Economic uncertainty and increased market volatility are a fact of business life. But by building up buffers and hedging against risks, companies can weather turbulent conditions such as currency fluctuations, a bank collapse or a possible exit of the United Kingdom from the European Union. Indeed, businesses can even benefit from the unusual financial environment, by taking advantage of negative interest rates, for example. Here we highlight five key ways to mitigate risk and potentially prosper in an unsettled world.
Once it seemed that stability was here to stay and that the long run of growth enjoyed by many countries since the 1990s would continue for ever. The financial crisis, eurozone crisis and a wave of geopolitical unrest shattered that illusion. Instead, companies have to contend with low growth and low inflation. More recently, these challenges have been exacerbated by new sources of uncertainty such as slowing growth in China and choppy oil prices.
Economic and political turmoil have increased the volatility of shares, bonds, currencies and commodities in the post-crisis period, according to Alexander Schreuder Goedheijt, head of Foreign Exchange (FX) Solutions at ING Wholesale Banking. However, the problems have been inadvertently worsened by post-crisis regulations. These were designed to improve the stability of the financial system but have hampered banks’ ability to act as market makers and provide market liquidity. “In the past, large banks were willing to take market risk on their books and then calmly trade their way out of it,” explains Schreuder Goedheijt. “That has become more difficult and less attractive due to an array of regulations." As a result, markets have become less accessible, less liquid and smaller, making a wide range of transactions, from capital raising to hedging, more difficult.
Understand your risks
Increased volatility in markets such as FX must be taken into account when considering investment, liquidity management and funding options. Timing, and an insight into the relationship between the various risks, is critical, according to Lody Prijs, head of Corporates FM Client Solutions Group at ING Wholesale Banking. He advises companies to take as broad a view as possible of their business activity and the potential risks they face: "One way to do this is by using a risk analysis tool, which takes volatility into account and makes it possible to assess company-specific risks."
ING’s Risk Analytics Tool enables corporates to understand how risks will change when they execute a transaction and what the impact of a hedge would be. It is also enables a company to benchmark its business against peers in the same sector. "We look at the overall financial picture, including balance sheet, income statement, raw materials and debt currency mix,” says Prijs. “In large companies you often see that risks are subsequently reduced by other developments. So you always have to look beyond the individual transactions.”
Diversify – and build in a buffer
When it comes to funding, Prijs advises against putting all your eggs in one basket. "Companies can tap into multiple sources of capital. You spread your risks by diversifying funding across various markets."
Not all corporates can easily diversify their funding sources – but they should still guard against markets being closed. According to Theo Korver, ING's global head of FM Client Solutions Group, the high-yield bond market is sporadic in nature. “There were no high yield bonds in the first two months of the year due to increasing uncertainty in Europe and China,” he notes. “It is not inconceivable that companies may have to go a full year without access to this market. Those seeking refinancing in this market since the end of last year are therefore effectively up a creek without a paddle."
To avoid a potential funding shortfall, companies that rely on the high-yield market for financing should create funding buffers. Korver holds up Liberty Global, an international cable company with operations in 14 countries, as a exemplar of funding management. “They are already refinancing transactions that will expire in four or five years for a new eight-year period,” he notes. “This creates a time buffer and avoids having to refinance when the market is unfavourable."
Adopt an incremental approach to transactions
Companies that are sensitive to currency fluctuations need to be on their guard, according to Korver. "Central banks are less able to manage currency risks,” he says. “Furthermore, intraday volatility has increased dramatically.” Last year, the Swiss franc gained 40% in 30 minutes when the Swiss Central Bank abandoned the cap on the currency's value against the euro, for example.
One way to mitigate such risks is to avoid large transactions and instead make a series of smaller transactions over a longer period, according to Korver: "This limits the risk of market sensitivity on any given day."
Look for hedging opportunities
A simple method to limit currency risk is to seek natural currency hedges. The aircraft market, for example, is mainly priced in US dollars. European aircraft manufacturers, such as Airbus and Safran, are therefore sensitive to euro/dollar rate movements. To avoid such risk, they could move some production to dollar countries and ensure they have as many dollar contracts, explains Korver.
However, natural hedges are not possible for all companies. Instead, companies can use derivatives, such as FX options, to hedge against risks such as currency fluctuations caused by geopolitical or economic instability. Korver notes that despite Russia’s turbulent history, many companies declined – to their detriment – to take advantage of FX options that would have protected them when the ruble nosedived.
Companies can also hedge against other types of risks using derivatives. For example, one ING client hedged against the risk of an another bank with which it does business getting into trouble. "He used us to buy protection for his position in that bank,” says Korver.
Take advantage of market anomalies
The challenging economic environment has prompted central banks around the world to use unprecedented monetary policy measures, such as negative rates. Negative rates have played havoc with corporates’ liquidity management strategies – it is impossible for them to earn a positive yield on their short-term surplus cash. However, they have also presented some opportunities, Korver notes: "A French client can issue bonds and pay negative interest: they receive money because [the benchmark interest rate] Euribor is below zero." It can also be advantageous to convert debt from one currency to another, such as the Swiss franc, to obtain a negative interest rate. Korver expects such transactions will prove increasingly popular, and that anomalies created by unsettled markets will become frequent occurrences that should be monitored and exploited. "More volatile markets are the new normal," he adds.