Corporate currency speculation
In a recent article the Bank of England drew the attention to the increasing role of non-banks in the foreign exchange market. The authors described how non-bank financial institutions use the market for both hedging and profit generation while non-financial corporations predominantly engage in hedging to reduce currency exposure arising from their underlying business. This picture they draw may be misleading and unintentionally support the widespread inappropriate distinction of (bad) speculation of banks versus (good) currency trading related to foreign-trade and other “real” activities of firms. But, speculation as an expectation-driven search for currency profits is part of the business of both groups of non-banks although as I would like to argue manifestations differ for obvious reasons.
In general, in academic debates and official publications the word “speculation” is avoided. Instead authors speak of “profit seeking” or “position taking” or even of “arbitrage”. Speculation sounds vulgar, naming a highly doubtful and undesirable activity. While it is widely known, and in a sense accepted as unavoidable, that financial institutions speculate, non-financial corporations suspected to make money in this way risk a high reputational damage.
This may be one explanation for the findings in the BOE article. Since, as the authors mention, data on non-bank activities are rare, the results rely strongly on information gathered in the Market Intelligence programme of the Bank of England under which Bank staff is meeting frequently with a wide range of market participants in order to gain a better understanding of market developments. This means that corporations told them – as they always tell when asked – that they use foreign exchange markets primarily for hedging purposes. A long history of massive foreign exchange losses and scandals tells a different story. The list of famous cases includes such illustrious names as Volkswagen, Showa Shell and Nippon Steel with losses of up to 1,580 million US dollars. Inhouse trading often deliberately functions as profit center and the old joke of “Siemens, the bank with the attached electrical department” became only obsolete when the firm was granted bank status by the German authorities in December 2010.
So did the firms lie to the Bank of England when asked about their forex activities and did Bank staff naively take these lies for true? The answer is that both sides rather seem to practice a generally accepted linguistic convention focusing on alleged intentions and ignoring the fact that it is not motives which determine whether a position is to be called “speculation” but technicalities:
Basically, any open position in a foreign currency – that is, any position which is not matched by a second one of opposite sign, equal amount and equal maturity – includes an element of speculation. 100 Swiss francs owed for one month can only be offset by 100 Swiss francs lent for the same period of time: neither 80 nor 120 Swiss francs, not for two weeks or three months, not earlier or later, neither in US dollars nor in Korean won. In each of these cases, the currency risk is not eliminated and the value of the position changes with a rise or decline in the exchange rate resulting in a profit or loss for the market actor. In this sense, hedging defined as an activity which matches an open position thereby offsetting currency risk is the opposite of speculation.
In practice, however, the concept of hedging is fraught with ambiguities. Traditionally, three measures of exposure to currency risk are distinguished. They are known as transaction exposure, translation exposure and economic exposure. These concepts are generally understood to describe three channels through which companies perceive exchange rate changes to affect their profitability. But, they also may serve, with varying degree of flexibility, as an excuse for deliberately speculating in the foreign exchange market. A closer look at the concepts illustrates this point:
Transaction exposure measures the firm’s actual transactions that will foreseeably take place in foreign currency. As I wrote elsewhere:
Transaction exposure always involves an identifiable cash flow with an exchange of currencies at maturity. For instance, this may result from a trade payment, a short-term investment in foreign currency, interest payments on foreign assets or dividend remittances from abroad. … A Dutch exporter expecting to receive a payment in US dollar next month may sell the amount in advance in the forward foreign exchange market settling this transaction at maturity with the incoming dollars at the price agreed one month ago. In this way, the price in euro is “locked in” and the position is no longer exposed to currency risk.
The important point is that the transaction is self-liquidating. No doubt about the hedging character here.
Other concepts require an explicit decision about the extent to which a position should be hedged and about whether, and in which way, it is to be seen exposed to currency risk at all. This is where scope for speculation comes in. Again, I cite myself:
Translational hedging requires determining the translation or accounting exposure to currency changes. Translational hedging deals with the valuation of a firm’s assets and liabilities in foreign currency and the resulting fear of losses on positions that are reflected in the balance sheet. Evaluating the motives and logic behind a hedge strategy in these cases is extremely difficult from outside as the relation between the original position and the hedge may be a very loose one:
For example, is it hedging or the simple wish to reap the benefit from an expected change in the exchange rate when a firm decides to partly hedge the value of an inventory of goods which were produced and reported at historical costs but not yet sold, and wouldn’t the firm at least need to know the final country of destination of these goods and the contract currency before making a decision? What if the company in question has a wide range of activities in many countries and assets and liabilities in more than one currency? Under which circumstances should the latter be regarded as (partly) offsetting one another? What if the currency earned with the sales is not intended to be changed into home currency but used to buy materials, or changed into a third currency for that purpose? Similar questions arise for other balance-sheet items, too.
Since translational hedging leaves ample scope for interpretation it can be used deliberately for profit seeking, i.e. speculation, without having to fear reputational damage.
This holds even more for the third measure, economic exposure, which offers even greater flexibility and scope for interpretation:
Economic exposure is roughly defined as the impact of an exchange rate change on a firm’s discounted cash flow or present value at a specified future date. In principle, this would include taking into account price and income elasticities in various markets, and the sensitivity of cost components to exchange rate changes over long time periods, blurring even more the relationship between net exposure and hedge.
With its focus on banks and non-bank financial institutions such as hedge funds public awareness of non-financial corporate activities in financial markets is low. One example is the recent consternation in reaction to the withdrawal by Siemens Bank – a subsidiary of Siemens AG – of more than half-a-billion euros from a large French bank in order to deposit the money with the ECB. Information about corporate activities is rare and mostly restricted to anecdotal evidence or – as in the case of the UK – on “market intelligence”.
In the foreign exchange market which had long been an interbank market with a negligible number of non-bank players this neglect was long justified. However, the situation has changed. In 2010, the non-financial corporate sector accounted for around 13% of estimated global turnover. In 2007, the share had been even 18%. The reason for the decline after years of growth is not clear. One explanation may be, as the BOE authors presume, the negative impact of the financial crisis on trade. The relation between trade and foreign exchange market volumes, however, is a loose one: Compared to the estimated daily $4 trillion forex trades world annual exports were $14,950 billion in 2010. Another, and in my opinion more plausible, explanation is that non-financial firms cut back their riskier financial businesses in reaction to the crisis.
The foreign exchange market is largely an unknown quantity. Surveys conducted under BIS auspices give only a momentary impression of a fraction of total foreign exchange business worldwide every three years. Only a number of countries and banks are included. Participants are asked to report all arm’s-length trades which means trades in which the dealer is indifferent as to the counterparty. For example, not included are in-house deals and deals with other offices of the same institution. Excluded are also deals of large globally operating firms within private corporate networks “bypassing” banks. All these activities require closer scrutiny, in particular in view of recent policy ambitions to curb speculation by taxing it.