Currency markets rarely hit the headlines during periods of stability. So it is unsurprising that, in the aftermath of the UK’s Brexit referendum, the precipitous fall in the value of the pound acted as a lightning rod for hysteria.
Sterling had dropped 8% against the dollar in a single day. To put that into context, since 1970, the size of the average daily move has been around 0.6%. Before June 2016, the most sterling had fallen against the dollar in one day had been 4%—and that was on Black Wednesday, when the UK dropped out of the European Exchange Rate Mechanism.
That said, for a seasoned board member, this type of risk will have been a familiar one. Sudden currency devaluations may appear like bolts from the blue. But—much like lightning strikes—they happen more frequently than most people assume.
Over the past five decades, there have been seven separate occasions on which sterling has fallen by 20% or more against the dollar in the space of a year. If your business is exposed to multiple currency pairs, the likelihood that at least one of them will experience a similar move increases. And that’s without taking into consideration the equally significant market risks that even domestically focused businesses will face: from interest rates and commodities to inflation.
All told, if you’ve been in a position of fiduciary responsibility for more than a handful of years, the threat of losses from a market dislocation is less of a remote bogeyman, and more just a normal part of doing business.
So how should a board engage with this? The obvious answer is that if financial market risk is a normal part of doing business, hedging it needs to be as well. Every board should be aware of the financial risks their firm is exposed to, and the magnitude of the damage these could cause. More importantly, the decision around whether and how to protect profitability from these risks must be an active, informed one. Following the path of least resistance is unlikely to result in an optimal strategy.
That is not to say that every board member needs an in-depth knowledge of each market risk exposure and the derivatives available for hedging it. But they should have sufficient knowledge to challenge the decisions that have been made by their finance director, and in particular how these are in the firm’s best interests. This will allow you to ensure that the financial risk management strategy has been implemented because it is aligned with the overall business strategy—not because it happens to involve products that the company’s banks were eager to sell.
There are a number of key questions you can ask to ensure that the board has an appropriate understanding of its financial risk policy:
- What is our risk appetite—i.e. what is the maximum loss we’d be willing to tolerate?
- Does our hedging strategy prevent this maximum loss from being exceeded, or just make it less likely?
- What does “best practice” look like for financial risk management in a company like ours?
- How does our hedging strategy compare to those of our peers?
- How do our hedging products behave under different market conditions? Do they allow us any upside if the market moves in our favour, or are we locked in?
- How easy or costly would it be to cancel the hedges in the event that our business takes a different turn from our original forecast?
- What proportion of our cash flows have we hedged? Why have we left the remainder unhedged?
- Could our hedging strategy involve liquidity demands (e.g. posting margin) and how are we going to meet these?
- Who are our counterparties, and how can we quantify our risk exposure to them?
Crucially, asking these questions will ensure that both the board and the finance director have a robust understanding of how their hedging strategy is likely to perform and what it costs (both in terms of actual cash and opportunity cost). In almost all cases where hedging strategies do go badly wrong, the root cause is that this understanding was missing.
None of this is meant to suggest that there is a silver bullet for hedging financial risk—indeed, even the optimal strategy will not be able to completely eliminate all risk from market shocks. But a board that engages with this topic proactively will find that it’s risk management strategy can be a key driver of the company’s success.
Jackie Bowie is chief executive at independent financial risk advisory firm JCRA.