Articles

The 10 most common pitfalls of risk management

By Harry Mills June 25th, 2019

Pitfalls of risk management

Clients often come to us after falling into the same pitfalls when attempting to manage their foreign exchange risk.

Unfortunately, over the years we have seen that the same mistakes are made across all sectors, with both large and small businesses, and they often lead to costly consequences. In this article, we’ll highlight the pitfalls that are all too common, and explain how we can help you to avoid them.

  1. Not knowing the extent of your foreign exchange exposure

Foreign exchange exposure refers to the risk associated with activities in currencies, other than your firm’s home currency. So, for a UK company we would consider a foreign exchange exposure arising from any non-sterling import costs, export revenues, borrowing/deposits, overseas subsidiaries or overseas assets.

Understanding the full extent of your foreign exchange exposure involves getting to grips with the various cash in and outflows generated from all activities in foreign currencies. It’s important to appreciate the magnitude of your foreign exchange exposure in relation to your costs, turnover and profits. For example, a net-exporter is detrimentally affected when their home currency increases in value. If the contribution of export revenues to total turnover is relatively high, the exposure and potential risks are greater.

Early in the process, your Account Manager here at Smart will talk you through the factors that can affect currency markets in order for you to get a better understanding of your company’s exposure levels. It is important to do this before taking any further steps. Neglecting to account for volatile currency movements can lead to disastrous consequences.

 

  1. Allowing a market view to influence or drive strategic decisions

The foreign exchange market is by far the biggest global financial market, with daily trading volumes exceeding $5 trillion. Famously volatile, the currency market is continuously attracting swathes of investors looking to profit from betting on a currency’s relative strength. We publish a Quarterly Forecast document which highlights the wide-ranging opinions and predictions from some of the market’s key participants from retail and investment banking – even the players in the market itself don’t know where prices are heading from one day to another.

Markets move quickly, driven by sentiment, rumour, economic data releases, central bank comments and political rhetoric to name a few. In an age of high frequency trading, it’s common to see big swings (we call this ‘price action’) of 1-2% in an afternoon. If you have a view on the direction of currencies we strongly urge you not to take it into the boardroom. The currency market is entirely outside of your control and, if we believe the market is efficient, the price reflects all available information and as a consequence, you cannot beat the market since prices should only react to new information.

We have seen many times how devastating taking a view on the market can be on business performance. We always encourage strategic decision makers to consider the chain of accountability within the organisation and to ensure bets are left in the casino and not in the P&L statement. Our experts can put a reliable strategy in place, enabling you to make informed decisions that offer certainty.

 

  1. Not working to a structured risk management policy

A risk management policy can take many guises, from a bullet-pointed process guide to a comprehensive, formal policy written into company documents, and everything in-between. The requirements of the policy will depend upon the complexity of the organisation and the extent of the foreign exchange exposure. For example, a major UK charity with an annual income of £100 million, of which 50% is in foreign currency, would likely require a more detailed and comprehensive policy than an SME importing £1 million of goods each year. That said, the core principles are the same and both organisations should have a clear process that defines their approach to risk management.

As a minimum, a good policy will include authorities and responsibilities, strategic objectives, how risk is measured, and how risk is managed. The team at Smart have developed the Smart FX Policy Template which we can customise to your individual needs.

But why bother with a policy? Policy dictates action and gives clear boundaries and authority levels which employees at all levels can use for guidance and support. Without a policy, who or what would trigger action? And how would those actions be measured? A policy gives a framework and sets the objectives for risk management. The strategy is just one part of the policy, but it’s important that the strategy aligns its KPIs to the business’ goals. This will give the policy a clear direction.

 

  1. Unclear, or non-existent risk management objectives

Objectives form a crucial part of the risk management policy, providing a clear platform to measure the performance of the strategy. We strongly advocate setting objectives that align to business goals. For example if the organisation has a goal of improving its credit and liquidity position, then a strategy which could cause a drain on cash would be inadvisable. Alternatively, consider a business with specific investment and scaling targets; a well-aligned risk management objective would be to protect operating profit margins at budgeted levels. In turn, this would dictate the tolerable level of risk and therefore the type and amount of hedging that fits that criteria.

 

  1. Focussing on the rate, and not the risk to P&L

The foreign exchange market provides ample potential distractions to decision-makers, evidenced by the sheer volume of speculators participating in trading activities day in day out. We have found over the years that intraday currency movements can be hypnotic, and often prolong decision-making. We’ve seen that operating without a clear policy can allow for opinion and subjectivity to takeover, often leading to situations where holding off for a better rate or chasing the market occur.

It’s tempting to let rates or an academic interest in markets drive decisions, but the potential risks to business due to an action (or inaction) should be at the forefront of strategy. We can advise you on how best to implement a hedging strategy for your company, based on our analysis of your exposure and positions. We follow a thorough, four step process to ensure that your strategy is correctly implemented, monitored and refined, and we always link strategy objectives to your overarching business goals.

 

  1. Use of overly complex derivatives which present risks and give rise to earnings volatility

Hedging doesn’t have to be complex, and we find that when managing risk it’s a good idea to keep things simple. Less really is more! Why do we take this approach? Because the simpler the hedge, the easier it will be to revalue, which is key to knowing your overall position and assessing your risk. More complex trades are also more difficult and costly to exit, pre-deliver or extend.

Complex derivatives often look attractive from the outset, offering above-market rates or myriad other bonus features. But there’s no free lunch, and the risk/reward profile of these trades tends to be excessively skewed to the downside for serious risk managers to take on. Features we would determine as complex include, but are not limited to:

  • Leverage (aka ‘gearing’) meaning your potential liability is greater than your protection, which can result in significant over or under-hedge scenarios.
  • Knock in barriers are not always bad , but often the impact of a knock in event occurring is negative.
  • Knock out barriers: like the knock in, knock out barriers can be used constructively. However, if the trigger results in the hedge ceasing partially or fully, there is a substantially higher level of downside risk.
  • Any accrual/accumulation type product whereby returns are subject to the future spot rate movements add additional layers of complexity and can result in early termination (un-hedged), uncertain and uneven cash-flows, and obligations to deliver multiples of the notional amount (leverage).
  • Binary options can provide attractive pay-outs but the return is all or nothing. From April 2019 the FCA banned the sale, marketing and distribution of binary options to retail consumers.

Complex products are mostly traded by those chasing the market or attempting to recover a losing position, which often occurs due to holding off. In addition to the obvious greater levels of risk and uncertainty associated with complex derivatives, the potential for a blow-up on the balance sheet shouldn’t be overlooked. Reliable position valuations throughout the year will help avoid nasty surprises at year-end. We can ensure that your strategy is monitored and maintained using our market-leading technology.

 

  1. Not factoring the cash-flow implications

Most hedgers factor the cash-flow implications to protect against known risks, avoid downside threats, and guard against uncertainty (unknown risks that can’t be easily quantified). We advocate an approach that links hedging strategy to business objectives, and we understand that cash is the lifeblood of business. Therefore, we believe it’s important to carefully consider how any hedging transactions could impact your access to liquidity throughout any contract’s life cycle.

If cash is tight, or forecasted to be so, then it makes sense to consider products that minimise exposure to negative Mark To Market (MTM) risk; that is the chance that you may have to pay margin call (deposits/collateral) to your counterparty. You can read more about counterparty risk here. Different hedging products exhibit varying MTM profiles, meaning some are more or less risky in terms of exposure to margin calls on your cash.

Of course the potential risk of not hedging is usually significantly larger than MTM exposure, but it pays to take into account your potential future exposure as part of your overall hedging policy. Smart’s market-leading position monitoring and analysis tools can help you plan effectively, with position sensitivity analysis highlighting future cash pinch-points, reliable MTM reporting and valuations, and risk management policy analysis and compliance reporting.

 

  1. Overlooking group/internal risk mitigation opportunities

The first port of call for foreign exchange risk mitigation is to avoid foreign exchange altogether. If revenues are generated in the same currency as expenses are incurred, this presents a natural hedging opportunity. There may be differences in the timing of cash-flows, which might make a perfect hedge difficult or impossible, however there are solutions to manage this risk in a cost-effective way.

Currency exposure netting is a somewhat different concept to natural hedging. Global businesses can also operate a central treasury and utilise inter-company multilateral netting. This means payments and receipts from a group’s global entities are managed centrally and net payments are made, therefore reducing exposure levels at subsidiary/local entity level. For example, if a UK company importing has import costs in US dollars but also has a US office generating revenues in dollars, the company may be able to match the cash-flows.

In summary, it is always important to consider the different ways in which your risk can be reduced naturally. Often there are ways to offset risk by matching suppliers and sales in the same country, or to ask suppliers to pay you in your own currency. Matching the cycles of your payments and receipts is a good way to avoid risk.

 

  1. Not considering the reporting of derivatives and potential volatility in P&L

A derivative is a financial contract with a value derived from an underlying asset; in foreign exchange this is the underlying spot price for a given currency. Derivatives contracts include futures, forwards, and options. The prevailing value, or Mark-To-Market (MTM) value, of derivatives contracts must be reported in annual financial statements, which can lead to unexpected volatility in P&L.

Using derivatives is not always as straightforward as it appears. Sometimes the derivative will have to be accounted for separately, even being split up into different parts – ‘time value’ and ‘intrinsic value’. This can actually lead to more, rather than less, P&L as the derivative shows up in different sections of the accounts, sometimes even in different years, to the exposure being hedged. Smart can assist in providing guidance around the accounting of various hedging instruments, and proposing solutions that minimise earnings volatility, so that your company meets its financial objectives.

 

  1. Failure to understand all hedging solutions at your disposal

Most accountants and persons involved in finance for business are au fait with basic hedging instruments, but the potential toolbox is vast and the choices can be mind-boggling. What’s more, the prevalence of aggressive selling of potentially inappropriate or unsuitable trade types to businesses is commonplace, meaning negative client outcomes occur all too often. We take a client-first approach where driving positive outcomes for customers, aligned to company objectives is paramount.

Once your Smart Account Manager has fully understood the requirements of your company and you have created a risk management strategy together, you can then learn about all of the hedging solutions available to you. It’s best to give yourself a thorough understanding of every option, in order to hedge effectively.

Adoption of Smart’s BudgetRisk, and Solution framework will ensure that you focus on the most pertinent aspects of your company’s risk management processes; aligning hedging KPIs to company objectives.

To discuss our B.R.S approach and risk management strategies further, please contact your Account Manager on 020 7898 0500.

 

Author: Harry Mills

Head of Risk Management Solutions

Harry is responsible for the running of the corporate trading team, the development of the firm’s risk management products and services, and oversees several key client and counterparty relationships.