Risk aversion in the currency markets
The business magazine, December 2007
Risk aversion in the currency markets - What does this mean for the UK Corporate?
“ Eliminating FX exposure is nigh on impossible so effective risk management techniques are essential “
The latter stages of 2007 have seen increased volatility in the financial markets reminiscent of the conditions seen in 1998. It was back then that Russia defaulted on local government bonds and the subsequent collapse of the hedge fund Long Term Capital Management resulted in wild swings in the currency markets ultimately causing the Dollar to tumble. This time round, the cause has been a weakening of the US housing sector and the well publicised problems in the sub prime mortgage market. With most of the debt sold on by the lending banks, investment houses have found themselves in the situation where they are unable to re-value their assets.
The news has led to mass risk aversion in the financial markets most notably in global equity markets but also in the currency markets. What we mean by ‘risk aversion’ is that investors who have positions in the market decide to close these positions in order to neutralise their risk and instead look towards safe havens such as government bonds to shelter their money. It is this risk aversion that has caused the unwinding of the carry trade (where an investor borrows in a low yielding currency e.g. Japanese Yen in order to benefit from increased yield elsewhere e.g. New Zealand) resulting in exaggerated movement in most currency crosses. For example NZD/JPY fell almost 25% from 97.81 to 74.21 inside a month.
Whilst this is the most extreme of examples, there were similar falls for GBP/JPY which many UK corporates will have exposure to. Of greater interest to most UK corporates is the performance of Sterling against the US Dollar. UK importers have had the luxury of seeing Sterling as the dominant force over the US currency in recent years posting a twenty six year high of 2.1160 on 9th November 2007. However, recent widespread risk aversion has resulted in the Dollar strengthening against both Sterling and the Euro as speculators look to unwind ‘short’ Dollar positions. This resulted in GBP/USD retracing all the way back to a low of 2.0350 on 16th November 2007 representing a 3.8% move in just 7 days.
So, what does this mean for UK corporates? Foreign exchange is an unfortunate by-product of any UK importer or exporter’s business. Rarely will any corporate, especially in the SME market, find a perfect hedge for their currency exposure so fluctuating exchange rates will ultimately have an impact on a company’s bottom-line. Eliminating FX exposure is nigh on impossible so effective risk management techniques are essential. A simple FX policy is often the first point of call. It encourages a disciplined approach to treasury risk management helping to reduce the emotions of fear and greed which may otherwise influence a company’s decisions. Once a policy is in place with parameters that suit the individual business, a corporate can look to covering their foreign exchange exposure in the market and this is when timing becomes key.
