The Australian dollar experienced astonishing volatility in 2007, and many are expecting more of the same in 2008.
By Jan Barned
Over the course of 2007 the Australian dollar experienced unexpected volatility not anticipated by many industry observers. It was not simply the gyrations that caught many off guard, but also the unpredictability. Most financial institutions will now admit they did not see this coming.
And certainly from anecdotal evidence, businesses also did not anticipate instability in the AUD.
With the AUD trading in a range of 70 to 79 cents compared to the US dollar (USD) in 2006, most forecasters were calling for a similar performance during 2007. Very few expected the AUD to break through the US 80 cent level during 2007.
However, unforeseen economic conditions impacted the AUD during 2007. As Tony Morriss, currency strategist and Paul Vantarakis, head of FX institutional sales from ANZ Investment Bank note: 'A key theme in currency markets over 2007 [was] USD weakness, driven by softer US economic conditions and [interest] rate cuts while central banks have diversified their holding away from the US.
'[Interest] rate differentials and the extended strength of the global commodity boom have also moved in the AUD favour to an extent that was not expected at the start of the year.'
However, it was not the movement through the 80 cent level that caught many off guard, but rather the overall volatility of the AUD. 'In April 2006 the AUD was trading at 70.2 cents against the USD. At its peak in November 2007, the AUD was trading above 94 cents, a movement of 24 cents in less than 20 months,' says Peter Pontikis, Suncorp Banking's group treasury strategist.
'During 2007 we saw the AUD move to 89 cents in early August, within the space of two to three weeks drop-ping to 76.76 cent lows, and then undertaking a rapid recovery to eventually peak at 94 cents. However, that was not the end of it, for as the year came to an end the AUD had lost the better part of nine cents and had plummeted back to the 85 cent level,' exclaims Pontikis.
Such volatility has not been seen in recent times. 'This 17 cent trading range compares with a post-float average of around 12 cents, with the AUD trading at a 9 cent and 7.5 cent range in 2006 and 2005, respectively,' note Morriss and Vantarakis.
So, how did those managing this risk fare?
Paul Edwards is senior manager treasury sales, HSBC Bank Australia. He says: 'We have a wide cross-section of clients from institutional to small enterprises. Some of those clients adapted very well to the changing environment, whereas others were more reluctant to respond to the appreciating AUD. The clients who performed the best in the face of the volatility over the course of the year were those that continued to add to their hedge position over the year. Some clients were initially reluctant to transact in the face of the gyrations, in particular during the month of August. But those who did take advantage of opportuni-ties have done very well over the course of the year.'
The rise involatility and the rally for the AUD above 90 cents was not anticipated. '[It] was a painful experience for exporters, especially those not in the resource sector and for importers who had covered at lower levels, say Morriss and Vantarakis.
One such importer, who declines to be named, confirms: 'In the first half of the year we hedged approximately 60 per cent of our second-half commitments based on advice from several leading financial institutions that the AUD was going into the low 70 cent level. Within four weeks, the market went the other way, and all our option contracts were triggered.'
For those organisations that had formal foreign exchange policies in place, 2007 would certainly have tested them.
CPA Australia endorses the formulation of a foreign exchange policy that addresses management of foreign exchange risk within an organisation. Such policy should be developed regardless of current foreign exchange movements, focusing on the impact of such movements.
'We don't manage foreign exchange risk by trying to predict what may happen to exchange rates,' confirms Frank Micalleff, group treasurer for Orica. 'We formulate our strategies based on what is plausible and the downside impact of unfavourable moves. The policy was not amended during the events of 2007, it is robust and allows us to deal with volatile currency movements. We basically have had the same policy for five years, and it has worked for us all the way from 50 cents to current levels.'
Although experienced treasurers are well aware of the benefits of a robust foreign exchange risk-management policy, often these policies are not understood by those operational business units.
'OneSteel has a hedging policy that requires all material foreign exchange commitments to be identified at the time of commitment to a centralised treasury, and the net position hedged,' explains OneSteel treasurer Mark Hedges. 'Although this policy did not change during the period of high volatility [in 2007], steps were taken to reiterate the policy to business units.'
In order to manage the risk and varying degrees on level and tenor, a superior foreign exchange risk-management policy will include flexibility around the types of products an organisation can use. This enables the risk to be managed in line with the current foreign exchange environment.
In an environment such as the one that existed in 2007, many organisations will review hedging strategies. 'There appears to be a greater willingness to look at foreign exchange options, as these provide a higher degree of flexibility in managing an uncertain future, even though higher volatility has increased the cost of these products,' confirm ANZ Investment Bank's Morriss and Vantarakis. 'With the AUD trading above 90 cents, many importers extended the tenor from 12 months to 18 months.'
HSBC's Edwards agrees: 'Traditionally the Australian market hasn't had the appetite to pay premiums and purchase vanilla options. However, in 2007 many clients made good use of option structures. As the AUD overshot most importers' budget levels and profit margins increased, paying premiums for those options became an easier decision. Exporters have also benefited from growing forward margins as the Australian dollar interest rate tracked higher. This benefit also made using options attractive for this client sector.'
This year many are expecting recent trends surrounding the AUD to continue. 'We expect volatility to remain high in light of the degree of uncertainty over the global and local outlook for 2008,' state Morriss and Vantarakis. 'A move to a higher global interest-rate environment also argues for a more elevated level of volatility.'
Suncorp's Peter Pontikis states: 'The resources boom has boosted the AUD to a fair value of 85 cents. We advise our clients to be prepared for the currency to spend 2008 consolidating its extraordinary gains of the previous one to two years.'
With this in mind, have organisations considered hedging strategies for 2008? OneSteel has a process for developing hedging strategies. 'The key challenge has been to accurately identify all of the company's direct and indirect foreign exchange exposures, their source and then the impact of the exposure,' Hedges says.
'We then review these exposures, the duration of hedging for indirect exposures of items under term contracts and then identify any natural hedges. Only then can strategies be recommended.' Orica's strategies always revolve around minimising the impact of currency volatility without giving away all the upside participation. 'We look for points of time where exchange rates offer us ‘cheap insurance premiums,'' Micalleff says.
What is most obvious about the AUD during 2008 is that we will continue to see volatility in the currency.
Given the events of 2007, both financial institutions and organisations alike will be more actively managing these movements.
Possibly the best advice we can all heed is from Orica's Micallef: 'My advice to anyone who handles exchange-rate risk by hoping that rates won't move much needs to develop data and strategies to establish their pain threshold, and if a 10 per cent currency move puts you past that threshold, then you need to actively manage the risk.'
Jan Barned is CPA Australia's policy adviser for finance and treasury.
Foreign exchange options
A foreign exchange option is similar to an insurance contract. For a premium, the purchaser can insure against adverse exchange rates. The option differs from a forward-rate contract in that if the exchange rate moves adversely for the purchaser, then the option can be exercised. If the exchange rate moves favourably, then the option can be abandoned and the purchaser can take advantage of the favourable exchange rate.
Through the purchase of a foreign exchange option, the purchaser is guaranteed a minimum worse-case exchange rate (referred to as the 'strike price'), with unlimited participation in any favourable movements in exchange rates.
A foreign exchange option will require payment up front of the premium. This cost will vary according to a number of variables within the transaction, including the strike price set (worse-case exchange rate), volatility of the currency market at the time the transaction is set, credit risk of the purchaser and length of the transaction (to maturity date) to name a few.
An example of foreign exchange option transaction: Importers' scenarios at maturity
If at maturity the spot rate is below the strike price, the importer would exercise the option and purchase the for-eign currency at the strike price.
If at maturity, the spot rate is above the strike price, the importer would allow the option to lapse and trade at the spot rate. Exporters would then lapse the option if they spot rate is below the strike price and exercise if the spot rate is above the strike rate.
