The High Cost of Emotions: Mitigating Behavioural Biases in Currency Management
23 February 2023 · 3 min read
Beware of behavioural biases in currency management! Don’t let inherent biases affect your work. Learn how to optimise your currency management by understanding the cognitive biases behind your decisions.
Behavioural biases are systematic but unconscious errors that result from the mental shortcuts we all use when making decisions. These biases can affect the judgment of CFOs and treasurers when managing currencies.
Check out this episode of CurrencyCast where we do a quick review of the most common behavioural biases in currency management. In this article, we explore in more depth what are these cognitive biases and how they impact the company’s performance. In addition, we analyse why the use of FX-automated solutions can help mitigate their effects.
Financial decisions: rational or emotional?
Behavioural biases were made famous by two Israeli psychologists, one of whom was Daniel Kahneman, the well-known author of Thinking Fast and Slow and winner of a Nobel Prize in Economics. He proposed that financial decisions are not always rational. In fact, the people behind these decisions are human and usually act on emotion or make mistakes processing information.
This is the basis for behavioural finance, a field of study that combines psychological theory with conventional financial economics. As a result, the same phenomenon happens in currency management, when the CFOs and treasurers have to make decisions about the hedging strategy.
That’s why this is a significant concern for currency managers. These biases can lead to suboptimal decision-making, resulting in higher currency risk exposure, increased costs, and reduced profitability.
Let’s take a look at the most common behavioural biases in currency management to further understand this challenge.
The most common behavioural biases in currency management
Some of the most common behavioural biases in currency management include:
- Conservatism bias: Occurs when the finance team is too slow to update their beliefs when confronted with new evidence.
- Forward rate bias: The tendency to view a large interest rate differential between two currencies as an opportunity for an easy financial gain, rather than a sign of impending risk.
- Overconfidence bias: Occurs when CFOs and treasurers feel unrealistically sure about themselves when managing currencies.
- Loss aversion bias: This occurs when managers take too much risk to avoid what they see as a painful loss. At the same time, they may be too risk-averse in the face of favourable market opportunities.
Now that you better understand how cognitive biases may present in the context of currency management, it is also important to analyse how they impact decision-making.
How behavioural biases shape your business decisions
After having a clear idea of what are behavioural biases, it is also important to see how these human biases can have a negative outcome for the company. Some of the challenges linked to human psychological influences are:
- Hesitation to invest and constrain the future of the company.
- Reluctance to hedge currencies which can increase currency risk exposure.
- Managers tend to speculate in currency markets, resulting in poor outcomes.
- Subpar financial modelling and higher chances of putting the firm’s competitive position at risk.
As you can see, it can be dangerous to let emotions play a part in the financial decisions of a company. That’s why CFOs and treasurers should find a way to be more objective and rely on as much accurate data as possible.
Overcoming behavioural biases with FX automation solutions
One way of mitigating the challenges of cognitive biases influencing currency management is to implement an automation solution. Automated FX risk management solutions can help mitigate the effects of behavioural biases in currency management by removing systematic errors and powering carefully defined business rules.
Delaying hedges execution with static and dynamic conditional orders is a great way to ease concerns about the high cost of hedging in the face of unfavourable forward points. By automating hedging programs CFOs and treasurers can remove currency risk with great precision, making it possible to increase profitability by embracing currencies.
This realization will help companies do away with behavioural biases in currency management.
Behavioural biases in currency management can lead to suboptimal decision-making, resulting in higher currency risk exposure, increased costs, and reduced profitability. CFOs and treasurers must be aware of these biases and take steps to mitigate their effects.
Currency management automation solutions can help remove systematic errors and power carefully defined business rules to prevent the effects of behavioural biases. By doing so, companies can optimize their currency management strategy and foster growth by embracing currencies.
Kantos is a unique currency management automation software that empowers companies to embrace foreign currencies and reap the benefits of a multi-currency approach by automating the entire FX workflow. Kantox helps you to optimise your FX risk management with the help of innovative technology to automate all your hedging programs, have full control with customised business rules, and have clear visibility over your cashflows.
Talk with our currency management specialists to find out more or take a tour of our product.