Currency Pulse #23 - The Full Gamut

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The full gamut: Merck KGaA

As we can infer from the recently published Management of financial risks guidelines , the finance team at the German pharmaceutical and chemicals company Merck KGaA applies the full gamut of FX hedging strategies: 

1. Systematic hedging. Exposure to FX risk is "systematically hedged" and "speculation is prohibited". The functions of trading, settlement and control are "strictly separated", while counterparty risk is constantly reassessed.
2. Balance sheet hedging. Merck hedges FX-denominated "receivables from and liabilities to third parties". Balance sheet items are "hedged in full" in order to remove the accounting impact of FX gains and losses.
3. Cash flow hedging of forecasted exposure (with hedge accounting). The net forecasted exposure for the incoming 12 months is hedged with what looks like FX layered hedging programs that aim for a hedge ratio between 40% and 90%, starting at 25%. 
4. Firm commitments. Firm purchase commitments in non-functional currency are hedged over the next 12 months. (In  other words: Merck applies combinations of FX hedging programs ).
5. Credit risk management. Credit risk in accounts receivable is managed with the help of country-specific ratings. Note that systematic FX hedging is an indirect way to manage credit risk .

This commitment to be on top of all FX-related challenges surely requires some degree of automation—things like swap execution and the compilation of the documentation required for Hedge Accounting are resource-intensive activities.  

There is one additional point that merits our attention. Why does the finance team provide investors with such detailed information? One possibility is that the policy simply adds to Merck’s long-standing tradition of reassuring investors about currency risk. 

A recent paper suggests another clue (*). The ‘over-delivery’ of financial information can be used as a way to increase the stock’s liquidity and enhance its status as an acquisition currency. While this does not apply directly to Merck —recent acquisitions have been paid in cash—, it is an intriguing idea. 

Be that as it may, it is clear that the company has fully embraced the legacy of its former CFO. Merck’s $66 bn market capitalisation is testament to the acumen of its scientists—but also to the skill and discipline of the finance team.

(*) Sheng Huang, Johan Maharjan & Vikram Nanda: “Liquid stock as an acquisition currency ”, Journal of Corporate Finance, April 2024.

Bi-Weekly Back Test: German manufacturer with USD and JPY sales (*) 

Our backtest concerns a German manufacturer group with foreign market units. As headquarters sell to subsidiaries in their own currency, the group is particularly exposed to the fluctuations of two major currency pairs: EUR-JPY and EUR-USD.

Given the competitive nature of the markets it operates in, subsidiaries have little leeway to increase prices in the face of a depreciating local currency. The Japanese yen is a case in point: it has fallen by about 15% to the euro this year alone.

The proposed solution is to implement automated layered hedging programs for both currency pairs. By achieving a smooth hedge rate over time, these programs allow firms to keep prices as steady as possible without hurting budgeted profit margins. 

In our back-tested simulation with data from 2020 to 2023, the ‘cliff’ —a measure of how much margins are impacted if selling prices are not changed in the face of adverse fluctuations in FX markets— was lowered by 50% with EUR-JPY. This reduces the Japanese subsidiary’s need to adjust prices.

On EUR-USD, one particular concern was forward points optimisation, as USD trades at a 1.80% annual forward discount to EUR. We therefore back-tested a layered program with two differences from the company’s current strategy:

• More granularity. The aim is to reach management’s desired 85% hedge ratio over time, but more gradually than with the current setup.

• Conditional orders. In order to delay hedge execution as much as possible, conditional FX orders were put on each layer of the program. 

The combined effect is to reduce the ‘cliff’ by 80 basis points and to generate material savings on forward points. Note that the number of FX trades is multiplied by 2.5 times. That’s why Multi-Dealer Trading platform connectivity —allowing for automated best-price execution— was also tested.  

(*) Every two weeks, Currency Pulse presents a real-life case. No names are mentioned and absolute values are changed. We use simulation tools to backtest, with historical data, our proposed automated hedging programs.

Pieter de Kiewit: the skills of Treasury managers

Kantox’s Agustin Mackinlay interviews Pieter de Kiewit , the well-known Amsterdam-based Treasury catalyst and consultant. The discussion ranges from trends in treasury recruiting to the importance of “spreading the message” about the relevance of treasury operations.

“TMS expertise is becoming a common requirement for positions in treasury, especially in companies with more than €1bn in sales” — Pieter de Kiewit 

According to Mr de Kiewit, the demanding nature of senior treasury positions will only increase in the future. Here are some of his main points:

1. Jargon. Some treasurers may be ‘too fond’ of their positions. This may lead them to overuse technical language. And that makes communication more difficult: “Deeper (language) may not mean better”. Lingo can lead to confusion and even disengagement.
2. Psychology. The always latent ‘insider bias ’ requires treasurers to be aware of their own preferences. As humans we tend to take the inside view when our forecasts are too narrowly based on the information in front of us—and treasurers are not immune to that.
3. Technology. We are seeing more candidates to top positions who simply refuse to consider positions in companies that have no Treasury Management Systems (TMS) in place. They have no desire to waste time on manual tasks that can be automated. 
4. Communication. Treasurers not only need to be able to ‘broadcast’ their views—they also need to have the patience to listen to what others have to say. Purely technical skills may matter less than the ability to include others in the success of the company.  
5. Message. It’s definitely the task of treasurers to effectively explain to internal and external stakeholders the strategic importance of treasury operations. Nobody outside the treasury community will ever do it. “Talk to non-treasurers and spread the word!”

Watch the full episode 👉 here

FX Knowledge Hub. Reducing contracting costs

In B2B setups, the temptation of buying directly in one’s own currency can be misleading. The underlying FX risk never goes away—it is merely transferred onto suppliers, who invariably apply markups to protect themselves from the risks and hassle.

By removing this friction, markups are sidestepped and contracting costs are reduced. Here’s an example from the Travel world. A Europe-based ‘bed bank’ sells a room in a New York city hotel for €100 to its European customers. The EUR-USD rate is 0.9700.

Suppliers A and B are willing to quote $92. But while supplier A only quotes in USD, supplier B quotes in EUR as well. With supplier A, ‘translated’ contracting costs are €94.85 = $92/0.97, and the gross margin is 5.2%. Supplier B, however, applies a 1% markup, raising the bed bank’s contracting costs to €95.83.

Buying in USD therefore translates into an almost 1% decrease in gross margins for the European bed bank. The flip side of this story: the company needs to ‘take ownership’ of the underlying FX risk management process. For more details and user cases, see our report Currency Management for B2B and B2C Travel Distributors. 

HBX Group as an ecosystem

HBX Group defines itself as “the world’s leading B2B ecosystem player in the TravelTech space.” That’s quite a definition. It reminds us of the book by authors Venkat Atluri & Miklós Dietz, quoted several times in Currency Pulse (*).

“The global economy is moving away from the pattern of discernible, separated sectors. Instead, ecosystems are taking over. They feature businesses that compete and collaborate with one another to better serve customers—the key drivers of the modern economy” — Atluri & Dietz

The authors foresee between $70 to $100 trillion in revenue accruing to ecosystem players in the next couple of decades. Note that participants like HBX Group are driving the ‘fintechisation’ of the Travel ecosystem—in payments, but also in FX risk management.

(*) Venkat Atluri & Miklós Dietz. The Ecosystem Economy. How to Lead in the New Age of Sectors without Borders (New Jersey: John Wiley & Sons, 2023).

Five Useful Links

1. Hermès and FX hedging. The French luxury group discloses an outstanding performance : consolidated revenue reached €13,427 million in 2023, up 21% at constant exchange rates and 16% at current exchange rates compared to 2022. The company credits strong sales growth and “the favourable impact of currency hedging”.

2. China’s falling export prices. The IMF notes that China’s falling export prices are putting pressure on the profit margins of the country’s competitors. “Policies that boost supply—such as investment subsidies to specific industries—would reinforce deflationary pressures, and potentially provoke trade frictions.”

3. Japanese firms and the yen. A Bloomberg article describes Japanese companies’ reaction to the weak JPY . While firms like Japan Tobacco hedge 100% of FX-denominated invoices, some leading export firms worry about the “relative decline in the Japanese economy”, the effects on supply chains and the risings costs of M&A deals [see ]. 

4. Import tariffs and the dollar. A Deutsche Bundesbank paper argues that imposing tariffs on imports from China backfires . This is because the resulting policy uncertainty increases demand for safe haven assets, leading to an appreciating USD. Chinese exporters then respond by lowering USD prices (by about 0.75% in response to a 1% USD appreciation).

5. Geopolitical risk. “It is unclear what Europe can do to hedge against Trump 2.0 ”, writes an alarmed Edward Luce in the FT Week-End. The truth is that the much-heralded poly-crisis scenarios have been, at least so far, averted. Kantox’s approach is: Keep calm and automate (see our report Currency Management Priorities for 2024 ).

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