FX in Uncertain Times: Speciality Chemicals
28 July 2020 · 3 min read
Speciality Chemicals firms derive a majority of their revenues from the production of gases, coatings, advanced materials, and numerous other speciality chemicals. This includes producers of high-performance specialised materials or more standardised materials—or even on a combination of the two. Because of the global nature of the business, most firms in the industry face significant currency risk.
In a special Kantox webinar, we assess FX risk management policies in the context of the ‘risk map’ of Specialty Chemicals firms. We also outline a set of best practices for currency hedging in the industry. As Kantox FX Specialist, Nadia Corbett, argues: “Treasurers need to assess the advantages of becoming more dynamic and leveraging data capabilities to achieve their risk management and reporting goals.”
Business models, company dynamics and currency hedging
Firms specialising in high-performance materials build their forecasts on their SLAs and on discussions with major customers, with whom they have close relationships. Because their pricing is fairly stable, forecast-based hedging is the norm.
However, the Covid-19 crisis has decimated accuracy and hedge effectiveness in recent months. Many firms have found themselves in situations of over-hedging, as a significant proportion of planned transactions —for which hedging commitments had been put in place at the start of the year— never materialised.
On the other side of the spectrum, firms that rely on standardised materials derive a majority of their revenue from the production of commodity chemicals. Some of them do not hedge at all. Their forecast risk is high because existing opportunities for substitution in the market create looser customer relationships.
Accordingly, most of these firms hedge individual transactions as they arise. The resulting manual workload means that hedging is difficult to complete to a high standard, especially in times of crisis when finance teams are busy with more urgent tasks.
Depending on their business model, Specialty Chemicals firms may have different goals when it comes to reporting currency hedging. While large, listed companies are concerned with creating a smooth hedge rate over time, smaller private firms might focus on protecting the profit margin on individual transactions. For companies with a group structure where foreign subsidiaries buy from headquarters and sell in their own local currencies, minimising accounting FX differences is the most pressing concern.
Mapping currency risk in the Specialty Chemicals industry
To understand the nature of currency risk, we need to consider two cases: (a) a typical back-to-back (B2B) transaction where the firm holds no inventory; (b) a more complex transaction for firms that maintain warehouse facilities.
In both cases, three related but distinct types of currency risks arise: Pricing risk, transaction risk and accounting risk. Currency risk results from fluctuations in the exchange rate as time passes by, and the transaction undergoes several phases.
In a simple B2B transaction, pricing risk reflects the risk that the FX rate used to set the price may go against the firm when the actual order materialises, thus hurting profitability. Pricing risk gives way to transaction risk as soon as the order is accepted. Between the acceptance of the order and the corresponding cash settlement —a time-lapse of up to 180 days in many cases—, the currency of a purchase order may appreciate (making the cost of goods more expensive), and/or the currency of a sales order may depreciate (creating lower than expected revenue).
Lastly, FX gains and losses are likely to show up in financial statements because of the time lapse between the moment the invoices are recognised and the moment of their settlement. The same principle applies to more complex transactions where the firm maintains a warehouse facility, although the transaction is because the purchasing-related events occur prior to the sales-related events.
How should Specialty Chemicals companies design their hedging programs? As François Masquelier, Honorary Chairman of the European Association of Corporate Treasurers, noted during the webinar: “The answer depends on the pricing dynamics they face in their own particular markets, and on their reporting goals”. Whether the primary concern of a firm is pricing risk, transaction risk, or the book impact of FX, fully automated hedging programs can be designed to adapt to any requirement.
If you’d like to find out more about specific hedging programs for the speciality chemical industry, check out our webinar on this topic: