Currency Pulse #3
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Forward points: risk & reward
Long-term U.S. treasury bonds yield more than Chinese government bonds. This is not news. Yet, currency managers still need to come to terms with the implications of this shift. For EUR-based importers from China, buying and hedging in CNY —compared to buying and hedging in USD— no longer translates into more net FX gains.
A scenario of persistent inflation in the U.S. is made even more complex by the ongoing negotiations about raising the Federal government’s debt ceiling. On May 24, Fitch Ratings placed the United States' long-term rating on Rating Watch Negative. There is no time for boredom in the FX world.
Mind the cliff
Our bi-weekly backtest concerns a Swiss firm in the energy measurements space. The company had voiced concerns about the effectiveness of its currency management policies. Managers were looking for better end-to-end traceability to improve, among other things, a complex audit trail.
At the operational level, they noted the recurrence of manual errors in swap execution during the post-trade phase. Stealing the show, however, was the concern with FX-induced performance variability, as the company wishes to keep its selling prices as steady as possible.
To tackle this key pain point, we proposed a 6-month linear layered FX hedging program. We back-tested it for the last four years alongside their existing 6-month static rolling program. In this type of set-ups, the main Key Performance Indicator is the ‘cliff’ — in this case, the average distance between hedge rates.
The smoother the hedge rate, the lower the ‘cliff’, and the lower the variability of economic performance. The results of the proposed layered hedging program speak for themselves. On the largest exposure (CHF-EUR), the average ‘cliff’ goes from 2.52% with the firm’s current hedging strategy all the way to 1.28%.
On a CHF 30m exposure, this amounts to CHF 372,000 annually in terms of reduced performance variability. Other currency pairs were back-tested with comparable results. This is exactly the type of results equity investors want to see.
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Rolling budgets
On CurrencyCast we had the pleasure of interviewing Frédéric Chapelle , Partner at PwC Luxembourg and Corentin Maricq , Manager Advisory at PwC Luxembourg. Among the many ideas shared by Messrs Chapelle and Maricq, the move towards rolling budgets strikes us as particularly relevant.
The case for rolling or continual budgets is well established. Promoters argue that “they provide businesses with more timely, useful, and accurate information than static forecasts”. In a world of pandemics, inflation and war, it is hard to argue against the need to continuously update projections. Rolling budgets, it is also said, encourage a ‘perpetual’ forward-looking attitude.
Frédéric Chapelle gives another twist to the story. He argues that a 12-month rolling budget —one that adds a new month to replace the month that has just passed—, may allow managers to nail down better projections. This, he implies, is especially relevant as developments in Artificial Intelligence (AI) in pricing, forecasting and simulation make it possible to assess a wider and richer array of scenarios.
Frédéric Chapelle argues that "...a 12-month rolling budget may allow managers to nail down better projections, especially thanks to developments in Artificial Intelligence (AI)"
So what is the takeaway for currency managers? When hedging forecasted FX exposures, a distinction is made between companies that protect profit margins during a particular campaign/budget period and those that keep prices as stable as possible in the context of a rolling forecasted exposure.
This story has legs — stay tuned.
Embedded finance & FX
Esteban Lopez writes about “The Currency Revolution in Embedded Finance ” in Finextra, the information and networking platform for fintech professionals.
Embedded finance, according to Bain Capital , is set to exceed $7 trillion by 2026 in the United States alone. As Esteban argues, automation technology makes it possible for participants to offer a range of international payments and currency management solutions.
These FX solutions will not only create new revenue streams for banks, fintechs, and payments companies — they will help them further cement clients’ online customer experience. And, as the author explains, they can also enhance players’ competitive position.
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