Treasury Management

A good foreign exchange policy is critical to the sound risk management of any corporate treasury. Without a policy, decisions are made ad-hoc and generally without any consistency and accountability. It's important for treasury personnel to know what benchmarks they are aiming for and it's important for senior management or the board to be confident that the risks of the business are being managed consistently and in accordance with overall corporate strategy.

The recognition of the financial risks associated with foreign exchange mean some decisions need to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile markets so that emotions are dispensed with and previous careful planning is relied upon.

This approach helps eliminate the panic factor as all outcomes have been considered including 'worst case scenarios? which could result from either action or inaction. However even though the worst case scenarios are considered and plans ensure that even the 'worst case scenarios' are acceptable (although not desirable), the pre-planning focuses on achieving the best result.

The use and acceptance of risk management as a key management issue is evidenced by the proliferation of risk management tools. Active risk management is a common characteristic in by far the majority of major corporations the world over. Not to manage financial risk is seen to be negligent as a company's management team is responsible for managing all the variables that ultimately affect the profitability of the company.

Objectives of Risk Management

• Minimise Costs
• Maximise Revenue
• Stabilise Margins in the Future

Hedging

One of the most important uses of derivatives is to allow users to offset their exposure to fluctuations rates by assuming an opposite exposure to their existing exposure, in interest rates on a loan for example. This activity called hedging.

The underlying principle of hedging is that as price movements in the cash market move one way, the move is offset by an equal and opposite move in the price of the hedging instrument (almost always a derivative instrument).

Hedging reduces risk but also reduces the opportunity for reward. It increases the certainty of future cash flows and allows market participants to plan into the future based on the certainly of the future cash flows guaranteed by hedging. Hedging does not increase or decrease the expected returns for a market participant; it simply changes the risk profile of those expected returns.

Consider this example

• A jewellery manufacturer will need to buy additional gold from its supplier in six months to produce jewellery that it is already offering in its catalogue at a published price.
• An increase in the cost of gold could reduce or wipe out any profit margin. To minimize this risk, the manufacturer buys futures contracts for delivery of gold in six months at a price of $800 an ounce.
• If, six months later, the cash market price of gold has risen to $820, the manufacturer will have to pay that amount to its supplier to acquire gold. But the $20 an ounce price increase will be offset by a $20 an ounce profit if the futures contract bought at a price of $800 is sold for $820.
• The hedge, in affect, provided protection against an increase in the cost of gold. It locked in a cost of $800, regardless of what happened to the cash market price.
• Had the price of gold declined, the hedger would have incurred a loss on the futures position but this would have been offset by the lower cost of acquiring gold in the cash market.
• Call us to know more about strategies to deal with your foreign exchange exposure and managing your treasury more efficiently.