00;00;00;12 - 00;00;31;26
The Netflix and Swatch FX Challenge. How do you manage currency risk when your functional currency steadily appreciates? Do you go for a layered hedging program? Or do you go instead for a static hedging program? Welcome to CurrencyCast. My name is Agustin MacKinlay, I’m the Senior Financial Writer at Kantox and your host. In this episode we discuss the foreign exchange related headwinds faced by two extremely successful global companies, Netflix and Swatch.
00;00;31;29 - 00;01;03;25
We show how, according to best practices in foreign exchange risk management, different pricing parameters call for different types of hedging programs we then add another dimension, interest rate differentials between currencies. And we show how the execution of such programs requires a significant degree of automation. Netflix and Swatch are examples of extremely successful companies with a global footprint. Yet both are facing the same type of FX-related headwinds.
00;01;03;27 - 00;01;33;14
Now functional currencies, the US dollar and the Swiss franc respectively have been steadily appreciating against most major currencies over the last couple of years. This is happening against a backdrop of expanding foreign sales. About 60% of total revenue, in the case of Netflix, comes from overseas markets and the company only expects that share to grow in the future. The same could be said for Swatch now.
00;01;33;18 - 00;02;04;10
In a recent letter to shareholders, Netflix informed that there was a fourth quarter revenue drag of about 200 million on account of the strong US dollar. And according to a recent Bloomberg article, Swatch suffered a 500 million Swiss franc drag on revenue on account also on the strong Swiss franc. What are the best practices in terms of foreign exchange risk management call for Netflix and Swatch?
00;02;04;12 - 00;02;38;17
That is going to depend on the pricing characteristics of the business. Broadly speaking, we can identify three types of pricing parameters. Number one, dynamic prices in which prices are frequently updated. Number two, some companies desire to keep prices as steady as possible for as long as possible, and that's a time tested commercial strategy. Number three, some companies desire to keep prices steady for individual campaign or budget periods and have the desire or the ability to adjust prices.
00;02;38;18 - 00;03;12;14
If there's a need for that at the onset of a new campaign or budget period? Where does that leave Netflix and Swatch? On the one hand, Netflix desires to keep prices as steady as possible for as long as possible. On the other hand, Swatch does not hesitate to increase prices or to change prices if there's a need for that in the face of adverse developments in currency markets. Now, there's different pricing parameters call for different types of hedging programs.
00;03;12;17 - 00;03;41;09
The only way to keep prices as steady as possible for as long as possible, without hurting budget and profit margins in the face of adverse developments in currency markets, is to apply what we call a layered hedging program. In which the exposure is in the shape of a forecasted exposure for revenues and expenditure over a number of periods linked together over time.
00;03;41;12 - 00;04;05;22
The way to do it is to hedge, to apply layers of hedges to forecasted exposures so that you end up with an average hedge rate that displays little variability over time. And that's how you keep prices steady in the face of unfavourable moves in currency markets. That is what Netflix has just announced that it was going to do.
00;04;05;25 - 00;04;33;15
But what about Swatch? Here, best practices would indicate a static hedging program in which part of the exposure is hedged right away, while conditional orders are used to protect a worst case scenario FX rate. Now things get a lot more exciting. Did you watch the Netflix series Class Act and Sintonía? Well, I happened to watch Class Act.
00;04;33;17 - 00;05;08;09
It's a very good series about the life and times of flamboyant French business tycoon Bernard Tapie, who one way or another dominated French business headlines in the 1980s and in the 1990. Only to fall spectacularly from grace on the heels of grave accusations of corruption. Well, why do I mention Class Act? Because we need to introduce another dimension into the hedging program, namely interest rates, or more precisely, interest rate differentials between currencies.
00;05;08;11 - 00;05;38;28
As we all are aware, starting in 2021, central banks adjusted upwards interest rates in an effort to fight inflation and inflation expectations. Only they did so at different levels. So currently taking one year interest rates, US dollar interest are higher than euro interest rates by about 2% and by about 3.5% percent against the Swiss franc.
00;05;39;00 - 00;06;14;18
All other currencies like the Brazilian real and the Mexican peso have even higher interest rates. But what does that mean for Netflix? In the case of Class Act, it's good news! And that's because given the interest rate difference between the euro and the dollar, the euro trades at a forward premium against the dollar. Meaning that there is an extra margin that can be captured by Netflix by extending the length of its hedging program.
00;06;14;20 - 00;07;04;06
Now, consider the case of Sintonía. That series is mostly sold in Brazilian reais, and there the situation is completely different because the Brazilian real as it has higher interest rates than the US dollar trades at a forward discount to the dollar. And that creates a high cost of hedging or high cost of carry. It can be minimised or at least managed by using conditional stop loss and profit taking on each layer of the layered hedging program, so that the company or finance team can delay somewhat the execution of hedges and obtain a better exchange rate.
00;07;04;09 - 00;07;42;01
And what about Swatch? Here, unequivocally the company is going to face what is called unfavourable forward points. This is because Swiss franc interest rates are so low that the Swiss franc trades at a forward premium against most major currencies, with a probable exception of the Japanese yen. That means that if you sell other currencies against the Swiss franc as best practices would seem to indicate, you're going to have a negative impact from those interest rate differentials.
00;07;42;03 - 00;08;09;02
Once again, this can be managed by having a conditional order to delay the execution of hedges as much as possible. Now we've come a long way. We started out this discussion by mentioning the fact that both Netflix and Swatch share a same type of foreign exchange related headwind, namely an appreciating functional currency in the face of increasing foreign sales.
00;08;09;08 - 00;08;36;09
That puts downward pressure on profit margins and on revenue growth. We then went on to discuss what best practices in foreign exchange risk management would indicate for both cases. And here we saw that determining factor was the type of pricing parameters. On the one hand, Netflix desires to keep prices as steady as possible for as long as possible.
00;08;36;12 - 00;09;09;12
On the other hand, Swatch does not hesitate to hike prices in the face of negative or unfavourable developments in currency markets. We then introduced the dimension of interest rates or more accurately, interest rate differentials between currencies. And we saw how companies, how the finance team can manage those interest rate differentials to their advantage. But this discussion is not over by any means because we need to introduce another element, namely automation.
00;09;09;15 - 00;09;42;08
Consider the complexities involved in running a layered hedging program. Members of the finance team need to execute a precise schedule of hedges. It is time consuming, a resource intensive activity, and it carries operational risks when it's done manually, for example, with the help of large spreadsheets. As another type of operational risk would pop up, namely spreadsheet risk, the risk of manual data input errors or formula errors or formatting errors.
00;09;42;10 - 00;10;13;23
Now Netflix informs investors that it has operations in more than 40 currencies. Just imagine: multiply the underlying complexity of those layered hedging programs by the number of currency pairs. And also imagine that each of those currency pairs will display a different scenario in terms of interest rate differentials, that is the difference between spot and the forward rates.
00;10;13;25 - 00;10;26;19
I think by now you see where I'm headed. All of this, at least in terms of best practices, in terms of foreign exchange risk management, is impossible without a significant degree of automation.
