I realize fully the reaction that may be caused by labelling some corporate Treasurers as speculators, but frankly that is what some of them are according to my de?finition of currency speculation. This is in no way whatsoever a criticism. It is however a reflection of the realization that while most corporate Treasuries see their main goal as management and reduction of risk, a (not small) minority see the Treasury as a profit centre in addition to the underlying business. These deliberately take asset and currency market positions for the specific purpose of adding to the company’s bottom line. There is no definitive answer as to whether this is “right” or “wrong” in very simplistic terms. It goes without saying that one had better know what one is doing if conducting such speculative activity. While adding to the company’s bottom line is clearly a good thing — both for the company and for the Treasurer —financial markets charge a risk premium for P&L or balance sheet volatility. This should be a consideration when deciding whether or not to allow active speculative activity within the Treasury, using that balance sheet.
The other and decidedly more frequent kind of speculation that corporate Treasurers go in for is in not hedging out currency risk. We looked at this in earlier posts in substantially more detail and it is certainly not for here to go through that again. However, within the overall topic of this blog, it is important to reiterate and make clear the point that not hedging currency speculation equates to taking a currency view, and that in turn equates to currency speculation. Granted, it is a stretch to ?t this type of currency “speculation” within the narrow definition chosen for this blog. There is after all an underlying asset. That said, not hedgingmeans leaving that underlying asset exposed to financial market volatility. Such a decision would seem to be speculative under most broad definitions of speculation. This is in no way to suggest corporate treasuries should hedge currency risk each and every time they have an underlying exposure. The aim here is not to counter one extreme with another. Rather, it is to seek to challenge an idea, an ideology almost.
The idea and the ideology is that currency hedging represents a cost, while losses due to not hedging are simply the result of unpredictable market volatility. To me, the latter represents an abandoning, a shirking of responsibility. It is part and parcel of the job of a Treasurer or finance director to predict their business needs. Should it not be also to predict the context within which those business needs exist, the context being of course the global financial markets that specifically affect the risk profile of their business? A corporate Treasurer may say that they have to explain the cost of a currency hedge to the company’s board, particularly if it had a notable impact on the company’s figures. They should equally have to explain when they do not hedge, and subsequently the company’s unhedged currency exposure leads to extraordinary losses and balance sheet pain. It is sloppy thinking to just leave it to the market to blame. If markets were completely unpredictable, strategists or analysts would not exist. Granted, some are better than others, but the very existence of the profession suggests that at least some are getting it right part of the time. That in turn suggests that a corporate Treasurer or finance director, who is far more senior in both experience and rank to a bank’s strategist, should be at least as well informed as the latter. Companies exist within the market context their businesses operate in. The two cannot be separated. Some need to do a better job of understanding that context.
This group makes up the vast majority of currency speculation and therefore of the currency market as a whole. The primary task of an interbank dealer is to provide liquidity and make markets in currencies for the bank’s clients. The principle is that all client positions have to be offset in the market (i.e. if a client sells you Euros against dollars, you the dealer are buying the Euros and therefore have to sell those Euros back to the market to keep a ?at exposure). In theory, the profit you make is the difference between your bid and the market’s offer. In practice, as bid–offer spreads have narrowed substantially, there has been a general shift within the currency markets towards keeping some exposures one gains or loses from clients in order to take speculative positions in the market to support the P&L of the dealing desk. In addition, a dealing desk can use the bank’s balance sheet to take speculative positions irrespective of client flow. Thus, while the reduction in bid–offer spread has reflected greatly increased information transparency and competition in the market, it has also resulted in a move to increase the “position taking” of an interbank or liquidity dealing desk. Such position taking may be more pro?table, and there is no question that it is when a highly experienced and professional chief dealer is in charge. However, this move has also undoubtedly added to the volatility of the dealing desk’s P&L. Equally, it may also have added to overall market volatility.
This may seem a contradiction, as narrower spreads should be a reflection of greater volume and liquidity. However, the reality is that as those spreads have narrowed, so position taking has increased. Larger positions are taken on by interbank dealing desks in order to maintain or boost P&L, and therefore as a result larger positions have to be unwound during periods of adverse price action. Equally, those narrow spreads can be an illusion. For instance, the normal spread in spot Euro–dollar may be one pip — i.e. 0.8910/11 — but try transacting USD500 million in that spread when the spot exchange rate is moving two or three “big ?gures” — 0.89 to 0.90 — a day!
Readers should note that when I say interbank dealers, I mean currency forward and options dealers as well as spot dealers. These also take positions as well as provide liquidity for the bank’s clients. Here too, like any market where competition has increased over time, spreads have narrowed and the emphasis to position taking has shifted proportionally. In addition, as the needs of clients have changed and become significantly more specific and sophisticated, so there has also been a move by forward and options interbank dealing desks to meet these needs with more exotic forward and options structures. The advantage for the bank concerned is that the spreads on these products are usually larger than those for plain vanilla forwards or options. However, markets work in real time. Here too, competition has quickly moved to narrow those spreads.