Flavours & Fragrances Industry – FX Risk Management in Uncertain Times
The Coronavirus pandemic is having a mixed impact on the Flavours and Fragrances industry. While the threat of supply chain disruption and layoffs remains ever-present, some sectors of the market appear to benefit from an inventory buildup and from increased demand for cleaning, sanitation and personal care products.
The economic shutdown has also led to increased volatility in financial markets. While some emerging market currencies have taken severe blows, the EUR-USD rate —the most relevant currency pair in terms of the Flavours and Fragrances industry — saw swings of +/- 7% in a matter of days during the turbulent trading sessions of late March 2020.
In this scenario, foreign exchange (FX) volatility requires urgent attention. As discussed in a recent webinar organised by Kantox, the crisis provides a good opportunity to raise awareness about the role played by currencies in the Flavours and Fragrances Industry.
Firms that embrace currencies with a strategic vision can expand the range of suppliers and customers while becoming more competitive. They can also reap the benefits of forward points, the difference between forward and spot exchange rates created by different short-term interest rates between currencies. But this strategic vision requires a change of mindset regarding currency hedging programs, as many participants still apply outdated procedures.
Mapping foreign exchange risk
To obtain a good understanding of currency risk in the Flavours and Fragrances industry, a useful starting point is to consider how prices are set across the value chain. In ad hoc contracts, pricing is based on three main variables: the price of the underlying commodity (usually in USD), the exchange rate, and the margin applied by the seller.
With framework contracts, prices and volumes are set for a given period; if volumes exceed the predetermined amount, the excess volume is priced on an ad-hoc basis; if lower volumes are required, penalties can be charged.
Depending on their business model, firms operate either with ‘back to back’ items with no inventory, or with inventory that is held, to meet the day-to-day requirements of customers. For back to back items, currency risk materialises from the moment a sales/purchase order is placed. To hedge the corresponding transaction exposure, a currency forward position is created at the moment of the sales/purchase order.
The accounting exposure shows up later as the corresponding receivables/payables are issued. This is a key point. While the relevance of accounting exposure is easy to grasp — because it shows up as FX gains/losses in financial statements — managers should be aware that transaction exposure is the one that matters in terms of operating profit margins. By paying too much attention to accounting exposure, managers run the risk of neglecting the transactional risk that is ultimately reflective of the performance of the company.
For companies where inventory is an integral part of day-to-day business operations, managing pricing risk is a key element in terms of competitiveness. Here, pricing risk starts when inventory is purchased and continues until the sales order is issued.
All the while, the value of the inventory fluctuates according to changes in the exchange rate and in the price of the underlying commodity. On the selling side, transaction exposure emerges with the sales order and continues right until settlement in cash takes place. Accounting exposure arises on both the purchasing and the selling parts. In practical terms, this sketched version of the FX risk map is complicated by the sheer number of positions in different contracts, markets and maturities.
Finally, forward points must also be taken into account. As the Federal Reserve cut its target for short-term interest rates from 1.75% to 0.25%, the forward discount of USD relative to EUR has been reduced. Why is this so important? Firms that are aware of the impact of interest rate differentials can take advantage of forward points as they hedge against currency risk. By setting up the correct programs, they can turn interest rate differentials into a competitive advantage. Many industry players are still not sufficiently aware of this advantage.
FX automation and the optimal risk management program
In order to take advantage of currencies and improve competitiveness, managers need to put in place currency hedging programs that fulfil a number of requirements. An optimal hedging program should adequately reflect the firm’s currency risk tolerance; it needs to be clearly communicated across the enterprise and formally documented, measured, reported and reviewed.
In addition, hedging programs have to be flexible enough to accommodate unexpected changes in market conditions. While this looks like an impossibly daunting task, especially on account of the large number of transactions, FX automation allows managers to rapidly and cost-effectively deploy programs that tick all the boxes.
With end-to-end FX automation, participants in the Flavour and Fragrances industry can monitor in real-time, 24/7, their exposure to currency risk. They can execute hedges based on their own set of parameters, a process that can be scaled up to any number of transactions and currency pairs.
The benefits of automation are reflected in three dimensions: risk, growth and cost. From the risk standpoint, operational risk is reduced as human error is taken out of the equation, while transactional currency risk is virtually eliminated. From a growth perspective, automation allows firms to increase the number of potential clients and suppliers and to expand into promising new markets.
Last but not least, by automating the process of currency hedging, managers can stop worrying about FX risk and devote more time to value-added tasks, while making sure that the business is fully prepared for unforeseen events — a particularly valuable benefit in these agitated times.