank to be accurate and true but the Bank expresses no representation or warranty of such accuracy and accepts no responsibility whatsoever for any loss or damage caused by any act or omission taken as a result of the information contained in this document. No prices or rates mentioned are bids or offers by the Bank to purchase or sell any currencies, securities or financial instruments. Except as otherwise may be specifically agreed, the Bank has not acted nor will act as a fiduciary, financial or investment adviser with respect to any transaction that it has executed or will execute. Any investment, trading and/or hedging decision of a party will be based on its own judgment and not upon any view expressed by the Bank. The issuing of this document is not a commitment to enter into any transaction or to negotiate terms or conditions thereof. The decision to make a firm offer on any transaction may be subject to, inter alia, BoI’s assessment of the final structure of, and the risks involved in, any transaction, internal credit approvals, satisfactory outcome of due diligence and the execution by the relevant counterparty of legal documentation acceptable to BoI. Opinions expressed herein reflect the judgment of BoI as at 07/12/2016 and may be subject to change without notice if the Bank becomes aware of any information, whether specific to any transaction or general, which may have a material impact on any such opinions. Nothing in this document should be relied on as providing legal, tax or economic advice or recommendations. You should obtain independent professional advice before making any investment, trading and/or hedging decision. This document is the property of BoI. The content may not be reproduced, either in whole or in part, without the express written consent of a suitably authorised member of BoI staff. Bank of Ireland is regulated by the Central Bank of Ireland. In the UK, Bank of Ireland is authorised by the Central Bank of Ireland and the Prudential Regulation Authority and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our authorisation and regulation by the Prudential Regulation Authority and regulation by the Financial Conduct Authority are available from us on request. The Governor and Company of the Bank of Ireland is incorporated in Ireland with limited liability. Registered Office - 40 Mespil Road, Dublin 4, Ireland. Registered Number - C-1. If you would like to discuss any of the issues raised further please email [email protected] Summary & key takeaways for 2017: • FX volatility expected to remain at elevated levels • Political risks now centre stage in Global FX markets. • Focus on key European elections & potential to undermine EU stability • EUR/USD: downside risks dominate current market sentiment • EUR/GBP: Heightened volatility from significant political uncertainty Would you like us to keep in touch? Please click on the button and fill out your details to receive further communication from us. click here