Crisis and Currency Risk: Being Prepared for the Possible Second Wave of COVID-19
COVID-19 Situation and Currency Risk Management
Without a vaccine or cure for COVID-19, any rebound in economic activity risks being suddenly disrupted again. It is therefore essential to learn from the first wave and implement lasting changes to business and operating models to improve resilience. This is particularly critical in the context of crisis and currency risk, where global economic instability and exchange rate volatility can further weaken companies operating internationally.
Using Scenarios to Manage Currency Risk
First, it’s essential to determine exactly where and how the crisis has impacted your existing models and, consequently, where the risks and opportunities lie within your value creation ecosystem. This allows companies to react swiftly to the inevitable changes we will continue to face in this unstable environment over the coming months.
Economic Recovery: The Role of Risk Management During Uncertainty
The term "new normal" has been widely used recently. In the context of risk management, this "new normal" simply means we will continue to face extreme risk scenarios (“Tail Risk”) for some time.
Risk management allows organizations to take on greater growth risks and is one of the key differentiators for achieving strong, profitable growth. The commercial benefits go well beyond crisis avoidance — risk management is integral to sustainable growth and the value creation process.
Clear processes enable timely and efficient responses when a risk materializes. A scenario-based approach allows for the creation of escalation and reaction procedures based on the materiality of potential damages.
When it comes to currency risk, the person responsible must have clear parameters, as the impacts of currency fluctuations are immediate and significant on company profitability. The escalation threshold must be low enough to reflect the potentially large and prolonged consequences of inaction.
Scenario analysis is the simplest form of “stress testing.” This analysis does not attempt to predict future exchange rates. Instead, it provides clear visualization of risk exposure across a range of potential exchange rate scenarios and shows the sensitivity of business results to these fluctuations.
It quantifies the cash flow impact of these scenarios and allows businesses to understand risk as the variance between expected (budgeted) outcomes and worst-case outcomes, or to define their risk universe — the range between best and worst-case outcomes. Your risk management must be robust in the face of multiple possible outcomes.
The New Normal and SME Readiness
In this “new normal” brought on by COVID-19, any company — exporter, importer, or both — must be able to clearly quantify its currency exposures to factor them into business model comparisons.
Using scenarios to gain clarity on currency risk should become the standard for any SME engaged in international business.
The Market
Several positive catalysts (“risk-on”) are coming to an end — Wall Street earnings releases, encouraging early vaccine results, the new EU recovery fund, and potential fiscal stimulus in the U.S. and elsewhere. However, the presence of COVID-19 in the U.S., which has recently surged, alongside a confusing government response, could shift the risk environment. Upcoming economic indicators are unlikely to confirm a V-shaped recovery. It’s best to prepare accordingly.
Economic forecasts should be approached with caution for the remainder of 2020 and into 2021. A scenario of increased volatility and less predictability is emerging and should be reflected in company stress testing.
Comparing forecasts from major banks (Canadian and international) shows major differences. Some expect the Canadian dollar to return to 1.30 versus the U.S. dollar, while others predict 1.45.
For $1 million USD in currency flow, that’s a 150,000 CAD difference! It’s difficult to predict exchange rate levels or direction for 2020/21 when no clear consensus exists among experts.
Implications for SMEs
Whether recovery is V-shaped or U-shaped will affect the volume of products/services bought and sold internationally.
As a result, currency exposure may differ from initial expectations. The impact on your hedging program is direct. The company could be over-hedged, leading to unnecessary costs.
Depending on how exchange rates have moved since your hedging positions were established, closing them may provide liquidity or prove too costly. In the latter case, consider restructuring your hedge positions to preserve cash flow.
To protect liquidity, review any rolling hedge programs that might continue at the expense of credit or cash reserves.
A more volatile, less linear environment will likely bring sharp currency swings and unstable correlations between currencies.
Crisis and Currency Risk: Prepare Your Hedging Plan
A company exposed to multiple currencies can no longer rely on diversification, as the relationships between currencies have become too inconsistent.
In this environment of significant, abrupt currency shifts, prepare a trade execution plan that accounts for reduced market liquidity.
Can you roll positions outside of month-end to avoid the usual congestion and bottlenecks in low-liquidity periods? Stagger your hedges to minimize the impact of volatility and limited liquidity.
Choose simple hedging products whose market value is easy to estimate, in case you need to close or restructure. Establish valuation benchmarks for your positions.
When market moves increase the market value of your hedge positions, it may be beneficial to close part of them to free up liquidity. However, define in advance the parameters that will authorize such action. You must track the evolution of your exposures and the gap they may create relative to your target margins.
Maintain a Risk Management Policy
Regularly (and frequently) review your expected cash flows, revise your scenarios based on updated projections, reassess your exposure, and validate the relevance and size of your existing hedges. The exchange rate scenarios used in simulations should be broad enough to account for expected volatility.
Protect your commercial margins, manage your currency risk, and maintain your flexibility as much as possible. Be prepared rather than reactive! A lack of risk management policy can lead to increased costs, lost market share, and a significant drop in profit margins.
The New Normal: What to Watch
Unprecedented government and central bank actions have supported businesses and markets — but not without long-term consequences. Will we face inflation or deflation? Big questions remain about the virus’s longevity, global economic recovery speed, second-wave risks, vaccine rollout, cost, and more.
Society will continue to change in this "new normal." How will consumers behave? Will their political views and voting behavior shift? What about Brexit? The EU? The U.S. election? What will happen in emerging markets? How will we sustain growing debt levels? How will supply chains reorganize? Will trade tensions worsen?
The "new normal" is already a driver of change. Volatility is likely to stay high for extended periods. It's best to regularly update (or implement) a currency risk management policy to face this new landscape. Be ready!
The Bank of Canada's Risk Management article outlines the institution’s approach to risk, including insights into financial risk management during times of uncertainty.
For more information, read: Crisis and Currency Risk: Coronavirus – What Now? and Crisis and Exchange Risk: Asking the Right Questions.
Note 1 : A flexible forward contract allows a company to lock in an exchange rate today for a specific amount between two future dates. The holder can draw down partially or fully at any time within the term, at the pre-agreed rate.
International Markets: A World of Opportunities
Expanding into foreign markets drives growth but also exposes SMEs to risks. Tracking the successive impacts of exchange rate fluctuations on anticipated business performance is particularly complex.
D-Risk FX provides SMEs with performance, risk, and scenario analyses by market, currency, and business line—leading to a tailored hedging strategy and real-time visibility on projected financial performance.
Gain autonomy, automate your processes, and approach foreign markets with the confidence of a clear currency risk strategy and the tracking tools to support your ambitions.