It may seem like the economic reaction to the coronavirus crisis is severe, but currency ranges remain, for the most part, relatively narrow. This is largely due to coordinated policy, both fiscal and monetary, from many large countries and economies.
Fig.1. The trading range in the first quarter of this year compared to the annual range over the last 10 years is actually lower than the years immediately following the financial crisis, or great recession.
What Contributes to Currency Volatility?
Fig. 1 compares the trading range in Q1 of 2020 with the annual range over the past ten years. On average, the years immediately following the financial crisis were much more volatile from a currency perspective. The currencies that have been the most volatile, so far this year, have been the emerging market and commodity currencies. Commodity currencies, such as the Norwegian Krone and the Canadian dollar, are typically large exporters of commodities, specifically oil. In fact, the six currencies with the largest deviations (red in graph above) from their 10-year trading range all have a correlation with oil prices above 60%, whereas the Euro is only 25% correlated with oil prices.
The oil price war, which started the weekend of March 8, has had a material impact on currency volatility, while the impact from the pandemic has been muted by coordinated central bank and government policies. For example, the Federal Reserve’s total assets have increased by 56% since February 26, 2020 from $4.1 to $6.5 trillion.
Fig. 2. For companies that operate and source internationally, the stronger U.S. dollar presents an opportunity.
On the opposite end of the spectrum are safe-haven currencies. Safe-haven currencies are typically currencies that have low historical volatility, especially during a crisis, and are driven by a large number of factors, including current account surpluses and low interest rates. The willingness and ability of a country to intervene in currency markets to stabilize its currency is also important. The traditional safe-haven currencies are the Swiss franc, the Japanese yen and the U.S. dollar.
The U.S. dollar index (trade-weighted measure of U.S. dollar value) has strengthened more than 5% since its low in February, 2020, though it is 6% and 5% weaker against the Swiss franc and the Japanese yen, respectively. So, for the majority of currency pairs, if you are a company sourcing or operating in a foreign country, this presents an attractive opportunity.
As many companies release earnings over the next few weeks, currency volatility will be an important aspect of their performance.
Large companies that operate overseas will see currency headwinds reduce their foreign net income in U.S. dollar terms. Although this impacts equity ratios and stock prices, it is largely a non-economic or non-cash event. During economic slowdowns, companies tend to focus on that which they can control – such as operating costs and margin. As discussed above, a stronger U.S. dollar presents an opportunity to reduce operating costs in a foreign country or to reduce Cost of Goods Sold (COGS) for companies sourcing internationally. Both of these would have a positive cash-flow impact, which is important if top-line revenue is stagnant or receding.
Fig. 3. In the Mexican market, the spot price has weakened tremendously, largely tied to oil prices. Then the question becomes, how do you effectively manage currency risk during heightened volatility?
Let’s take the example of the Mexican peso. It's weakened significantly which benefits companies that source and operate in Mexico. In addition, the expectations for future peso valuation have changed. This creates opportunities for companies to hedge utilizing options or option structures, especially structures that include sold puts, such as a collar or risk reversal.
A collar consists of a bought call option and a sold put option, and volatility skew indicates that puts are in demand, which drives up the price. The current market conditions shift this structure in the favor of the currency buyer, in this case, the peso buyer. The collar is a great solution that provides a known worst-case hedge rate with some upside potential and can be a good alternative to a traditional forward.
As discussed, volatility skew would benefit the currency buyer of the company that is sourcing and operating in Mexico. Additionally, a buyer of future-dated pesos benefits from the forward points. Forward points are calculated via the interest rate differential between the two currencies. Companies utilize forward rates to lock in a specific value at a specific point in the future. The forward rate is a combination of the spot rate plus the forward points. If interest rates are higher in the currency being purchased, the company receives a discount; and the inverse is also true.
For buyers of the South African rand, the Mexican peso, and the Brazilian real, it is an opportune time to hedge. For sellers of safe-haven currencies, such as the Japanese yen and the Swiss franc, it is an opportune time to hedge, as well.
What about Existing Hedges?
What should you do with your existing trades in the midst of economic uncertainty?
There are primarily two types of hedges: balance sheet and cash flow. Balance sheet hedges are for items that have a corresponding monetary asset or liability on the balance sheet. These typically have a high degree of certainty and a short duration.
Cash flow hedges, on the other hand, are hedges of forecasted transactions which have not yet reached the balance sheet. These typically have a longer duration with less certainty.
For companies that have existing hedges where they have sold a currency forward, many of those hedges may be in-the-money due to recent market moves. These in-the-money trades will have a positive value and can be closed out and discounted to today with a cash payment to the company from the counterparty. This is especially effective for cash flow hedges.
Given the uncertainty of our current economic environment, many companies are re-evaluating their need for cash flow hedges. If an underlying transaction has become unpredictable, a company could offset an existing hedge against the underlying position and take the cash value, which would be beneficial in these times. The company can then choose to either remain unhedged or restructure the hedge at current rates. A company can also choose to partially unwind a hedge as well. For example, a company can net present value 50% of an existing hedge to adjust for the probability of the underlying exposure.
In summary, market conditions in the currency market may not be as bad as initially anticipated and do create opportunities for companies to mitigate risk. The key is to be informed and keep hedge policies dynamic.
Ready to Help
Many companies are evaluating their hedging programs and policies given the dynamic nature of today's markets. Do you want to seek out new perspectives? To learn more about how we can bring ideas, insight and solutions to you, please call PNC’s Foreign Exchange group or visit pnc.com/fx.