Welcome to CurrencyCast.
Make FX hedging great again! 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 implications of recent episodes of financial markets volatility in terms of foreign exchange risk management. I will discuss the five following points. Number one, the three interrelated challenges faced by currency managers. Number two, the breakdown in correlations. Number three, we'll discuss the importance of 24/7 financial markets and currency markets monitoring. Number four, we'll deal once again with the urgency of optimising forward points management. And finally, we'll discuss the rise and rise of the multi-currency world. Erratic, incoherent, unpredictable, confusing.
These are some of the terms used by the Wall Street Journal and the Financial Times to describe Donald Trump's economic policies. Because it goes well beyond the US president's tariff policy. Every time the US equity markets wobble, the president threatens to upend the independence of the Federal Reserve, the Central Bank of the United States. And that only aggravates financial markets' volatility.
What does that mean for currency managers at corporations? There are three interrelated scenarios here. Number one, increasing foreign exchange market volatility. Number two, less than stellar visibility in terms of cash flows when it comes to financial planning. And number three, shifting interest rate differentials between currencies. Now, the good news is that best practices in foreign exchange risk management, provide companies with the tools to simultaneously tackle all these interrelated problems.
We're talking here about automated hedging programs and combinations of hedging programs, including micro hedging programs where the exposure is in the shape of firm sales or purchase orders, programs that protect the budget rate for an entire campaign or budget period and layered hedging programs where the hedge rate is built in advance by adding successive layers of hedging. Now, one word about rising hedging costs, always a possibility in a scenario of financial markets volatility.
Number one, if you trade with multi-dealer trading platforms, make sure that they include best price execution features. And number two, if you're facing unfavourable interest rate differential, make sure you have the tools to delay the execution of hedges. One of the most striking aspects of the recent episodes of market volatility or financial markets volatility has been the breakdown in correlations.
The most talked about correlation breakdown regards safe haven assets, as neither the US dollar nor US Treasury bonds appear to have fulfilled that role. Instead, they were replaced by the surging Swiss franc and Japanese yen against the US dollar. But what are the implications, if any, in terms of foreign exchange risk management? I think we can single out two points here. The first point regards the so-called portfolio approach to foreign exchange risk management. It largely relies on correlation analysis between currency movements to optimise exposure netting.
But what if correlations weaken or change? ⁓Well, that is certainly a very interesting development to watch. The other element regards the exchange rate between the euro and the Danish krone. We've seen in recent episodes of weakness in US equity markets that the Danish krone somewhat weakened against the euro and that has largely to do with the fact that large, so pension funds, Danish pension funds are equity investors in the United States markets. Now, if you go to the earnings reports, quarterly earnings reports or annual reports of most Danish companies, you will notice that most of them do not hedge their exposure to the euro, which is again a very really interesting development to watch.
Now, to be sure, much more empirical work remains to be done before we properly assess any breakdown in correlations in currency markets. Note also that currency management automation does not rely on such correlation analysis. Let me now discuss the wisdom of forward points optimisation. We've seen over recent weeks that the Swiss franc and the Japanese have been surging against the US dollar and is putting some pressure on Swiss exporters.
As they are likely to face, on the revenue side, some foreign exchange headwinds in the coming weeks and months. To add insult to injury, this is happening against the backdrop of an increasing forward premium of the Swiss franc to other currencies. Taking one year forwards and spot rates, the Swiss franc trades at a forward premium of 4.2 % to the US dollar and about 2 % to the euro. To say nothing about the likes of the Mexican peso, the Brazilian real or the Turkish lira.
So let me tackle this urgent problem from four different angles. First is the technical perspective. Then we'll discuss the behavioural angle. Then let me present the win-win situation in optimising forward points. And finally, we'll discuss the learning experience and the strategic imperative behind forward points optimisation. So let's start with a technical explanation.
We've discussed that matter already in CurrencyCast. You will face unfavourable forward points if you sell and hedge in a currency that trades at a forward discount to your own currency, as forward points reflect the difference between exchange rates with different value dates. Most of the times we take the exchange rate or the difference between the, say, three-month or six-month exchange rate and the spot rate.
It will also be unfavourable if you buy and hedge in a currency that trades at a forward premium. Now, how can managers protect themselves against that implicit high cost of hedging? Well, I think we discussed that ⁓ earlier on. You set a corridor for the exchange rate with the help of API real-time connectivity that allows you to put stop loss and save profits around that exchange rate. Now notice that each time that passes by and that neither of those limits are touched, then it means that the difference between the forward rate and the spot rate diminishes and then exactly in that proportion, your cost of hedging diminishes.
Note that throughout that process, your exposure remains under active management throughout. Now, let me maybe discuss the behavioural angle. Here, I start with the notion of the forward rate bias, namely the belief that a high interest rate in a currency might prevent it from falling against other currencies. Now, this is obviously not always the case. In fact, it's most of the times not the case.
It has happened in recent months and quarters with a Brazilian real to the ⁓ dollar and the euro. Many managers were thinking that the high interest rate in the Brazilian real will prevent it from weakening and decided not to adequately protect their exposure on the revenue side. But we know what happened. The Brazilian real not only weakened further but the Central Bank of Brazil raised joint interest rates to now at about 14.25 % further increasing the forward discount of the Brazilian real. So I think what I state here is best illustrated with a wonderful anecdote of that book, The Little Prince by Antoine de Saint-Exupéry.
Perhaps you remember the little prince had to uproot those baobab trees to prevent them from growing too big because of course there would be no place in the little prince's tiny planet. And that's obviously a metaphor for procrastination. Avoid procrastinating when you face unfavourable forward points, when you are in the grip of the forward rate bias. To do that, understand that there are tools and these tools allow you to reduce the cost of hedging in the face of unfavourable forward points.
Now let me discuss the win-win situation that is created whenever you optimise forward points. In fact, my colleague Nadia Corbett, Enterprise Sales Manager at Kantox, says it best when she says, it's a pure gain. So what is meant by that? There might be instances in which, so for example, you reduce your trading costs, but that would come at the expense of your liquidity providers, your banks, and perhaps you don't want to be in that situation. But when you optimise forward points, in this case by delaying hedge execution with the help of conditional orders, you're not taking anything away from your liquidity providers, your banks, your clients, your suppliers.
In that sense, it is a pure gain. So just do it! Now, let me mention also the learning experience and the strategic relevance of this point. I'll start by asking you a question. Who in the company is the only team that has the hard skills, the knowledge to understand the relevance of forward points management? Well, you guessed it. It's the Treasury team. No other team is likely to have those skills, either the commercial teams, the purchasing managers, or even top management and shareholders. That means that treasurers or members of the Treasury team need to perhaps improve some of those soft skills in communication, especially to be able to explain the strategic relevance of forward points optimisation.
Two recent books highlight the fact that monetary arrangements come and go. Money, A History of Humanity by David McWilliams and Our Dollar, Your Problem by Ken Rogoff. Both of these books highlight the fact that monetary arrangements cannot be taken for granted, not even when we're talking about the mighty US dollar. So what are companies to do in the face of that prospect? I think the solution is already in place. It is about what we call at Kantox, embracing currencies, namely taking ownership of the foreign exchange risk management process to confidently sell in the currencies of your customers and buy in the currencies of your suppliers.
A recent survey by Amadeus shows that 71 % of customers would spend more if allowed to use their own currencies. And that as much as 84 % of them would rather make payments in their own currency. When you sell in the currencies of your customers, you're able to open up new and potentially lucrative markets. You will be also in a position to lower the credit risk in your accounts receivables. And if you face favourable forward points, you could add extra margin or pass on some of ⁓ that margin expansion to your customers in the shape of lower prices thereby increasing the sales to asset ratio, always an interesting metric in firm valuation.
And when you buy in the currencies of your suppliers, you're immediately sidestepping FX markups that suppliers always charge whenever they sell in a currency that is foreign to them. You could also use those forward points optimisation in order to lower contracting costs. Now this is precisely what companies are doing. Let me mention just two recent examples. Shopify, the US marketplace operator, has just added more currencies to its marketplaces. Note that the market capitalisation of Shopify is north of $120 billion.
And speaking of market capitalisation, the Wall Street Journal reports that at internal meetings at Netflix, that plans are in place for that company to reach the $1 trillion mark in terms of market capitalisation by 2030. What is the strategy? Well, it is relatively obvious. It's go where your subscribers are. And these subscribers are naturally in the rest of the world, as India and Brazil are singled out as key markets for the expansion of the company. So there you have it.
Whether the dollar stays or not as the key international reserve currency, companies are all day already actively and fearlessly embracing currencies.
