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The more complex a business becomes, the more it needs to simplify its currency risk management. Welcome to CurrencyCast. My name is Agustin Mackinlay, I’m the Senior Financial Writer at Kantox and your host. In this episode, we explore the paradox of complexity in currency risk management. When a business goes from a domestic exporter to a consolidated group with foreign distributors, and then to a consolidated group with foreign production units, currency risk management can become impossibly complex that when the company needs to introduce an element of simplicity by focusing on managing net exposures.
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Now, let's see how that's done and let's consider the advantages of this approach. From the foreign exchange risk management point of view, the difference between a consolidated group with foreign production units and a domestic exporter can be mind boggling. Oftentimes, especially in the absence of proper automation, it involves moving away from hedging the exposure in each individual transaction to hedging aggregate exposures on a net basis. Is known as exposure netting,
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but what does it really mean? The broadest definition goes like this: Netting involves offsetting exposures in one currency with exposures in the same or in another currency, such that movements in currency markets create gains or losses in the first exposure or are offset by losses or gains in the second exposure. In practice, exposure netting involves three possibilities: Number one, a long position in one currency can be used to offset a short position in the same currency.
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So for example, accounts receivable and accounts payable in the same currency. Number two, if exchange rate movements are positively correlated, a short position in the first currency can be used to offset a long position in the second currency. And number three, if exchange rate movements are negatively correlated, long positions can be used to offset each other, just as short positions can be used to offset each other.
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To the extent that managing net exposures goes hand in hand with a centralised approach to foreign exchange risk management, where headquarters assume full control over the exposure at group level. The benefits of such approach include: number one, maximize netting, netting dramatic decreases the volume of foreign exchange derivative transactions, as only net exposures are hedged. Number two, better terms with banks headquarters can negotiate better terms with banks.
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That is lower bid-ask spreads than what could possibly be achieved by individual business units acting on their own. Number three, more focus on the business. In a centralised setup where headquarters carried out foreign exchange risk management, subsidiaries can focus exclusively on the business at hand. And number four, better liquidity management. As the volume of foreign exchange derivative transactions is reduced, so is the need to set aside cash for the purpose of collateral requirements.
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The advantages of managing net exposures should not distract us from the fact that ultimately the role of currency risk management is to enhance the value of the firm. This can be achieved by using currency management automation solutions that protect and enhance profit margins by avoiding unnecessary markups, optimizing interest rate differentials between currencies, and improving pricing. All without currency risk.
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If that can be achieved by centralizing foreign exchange risk management and focusing on net exposures, so much the better. A very promising mix of automation and net exposure management simplifies the portfolio approach outlined above, and focuses on managing net exposures from commercial transactions with the same currency pair, same value date and same amount. Stay tuned! We have lots more to say about this in coming weeks and months.
