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Financial Markets

Emerging market essentialsfor treasurers

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Contents

Counterparty risk

Net investment hedge

Custodian of cash flow

Cash flow forecast hedge

Forecasting against currency volatility

Aggregated foreign exchange rate forecast

Portfolio hedge approach

Conceptual approaches to foreign exchange risk management

IntroductionEmerging markets continue to be attractive to organisations due to the potential for lower costs and higher returns that they can offer. For treasurers working in companies expanding into these markets, however, many challenges can present themselves.

The financial risks associated with operating in highly volatile markets need to be fully understood and effectively managed so that corporations can see the full benefits of emerging market operations.

Today’s treasurer needs to manage both the liquidity and the foreign exchange exposures which arise from expansion into new regions and countries around the world. Liquidity gaps and risks are usually managed by a combination of tailored technology solutions and global banking partners to manage the liquidity challenges posed by expansion into new regions and countries around the world.

On the other hand, currency risk is often managed by the use of forward contracts, foreign exchange (FX) options-based hedging solutions and other derivatives which offer protection against volatile exchange rates.

With a variety of tools at their disposal, treasurers need to take a strategic approach to achieve an end-to-end view of the risks and requirements that entering a new emerging market entails.

FX options can carry a high level of risk and may not be appropriate and/or suitable for everyone. Please take all reasonable steps to understand certain key concepts before transacting in FX options. More information is available at currenciesdirect.com/options and in our product disclosure statement.

Counterparty risk can be hard to quantify in emerging markets. A good way to have the best understanding of this is if it is managed centrally, with treasury having a complete end-to-end view of all counterparty relationships; including more complex corporate structures and ownership patterns. However, the PwC Global Treasury Survey 2014 highlighted that operational counterparty risk is managed centrally by only one in three organisations, while 23% of respondents said that it is not managed at all.

Once an organisation opens up a branch in an emerging market country from which to sell its goods, it will need a relationship with a bank in that market. Cash generated by sales in the market will, initially at least, be held with this local bank. This exposes the corporation to counterparty risk, because any issues with the local bank could prevent the organisation from being able to move its money out of the country if it wanted to, or even expose it to the possibility of permanent financial loss.

Counterparty risk

If a company owns the office or factory that it is operating from, it also faces a net investment risk. At the year-end date, assets like property need to be represented on the company’s balance sheet. The first step to doing this is to value it in local currency. Once this has been established, the treasurer needs to understand what this price is in their domestic currency, which can be calculated by looking at the foreign exchange rate on the reporting date in question.

The risk here is attached to what the foreign exchange rate is on the specific reporting date. While the figure needs to be reported at the end of the year, the foreign exchange rate between the two currencies could move against the treasurer in the intervening time. One way to mitigate this is to engage in net investment hedging.

Net investment hedgeThe treasurer can do this by executing a forward contract six months in advance and designate that as a net investment hedge under hedge accounting rules. There will be a gain in the forward contract if the foreign exchange rate moves against the treasurer, offsetting any losses in the net asset value in their domestic currency of the emerging market asset.

Example

Arranging funding for ventures in emerging markets can attract currency and interest rate risks, particularly if funds that are raised outside the country have to be converted into domestic currency, with the resulting repatriation challenges further down the line. In Deloitte’s 2015 Global Corporate Treasury Survey, half of all respondents said that their biggest challenges in emerging markets are related to their ability to repatriate cash and manage foreign exchange volatility.

As custodian of the company’s cash flow, the treasurer must ensure that sufficient liquidity is available in the right currencies at the right time. Accurate and timely data and information is required to gain a long-term view of the company’s cash flow and to make informed decisions about the company’s future financial needs. Achieving this in emerging markets can be challenging, particularly for companies that have just entered a new market.

Custodian of cash flow

Many companies buy specialised software that brings the various data sources together and enables the required analysis. Alternatively, some banks can provide a global liquidity management solution.

Organisations that do not have internal expertise, resources or capacity to set up a cash flow projection and review mechanisms often turn to a bank or other outsourced service provider to get started. This helps them establish a routine for running cash flow reports, analysing the results and responding accordingly.

Cash flow forecast hedgeAn organisation that can accurately forecast cash flow out to 12 months into the future will know the monthly foreign exchange requirements it faces. For example, it may have to sell €500,000 every month for the next 12 months. In this situation, it can look at forward-looking strategies, such as forward contracts or a strip of lightly structured options-based hedges.

Example


Uncovering hidden foreign exchange risks in the business is one of the top areas of concern for treasurers that are tackling foreign exchange risk management. Hidden risks are often buried deep within the operations of the business in locally or regionally negotiated contracts. A CEB Audit Leadership Council survey found that a majority of treasurers (59%) have either “neutral” or “no” confidence in the accuracy and exhaustiveness of their foreign exchange data, so this is clearly a challenge for corporates.

Forecasting against currency volatility

The foreign exchange market is a very volatile asset class, so companies must adopt increasingly active and targeted strategies to manage their exposure to exchange rate risk, and also to create opportunities to increase competitiveness.

Aggregated forecasts offer a true market sentiment from the most accurate economists in the global foreign exchange market. If a company wants to arrange a long-term portfolio of hedges that have the potential to work for the treasurer whether the market goes up or down, aggregated forecasts can broadly suggest where the entry point for this portfolio of hedges may be.

Aggregated foreign exchange rate forecast


Example

Portfolio hedge approachTreasurers who use a portfolio of hedges usually do this to diversify their risk management programme so that they are covered for all eventualities. For example, a portfolio may be made up of 40% forward contracts to lock in a rate, protecting the treasurer if the market moves against them, but not presenting any upside if the market moves for them.

Another 40% of the portfolio may be made up of something more flexible, for example a lightly structured options-based solution. Like a forward contract, this provides protection if the market moves against the treasurer, but it will also provide a certain degree of upside if the market moves favourably.

The treasurer may finally choose to leave the remaining 20% of the portfolio in the spot market. By doing this, the treasurer is positioned to take 60% upside if the market moves in their favour (from the spot market and the lightly structured options-based solution), while retaining 80% portfolio protection from the forward contract and options-based solutions.


EXAMPLE 1

Forward contracts

ADVERSEMARKET MOVES

0% protection100% unprotected




100% potential participation0% unable to participate




FAVOURABLEMARKET MOVES

EXAMPLE 2 EXAMPLE 3 EXAMPLE 4

Spot market 0%100% 20% 20%

FX options solutions* 0%0%

100%0%

40%

40%

80%

0%

PRODUCT FAMILY

*e.g. long call / put / participating forward / range forward / forward extra

The overall choice about which types of products to include in a portfolio of hedges, and how to weight the percentages, is company-specific, but these examples highlight the tools that treasurers can use to protect themselves in the foreign exchange market. This is particularly relevant for companies that are moving into potentially volatile emerging markets.

Conceptual approaches to foreign exchange risk management

Combining two or more products may lead to a number of benefits in the face of favourable and adverse market moves, and could give you a hedge that performs whether the market rises or falls. The percentages below refer to the proportion of your foreign exchange exposure allocated to each product family.

Have you considered combining products?

These examples are only illustrative – many other variations exist

ConclusionConstantly changing market conditions can play havoc with the risk management and liquidity of organisations that move into emerging markets. Treasurers have a mandate to ensure that any volatility in the markets does not have a material impact on the organisation’s financial performance.

Understanding the financial risks faced in emerging markets is essential. This includes ensuring that the treasurer is receiving the right data from subsidiaries.

There are plenty of tools at the treasurer’s disposal to get this right. Finding the right partnership that supports the organisation’s international business strategy is important, because it frees up time that the treasurer can use to focus on a financial strategy that will add value to the business.

About usWith almost two decades of experience in international payments and foreign exchange, we are one of Europe’s leading international payment providers.

Our aim is to build partnerships with our clients. Using their business plans, we work with them to create a strategy that not only works now, but still does in six months’ time when the foreign exchange market may have moved against them.

Our clients range from SMEs to large corporates, and we use our extensive experience to enable businesses from all sectors to mitigate risk and achieve substantial foreign exchange savings.

As one of the first financial services companies outside of the banking industry to purely focus on foreign exchange, we are now trusted by over 150,000 clients and are authorised by the FCA* (Financial Conduct Authority).

For more information, please visit www.currenciesdirect.com/business

©Currencies Direct Financial Markets Ltd 2015. All rights reserved worldwide.

*Currencies Direct Limited is authorised by the Financial Conduct Authority under the Payment Service Regulations 2009 (FRN 504360) for the provision of payment services. Registered in England & Wales, No. 03041197, Currencies Direct Ltd, 51 Moorgate, London, EC2R 6BH.

Currencies Direct Financial Markets Limited is authorised and regulated by the Financial Conduct Authority for the conduct of designated investment business. FRN. 495699. Incorporated in England No. 05289789, Currencies Direct Financial Markets Ltd, 51 Moorgate, London, EC2R 6BH.

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