PIECING TOGETHER MONEY RISKS

It often happens to Canadian tourists visiting the U.S. A countryman buys $1,000 U.S. at a cost of, say, $1,400 Canadian — an exchange rate of 40%. However over the course of the next two weeks, as the Canuck is lounging on a beach in Florida without a care in the world, the Canadian dollar weakens, the greenback strengthens — or both. When he returns home, and proceeds to convert back to Canadian the remaining US$500 he has not spent, he finds that he has taken a hit on the exchange– albeit minor. Now imagine the implications for a Canadian company that has entered into a large deal to buy U.S. goods using a floating exchange rate, or has agreed to sell goods to a U.S. buyer at a fixed price. The difference can mean a loss running into millions of dollars.

Exchange rate risk — also called currency risk — is the risk of an asset’s value changing because of currency exchange rates. Essentially, a business has exchange rate exposure when the currencies for its expenditures and revenues are not the same. A company is exposed to foreign currency exchange rate risk when its sales commitments, projected sales, expenses, and assets and liabilities are denominated in various currencies. The greater the number of currencies, the greater the risk.

According to “The ABCs of the Foreign Exchange Market” by Eleftherios N. Botsas (Professor of Economics, Oakland University, and editor of the International Economic Letter), the price of a currency depends on supply and demand. If, for example, Canadians demand more foreign-made goods than foreigners demand Canadian-made products, the Canadian supply of dollars exceeds the foreign demand for dollars, and the price of the dollar will fall. If one currency appreciates over another, then the other currency depreciates. Appreciation of the U.S. dollar, for example, means the dollar price of the British pound has fallen — it takes fewer dollars to buy a pound. Therefore, the pound price of the dollar has risen (i.e. it takes more pounds to buy a dollar). This makes U.S. goods more expensive in Britain, and British goods cheaper in the U.S., even when domestic prices have remained the same in the two countries. Thus, appreciation of the dollar encourages U.S. imports and discourages exports.

According to the Inter-American Development Bank, currency exposure leads to three types of risk:

Exchange rate risk arises from potential exchange rate movements with respect to the currency in which an asset or liability is denominated. For example, a devaluation of the local currency in which the revenues of a large construction project are denominated raises the local currency cost of servicing debt issued by a foreign lender with a stronger currency. Therefore, an increase in cash inflows from the project is required for lenders and shareholders to receive timely payments.

Inconvertibility risk is present where there are exchange controls or other currency restrictions that prevent or delay remittances and timely debt service.

Accounting risk results from the application of internationally accepted accounting standards for converting foreign currency liabilities into domestic currency. The Inter-American Development Bank says that in principle, this only has accounting implications. But in the case of long-term projects, the reported financial condition could lead parties to make decisions that create liquidity problems.

Currency risk in practice

In the real world, how can exchange rate risk impact companies doing business in other countries? Consider the following scenarios:

A U.S. company buys CDN $100,000 worth of goods from a Canadian firm, with delivery in 60 days. The price is fixed but the exchange rate is floating, sitting at 1.4000 the day the contract is signed (meaning the American firm will pay the Canadian firm US$60,000 upon delivery). Let us also say that the profit for the Canadian company is anticipated to be 10% of this price. If the value of the Canadian dollar holds over the 60-day-period, the Canadian firm keeps the full CDN$10,000 profit it anticipated when the deal was signed. However if the value of the Canadian dollar deteriorates over the 60 days so that the exchange changes to say 1.4500, the U.S. firm will owe just US$55,000 upon delivery. The profit for the Canadian firm is consequently eroded to CDN$9,450. Consider multi-million-dollar deals and you can see how this can hurt a company’s bottom-line.

The U.S. dollar weakens while the Japanese Yen gains comparative strength. Japanese steel producers find they can then get more greenbacks for their Yen, so they can afford to drop their prices — sometimes to the very bone. With exchange rate fluctuations, countries are open to the risk of having goods dumped into their markets by nations with comparatively stronger currencies.

The Canadian dollar loses value compared to the U.S. dollar. Consequently, Canadian corporations become attractive acquisition targets to Americans. If, for example, a U.S. company is looking at buying a Canadian firm which has a price tag of CDN$500 million, using the spot exchange rate on August 2 (just over .67) the cost to the American firm would be just over US$337 million — a bargain by any measure.

Property and casualty insurance companies are also open to some interesting dilemmas:

A Canadian insurer writes exposures in the U.S., so the carrier decides to hold U.S. denominated assets in order to pay potential claims. If the Canadian dollar strengthens, these assets are worth less. For example, if the carrier held US$1 million in cash at an exchange of 1.4000, the Canadian p&c company would, in effect, hold CDN$1.4 million. However if the exchange was adjusted to, let’s say, 1.3500, that amount would be reduced to CDN$1.35 million, wiping CDN$50,000 from the asset side of the company’s balance sheet.

A U.S. insurer looks at an oil and gas risk in Venezuela and sets the premium at 688,500,000 Bolivars (US$100,000). Over the course of the next few months, the Bolivar takes a massive and unforeseen slide in value. Let us also say that the oil and gas risk suffers a catastrophic loss. The overall affect is that the risk premium for the account has been significantly discounted.

The Canadian branch of a British insurance company earns net income in 1997 of CDN$20 million on CDN$250 million of premium. In 1998, premium growth is completely flat, but due to good loss experience and prudent management, the company earns CDN$25 million. However, over the course of 1998, the pound sterling appreciates, from 2.2500 Canadian dollars for one pound, to 2.7500 dollars for one pound. So, while the carrier shipped home 8.99 million pounds sterling in 1997, it would have contributed just 9.09 million pounds in 1998 — even though it earned $5 million more in the original currency.

In the blink of an eye

It is understandable that currency risk is much more inherent in long-term transactions than it is in short-term deals. Many purchase agreements require payment in 30 or 60 days and it is very unlikely that a currency will devaluate a very great degree in that time period (at least when considering the currencies of mature, developed nations). Currencies can, however devaluate quite quickly in develop-ing nations.

Consider the collapse of an investment bank as a result of the Asia Crisis of 1997/98. Hong Kong’s Peregrine Investment Group, which in 1997 was the largest Asian investment bank outside Japan, had an unaudited profit for the 10 months ended October 31, 1997 of HK$386.7 million. But just three short months later, Peregrine collapsed due to an unhedged U.S.-dollar denominated loan of $265 million to a taxicab company in Jakarta. The taxi company couldn’t pay its debt because the value of Indonesia’s currency had plummeted. Between July 1997 and January 1998 — just six months — the rupiah lost almost 80 % of its value against the U.S. dollar. Consequently, a company doing business in Indonesian currency had to earn three times as much as it once had to earn to pay back its U.S.-dollar denominated debt.

The Asian crisis actually began in T
hailand when the devaluation of the Thai baht in July 1997 started a chain reaction of currency devaluations across South East Asia. This prompted monetary authorities in the affected countries to raise interest rates dramatically. According to the Toronto Dominion Bank, in spite of solid economic growth, the Thai government was unwilling to permit the appreciation of the Thai baht, which was pegged to the U.S. dollar. Liberalization of the financial sector in Thailand encouraged domestic companies to borrow heavily from abroad. The majority of the loans were denominated in U.S. dollars, which carried a foreign exchange risk that most borrowers did not hedge because it was too expensive. The Thai government could have reduced interest rates and/or lowered the baht exchange rate in 1996 to stimulate the economy. However, the high foreign indebtedness of many domestic companies deterred the government from taking such action, because a weaker baht would have made repayment of the foreign currency loans much more costly.

When things eventually hit the wall in Thailand, the currencies of the Philippines, Indonesia, Malaysia and South Korea all came under attack. The Taiwan, Singapore and Hong Kong dollars all experienced downward pressure as investment portfolios flowed out of the Asian region in a flight to quality from foreign currencies to U.S. dollars, and from stocks to bonds. This required monetary authorities to raise domestic interest rates, reducing growth prospects in the region and adding to selling on Asian equity markets. By November, the Hong Kong dollar was the only southeast Asian currency to remain pegged to the U.S. dollar.

What to do, what to do?

Over the last several years, entities open to currency risk have looked to the capital markets for instruments that can be used to counter such exposures. Exchange rate risk can be covered, for instance, through forward purchases of foreign currency or other financial contracts, such as put or call options that give the holder the right to buy foreign currency at a given exchange rate and time. Neither forward contracts nor other suitable financial contracts, however, are available for long-term cover. As a result, because loans for certain projects can span many years, the exchange rate risk cannot be adequately covered by these instruments, because issuers would need guarantees that years down the road, the project would still generate the funds necessary to service the debt.

Risk transfer vs. risk financing

In and of itself, exchange rate risk cannot be insured. But that doesn’t mean it can’t be wrapped into an integrated risk management program. The main point here is that the risk can be laid off, not by risk transfer, but through risk financing. According to the Swiss Re publication “Rethinking Risk Financing,” “Risk financing is a means of financing and managing an organization’s exposure to a variety of events that could adversely affect its cash flow, earnings and balance sheet strength. We immediately move beyond the boundaries of exposures that have been traditionally insurable to a widened scope of hazards, which may include non-performing investments, and political, weather and currency risks.”

Through a holistic risk-hedging program which can marry traditional p&c coverages with financial market instruments, a company can reduce volatility at each of the selected risk-retention levels. And while a company can address each exposure separately through various insurance and capital markets products, this approach can result in a company over-hedging — and thus paying too much for its risk management program.

Bringing together risks that are uncorrelated to each other (eg. a factory fire is unrelated to interest rate fluctuations or commodity prices) lowers the volatility, thus lowering a company’s cost of managing risk. This financially oriented integrated approach pushes insurance and reinsurance mechanisms to their limits. As sole and independent forms of financing, they cannot respond adequately. This creates the opportunity for strategic alliances between insurers/reinsurers and other financial institutions to provide more comprehensive risk financing covers for large corporate clients.

According to “Rethinking Risk Financing,” “…risk management, including proactive risk financing, provides a competitive advantage and allows organizations to experiment and take calculated chances in ways that were not possible before”.

The world is becoming an increasingly risky place. Whether the risks encountered result in positive or negative consequences depends largely on how they are managed. And they can be managed.