FX: The Critical Risk Few Truly Understand

With reports of possible trade wars and political uncertainty, the specter of foreign exchange risk and volatility is quickly becoming top of mind for senior level financial executives.

The Financial Executives Research Foundation (FERF), along with the Columbia University School of Business, has conducted a critical research study on the measurement of corporate foreign exchange risk.

FEI Daily Managing Editor Olivia Berkman sat down with Professor Trevor Harris, Ph.D., the Arthur J. Samberg Professor of Professional Practice at Columbia, to preview some of the findings of the upcoming paper. Below is a video interview and an edited transcript of the discussion.

Olivia Berkman: Professor Harris, can you summarize what your research has discovered so far?

Trevor Harris: That's a very big question, because it's all a question of where with start out. But the key conclusions are that most managers and board members and investors are using information and data about the business that is not representing what I think they're actually seeing.

The other broad conclusion is that there is no best practice, in terms of what people are actually doing. We have an approach that we believe people should be doing, but the outcomes are very broad. Many of our interviewees were hoping that they would actually see a best practice or get a best practice, and I know that that was probably some of what Financial Executives International members’ were hoping for. But at least to us, unsurprisingly, that is not the case because it's a very complex area and people have made these choices in many different ways.

Berkman: Given the global environment that we're in, is foreign exchange risk increasing?

Harris: That's an interesting question because what's happened -- if you go across many decades is -- that we go through periods of extreme volatility, and then it's sort of quietens down and everyone relaxes and then volatility comes back. When we started this project, we'd been in this sort of 2014 to 2015 period when the dollar was appreciating significantly and there was a lot of volatility. And with an appreciating dollar, at least for US companies, that tends to depress results. So people become much more anxious about the exchange rates.

What's happened in 2016 is that things are a little more stable, and if we look at what's starting in 2017, we're seeing actually the dollar starting to depreciate relative to other currencies. So people are a bit more relaxed, because it's actually going to help them to some extent, at least in the short term.  And that's certainly true with the major currencies.

When you get to currencies like the real in Brazil where many US companies have large operations, there's large amounts of volatility. And if you look at the geopolitical risks, around the world, it will be I think somewhat naïve to assume that volatility is not gonna recur. Whether it's this year or, you know, sometime in the near future.

One of the things that we show from the interviews and surveys is that people, because they went through this time of high volatility, people we reassessing the systems they had and how they were dealing with foreign exchange risk and volatility. And if we go into a quiet period, people should not stop doing that. This is actually the time to actually address some of these issues.

I should say one of the reasons we believe and, and some of this is from experience, not just from the surveys, that there is this issue in the impact of foreign currency volatility, is because people are dealing with legacy systems, or legacy approaches to it. And partly because of the way the accounting standards have been written. They were written many, many decades ago. So, again, even if we go through a period of relative lower volatility, it's certainly not fixed and stable. And this would be the time to address a lot of those issues, so that you can deal with the next round of more extreme volatility.

Berkman: What would the solution be? Is  and with with the Financial Accounting Standards Board (FASB)? Is it with industry prac- practice?

Harris: Actually all of them. The real, the essence of the problem or issue, is that, the, the initial mindset that people bring to foreign currency is they think of it in a transactional space. If we don't think about it in a corporation, just as individuals, we might invest in a a company in Germany, and it's a German listed company so they have euro as their primary currency. Those investments, when we liquidate them, we get euros and we convert them back into dollars.Or if it's a corporation, you make a sale to a European company or customer,  you invoice them in euros, you are exposed to that euro receivable until they pay you and then you convert it back into dollars.

So that's the mindset that people come in with. And if you're in that simple transactional space, it's all sort of common sense to some extent. The standards and the way that people deal with it is fine and, and a lot of the risk management and hedging is around those transactional type situations. But when, as multinationals and globalization has occurred and multinational business has expanded, there are a lot of companies that have businesses that operate in Germany, London, Brazil, wherever it may be. And they're operating in that currency. The dilem- or the core question that people have to ask themselves is, how do we want to measure the business, and what is it that's actually at risk?

For example for shareholders or other stakeholders, our minds the answer is that your risk is your net investment. Your risk is not the individual items. And so what you should be doing is translating the measures that have been made in that local currencies, we'll use euros as, as the example. And you measure everything in euros and you keep everything consistent in euros, and the only exposure is that net investment itself.

That’s the way that the accounting is done from the FASB point of view and the way most corporations are still doing it, partly because it's required. But in many cases, they have choices for their own internal measures, and part of what we were trying to understand is, how do you measure this internally and then communicate it to your managers, your board, and, and your investors?

Where the confusion arises or, or the disconnect is that anything that's a flow measure -- that happens through time -- people are treating as a transaction based exchange rate or exchange rate that's occurring three times. It's like that often in practice we use weighted averages.

But actually that's not. You've already started, in a sense, remeasuring what's happened. Those are not realizable. They're not retaining the relationships between the income measures, the revenue measures or the net income measures.

One of the areas where this is most extreme, is in terms of measurement of cash flows. What the final report is very clear, from all the responses as well as our own experience is, the cash flow measures that most people in management and even investors believe is free of accounting issues. That is completely false.

There is no cash flow measure that people are getting, certainly in external reports and based on our survey most of the internal reports, that is not subject to measurement  issues created out of this translation process. What you should be doing is just looking at the euro cash flows and if you want using one exchange rate which is probably the exchange rate that you would do everything else in. Accounting regulation does not allow you to do that.

But, again, internal managers don't do that. So when people talk about free cash flows, they're not free cash flows. And people talk about cash balances, they're not real cash balances, because they're sitting in a foreign subsidiary in a different currency.