Currency Pulse #24 — Flight to luxury

Hermès & currency risk: flight to luxury

The French luxury designer and manufacturer Hermès of Paris is in a league of its own. The group’s consolidated revenue amounted to €13.4bn in 2023, up 21% at constant exchange rates and 16% at current exchange rates compared to 2022.

The 42.1% operating margin achieved in 2023 was the highest ever for the company. Here's the intriguing part. The company informs investors that the strong operating results were partly due to the favourable impact of currency hedging:

Recurring operating income increased by 20% to €5.6bn compared to €4.7bn. Thanks to the strong sales growth and the favourable impact of currency hedging, annual recurring operating profitability reached its highest level ever at 42.1%, up from 40.5% in 2022 — Hermès.

Can we reverse-engineer Hermès' highly successful FX management? While we are not privy to the firm’s hedging strategy, a few details from the earnings reports —for both 2023 and 1Q 2024— allow us to infer some elements from the perspective of 'best practices':

(1) Pricing parameters: Hermès does not hesitate to hike prices in the face of adverse developments in currency markets. The firm raised prices by an average 7% in 2023. Price increases were in the double digits in Japan on account of the weak JPY. 

(2) Static hedging: These pricing parameters call for 'static' hedging programs in which a worst-case-scenario FX rate is protected with conditional stop-loss FX orders. Note that profit-taking orders can be added to take advantage of favourable market moves.

(3) Outperformance: Outperforming the budget rate is made possible by take-profit orders (TP) paired alongside stop-loss orders (SL) around the budget rate, and by hedging firm commitments, as hedges are executed at rates that are by definition better than SL.

(4) Forward points management: While TP may have been triggered on USD strength, the company likely picked up extra-margin from carefully hedging JPY on the selling side (EUR at forward discount) and BRL on the contracting side (EUR at forward premium).

All of this merits a resounding « Bravo ! » 

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Bi-Weekly Backtest: Italian petrochemical company with USD exposure (*) 

Our bi-weekly backtest concerns an Italian petrochemical firm with exposure to USD on the contracting side. We proposed a static hedging program with the main objective to protect a ‘worst-case-scenario’ (WCS) FX rate used in pricing.

As the company defines its pricing at the onset of a budget period, it sets a markup to arrive at the WCS rate. For example, if the spot EUR-USD rate is 1.1000 and the markup is set at 2.75%, then conditional stop loss (SL) orders are set at three levels from the spot reference rate: 1.75%, 2.75% and 3.75%. 

The average of the S/L orders thus matches the 1.06975 WCS rate to protect. In addition, a micro-hedging program for USD-denominated purchase orders is added, with hedges being executed on the back of firm commitments. During each period of the backtest period (2019-2023), the budget rate is outperformed.

This is because firm commitments are hedged at a rate that is by definition better than the SL orders. Outperformance reaches 11.82% in 2021, generating gains of €1.98 vs. the budget rate on a €16m annual exposure. The lowest outperformance (0.87%) occurs in 2022 as stop-loss orders are hit.

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

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Removing FX gains & losses

A Kantox blog reviews the rationale behind balance sheet hedging programs aimed at removing the impact of FX gains and losses from the income statement. Taking a value-maximising perspective, the key arguments for balance sheet hedging include:

A. Reducing net income variability to lower the cost of equity capital

B. Smoothing out earnings when higher earnings are taxed at higher rates

C. Allowing firms to scale by using more currencies in business operations

Read the entire blog 👉 here.

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Enrico Camerinelli: the future of B2B payments

On the Kantox’s podcast, Agustin Mackinlay talks to Enrico Camerinelli, a strategic advisor and Senior Research Analyst with Datos Insights. The discussion ranges from cash flow hedging to trends in B2B payments.

“One of the biggest risks is not realising that FX management is an overarching, comprehensive flow that encompasses more than just the conversion phase” — Enrico Camerinelli 

Treasurers may focus too much on reducing trading costs while missing out on a complete understanding of their firm’s exposure to currency risk. Here are some of Mr. Camerinelli’s main points:

1. Multi-currency processing methods. Currency management in a B2B setup is not a ‘one-off’ event  difficult—rather, it is more like a journey that encompasses the entire, end-to-end workflow.
2. Liquidity management and FX. ”Nobody loses his or her job if they don’t make that extra basis point by reducing trading costs. But they definitely risk losing their job if they don’t make the best use of the firm’s liquidity”.
3. Breaking down silos. Effective FX and liquidity management requires busting artificial silos between finance and commercial teams, headquarters and subsidiaries, marketing and production, etc.  
4. B2B payments. The B2B user is almost always a B2C user as well—the treasurer is also a consumer. “The expectations that you have as a consumer —user interfaces, mobile devices— are also reflected in your expectations as a business user”. 
5. Instant payments. “Americans are good at complicating their lives! The best thing they could do is to just look at what Europeans are doing in the instant payments space” (SEPA Instant Credit Transfer or SCT Inst.)

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FX Knowledge Hub. Forecast (in)accuracy and layered hedging

During a meeting of the recent European Association of Corporate Treasurers Summit in Brussels, ASML’s Jeroen Van Hulten mesmerised the audience as he presented an AI tool that took forecasting accuracy from 70% to over 96%.

At Kantox we hold an out-of-consensus view: the importance of forecasting accuracy is overstated (*). In a 12-month layered program with monthly granularity, for example, the degree of forecasting accuracy needed four months before value-date is less than 70%. It is actually 66.7% = (100%/12) x 8 months. This seems pretty manageable.

“Forecast inaccuracy should not be a problem for most companies when deploying their FX risk management program. By design, a layered hedging program tackles the problem of forecast inaccuracy head-on” — Toni Rami, Kantox Chief Growth Officer

And that’s not all. By adding a micro-hedging program for firm commitments (or balance sheet items), hedging is applied to near-certain exposure as soon as these accumulated items surpass treasurers’ hedge ratios. The upshot? It’s not possible on spreadsheets alone. 

(*) See Currency Management Priorities for 2024.

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Currencies & crowns: why it matters

The Bank of Canada confirms that its new $20 note will feature King Charles III as the portrait subject. These things matter. The BoC sends a subtle, yet important message that explains the success of CAD as a strong, trustworthy currency.

Canadian officials are conveying their rejection of the “time inconsistency disease” that plagues many republics to the south of their border. People may or may not like a monarchy. But they tend to see it as an ever-lasting arrangement. And that creates confidence.

This may also explain why Swedes, Norwegians and Danes call their currency the crown—krona, krone. A back-of-the-envelope calculation shows that, on average, a basket of CAD, SEK, NOK and DKK would trade at a 1.95% annual forward premium to USD. 

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Five Useful Links

(1) Exporters are importers too. A Bloomberg article highlights the plight of medium-to-large South Korean exporters. Unable to raise prices in their export markets, they suffer from imports becoming more expensive as KRW weakens. A 2023 survey shows that 49% of exporters have no contingency plans in terms of FX hedging. 

(2) ECB and geopolitical risk. ECB researchers use a geopolitical risk index (GPR) to assess the potential impact of ‘adverse events’. Industrial production declines by 0.15% six months after a 1 standard deviation geopolitical shock. Other scenarios: USD strength, higher credit spreads, reduced bank lending and corporate valuations. Sectors are analysed.  

(3) Brazilian corporates and FX. CompleXCountries —Global Treasury Intelligence publishes a Brazil Corporate Treasury update. There’s ‘good news/bad news’ on the FX front. While the central bank removed the requirement to submit full documentation for all FX transfers, the documentation still has to be prepared and stored in case of an audit.

(4) U.S. firms: King Cash. According to the Wall Street Journal CFO Journal, U.S. nonfinancial companies in the S&P 500 parked 56% of their funds in cash and cash equivalents, and the remainder in securities at the end of 2023, the highest level since the first quarter of 2020. “It’s about trying to capture as much of that yield as they can.”

(5) OTC derivatives. The Bank for International Settlements publishes the full 2023 data on OTC derivatives. Two trends appear to emerge: (1) Interest rate derivatives drove overall growth in 2023 (+8% yoy); (2) Outstanding FX derivatives declined by 0.4% in 2H 2023. With subdued FX volatility, interest rate risk management took centre stage.