Comparing Cryptocurrency to Foreign Currency

Cryptocurrencies such as Bitcoin have captured headlines in 2017, and the question of how modern cryptocurrencies compare to traditional foreign currencies is often raised. FX Initiative helps global businesses manage foreign exchange (FX) risk, and this article will explore some of the key differences between cryptocurrency and foreign currency from a corporate foreign exchange risk management perspective.

It is clear that cryptocurrencies are still in their infancy, but the debate in the financial community over the future growth of this digital asset class remains open. While many articles have focused on areas such as monetary authorities, regulation, costs, timing, and transparency, this article will offer a unique focus specifically on the areas of acceptance, exchange, utilization, obsolescence, and risk management.

Acceptance
A small but growing number of brand name companies promote their acceptance of Bitcoin, such as Overstock.com, DISH Network, Expedia, Microsoft, and others. In fact, Coinbase claims that 47,000 businesses integrate Bitcoin with their service. However, companies such as Dell and Fiverr announced their acceptance of Bitcoin in 2014 but have since updated their policies to no longer accept Bitcoin. As it stands today, cryptocurrency, unlike foreign currency, is not a universally acceptable medium of exchange for procuring goods and services.

Exchange
It is important to note that most major corporations who accept cryptocurrency are partnered with digital asset intermediaries such as BitPay and Coinbase to instantly exchange Bitcoin for fiat money such as U.S. dollars or euros. By doing so, the companies minimize their holding period and financial exposure to the heightened volatility of a cryptocurrency. Unlike foreign currency, which is not always immediately exchanged, a company’s acceptance of cryptocurrency largely depends on their partnership with intermediaries to transfer the financial risk immediately.

Utilization
While Bitcoin is increasingly used by investors and consumers, businesses still lack widespread utility for the cryptocurrency. For example, when a company earns foreign currency denominated revenue, they may also have foreign currency denominated expenses (i.e. payroll, suppliers, vendors, cost of goods, etc.), which creates a natural utility for the foreign currency. In contrast, most corporations that earn Bitcoin denominated revenue lack Bitcoin denominated expenses, which reduces the utility of the cryptocurrency for funding ongoing business operations.

Obsolescence
Although Bitcoin is perhaps the most well known cryptocurrency, there were over 200 initial coin offerings (ICO) in 2017, which collectively raised more than $3.2 billion. The following white papers on Bitcoin, Ethereum, Zcash, Monero, Bancor, Tezos, and EOS explain the pros and cons of each project, and there remains a high degree of uncertainty as to which cryptocurrency will emerge as the long term market leader. Unlike foreign currency, specific cryptocurrencies have the potential to become obsolete as newer and better technology evolves over time.

Risk Management
The Consumer Financial Protection Bureau (CFPB) warned about the potential issues with virtual currencies such as unclear costs, volatile exchange rates, the threat of hacking and scams, and companies not offering help or refunds for lost or stolen funds. Additionally, the most viable current means of managing Bitcoin's financial risk is simply transferring ownership though intermediaries. If and when firms such as the Chicago Board Options Exchange launch bitcoin derivatives trading products, foreign currencies have superior risk management products & services.

Overall, foreign currencies are widely accepted, easily exchanged, naturally utilized, lack obsolescence, and offer a range of risk management tools to mitigate risk such as over the counter (OTC) and exchange traded derivatives including forwards, swaps, options and futures. As we approach the 10 year anniversary of Bitcoin’s introduction, the adaptation of cryptocurrency in the business world will continue to be notable and newsworthy. Join the ongoing discussion and share your comments and stories on cryptocurrency and its impact on business.

FX Initiative is collaborating with cryptocurrency experts to help educate the business community. We’re creating compelling content and interactive risk modeling tools for simulating Bitcoin denominated transactions, hypothetical hedging instruments, and policies and procedures to facilitate a wider understanding of the practical application and potential of cryptocurrency. To learn more about foreign exchange risk management or to participate in our cryptocurrency collaborations, contact us here, email support@fxinitiative.com or visit FX Initiative at https://fxcpe.com.

Morningstar's Missing FX Risk Management

FX Initiative is fascinated with how global companies manage foreign exchange (FX) risk. This analysis focuses on Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia. Founded by Joe Manseuto in Chicago in 1984, Morningstar’s timeline outlines their expansion into Japan in 1998, Australia, New Zealand and Canada in 1999, and the opening of Morningstar Europe, Morningstar Asia, and Morningstar Korea in 2000. Today, the company has operations in 27 countries as outlined in their 2016 annual report (10-K):

The company’s Securities and Exchange Commission (SEC) filings offer 3 interesting highlights from a FX perspective:

1. Morningstar has direct exposure to 23+ currencies through their wholly owned or majority-owned operating subsidiaries.
2. 26% of Morningstar’s 2016 consolidated revenue was generated from operations outside of the United States.
3. Their most recent 10-Q for the second quarter of 2017 states that "approximately 69% of their cash, cash equivalents, and investments balance as of June 30, 2017 was held by their operations outside the United States."

The two main goals of a FX risk management program are to (1) minimize earnings volatility on the Income Statement and (2) preserve cash flows on the Balance Sheet. Hedging involves taking an offsetting position in a specific currency in order to reduce the impact of unfavorable foreign exchange rate fluctuations, whereby when the underlying position incurs a loss, the hedge incurs a gain, and vice versa. The goal of hedging currency risk is not to gain or lose, it’s to make the financial outcome more certain and predictable. Let’s examine Morningstar’s FX risk profile with a simple year over year comparison between 2015 and 2016 by examining their revenue, operating expense, and other income highlights.

First, let’s explore the impact to the Income Statement from a gross margin perspective (i.e. revenue minus operating expenses). In 2016, “foreign currency translations reduced revenue by about $9.5 million” and their “operating expense by $11.5 million”, for a $2.0 million favorable variance. In 2015, “foreign currency translations reduced revenue by about $26.9 million” and “operating expense by $23.9 million”, for a $3.0 million unfavorable variance.

Second, the impact to “Other income, net primarily includes foreign currency exchange gains and losses arising from the ordinary course of our business operations.” In 2016, “Other income, net” was a positive $6.1 million compared to a positive $1.2 million in 2015. This volatility comes from the “mark-to-market” revaluation of booked receivables and payables each period that is reported in earnings on a current basis. These exposures are booked and known, and serve as the foundation of foreign exchange “balance sheet hedge” programs that are employed by many companies.

As it relates to Morningstar’s discussion of their FX risk management strategy, they state “Our operations outside of the United States involve additional challenges that we may not be able to meet. There are risks inherent in doing business outside the United States, including challenges in currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.” They also state they “do not expect to repatriate earnings from our international subsidiaries in the foreseeable future.”

While Morningstar clearly discloses their substantial currency risk, the company surprisingly states that "We don't engage in currency hedging or have any positions in derivative instruments to hedge our currency risk." Their 2016 annual report also goes on to state that “Foreign currency movements were a factor in our 2016 results, although to a lesser extent than in 2015, as continued strength in the U.S. dollar reduced revenue from our international operations when translated into U.S. dollars. This has been an ongoing trend for several years and reduced revenue by $9.5 million in 2016 and $26.9 million in 2015.”

Morningstar.com’s articles offer various investor perspectives on hedging FX risk. For example, the article “Hedge Your Currency Risk When Investing Abroad” mentions that “Investors should definitely invest globally and they should hedge out at least part of their foreign risk.” Another example from the article titled “The Impact of Foreign-Currency Movements on Equity Portfolios” is that “Betting on currency movements is generally a fool’s game and should be avoided by the average investor.” Applying this advice, it appears that Morningstar is invested globally but doesn’t hedge any part of their currency risk, and their decision not to hedge is a bet on FX.

Finding the right balance between risk and reward is a classic tradeoff for any investor or organization. Morningstar is a highly respected global thought leader when it comes to investing, and they have clearly analyzed their corporate exposure to FX risk as it relates to revenue, operating income and net investments (as shown in the screenshots below). Additionally, Morningstar has an array of publications on currency such as their Currency Category Handbook, and offers data services such as their Morningstar Foreign Exchange Feeds. The company seems to have the personnel, operations, and resources to manage FX risk.

From an enterprise risk management perspective, foreign exchange risk is a non-core business risk that often poses more of a threat than an opportunity, whereas core business risks are related the strengths that a company is rewarded for taking on, such as investing in new products and research and development. Therefore, hedging foreign exchange risk allows firms like Morningstar to budget more reliably when engaging in international business in order to focus on their core strategic initiatives more effectively.

What are your thoughts on Morningstar’s approach to FX risk management? Each market participant must define their own risk appetite, and there is no “standard" protocol. However, in closing this analysis, a quote from Gary Cohn, the Director of the National Economic Council and former president and chief operating officer of Goldman Sachs, comes to mind: “If you don't invest in risk management, it doesn't matter what business you're in, it's a risky business.” Join the conversation and share your thoughts on FX risk management in the comments section.

To learn more about FX risk management, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples, and webinar events help simplify complex currency risk management issues using real-world scenarios from leading organizations such as Apple. Our mission is to help banking and corporate treasury professionals deliver effective currency risk management results in a time efficient manner. Start learning best practices for mitigating FX risk by taking the FX Initiative today! Click here to for more information >

Image Sources: Morningstar Inc. 2016 Annual Report (10-K)

Due Diligence & Distinguishing FX Derivatives

Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions.

At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives.

The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows:

1) Forward Contracts

• Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges.
• Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate.

2) Option Contracts

• Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures.
• Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity.

3) Zero Cost Collars

• Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium.
• Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate.

Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives.

To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative!

Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Identify the 5 Stages of the FX Trade Lifecycle

Foreign exchange trading is a critical element of currency risk management, and understanding the trade lifecycle can help organizations plan their hedging activities more efficiently and effectively. The foreign exchange trade lifecycle, as discussed in the FX Risk Management course, can be enhanced with automated resources and typically includes the following 5 stages:

1. The first stage involves identifying and evaluating exposures. To aid in the exposure identification and evaluation process, best practices relate to investment in quality automated resources such as an enterprise resource planning (ERP) system or treasury software application that can be set up to extract data across the enterprise to identify and evaluate foreign exchange exposures rather than manual analysis, which can be time consuming and limited in scope.
2. The second stage involves collecting and quantifying exposure details. These tasks can be automated through software modules such as a netting system for matching foreign currency inflows and outflows or a cash flow forecasting module for determining future exposures based on historical trends in comparison to manual collection and quantification processes through spreadsheets, which can be vulnerable to human errors and oversight.
3. The third stage involves developing and analyzing hedging strategies. This analysis process can be streamlined and structured with automated software that performs value at risk analyses and simulates hedge strategies such that scenarios can be modeled prior to trading in order to save significant time and costs down the road, whereas performing this analysis manually can limit the ability to compare economic and accounting strategies in a comparable format and in a time efficient manner.
4. The fourth stage involves the administration and execution of hedge strategies. This is increasingly facilitated through the integration of electronic trading platforms, where multi-provider execution platforms can be integrated for optimal rate bidding across numerous FX service providers in real time, coupled with automated straight though processing of trades with back office systems to handle transaction reporting, confirmation matching, and payments between counterparties rather than manually performing these critical tasks.
5. The fifth and final stage of the foreign exchange trade lifecycle is financial & managerial reporting. This communication and recordkeeping can be automated through the integration of accounting systems to enable seamless financial reporting for both internal and external audiences rather than manual reporting and compliance processes.

Overall, the 5 stages of the foreign exchange trade lifecycle include (1) identifying and evaluating exposures, (2) collecting and quantifying exposure details, (3) developing and analyzing hedging strategies, (4) administering and executing hedging strategies, and (5) financial accounting & managerial reporting. Each of these stages is essential when implementing foreign exchange trading best practices, and understanding the lifecylce can help organizations plan their hedging activities more efficiently and effectively.

To learn more about foreign exchange best practices and to observe how world class organizations such as Apple employ each stage of the FX trade lifecycle, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples and webinar events can help you and your team better mitigate FX risk and deliver measurable results to the bottom line, so get started today by taking the FX Initiative!

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The FX Initiative Team
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1. Select Your FX Risk Management Training Program
2. Complete Your FX Risk Management Training Education
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The FX Initiative Team
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