Using options for an each-way currency bet

By Nick Stride

Friday 28th May 2004

After two years in which the New Zealand dollar has performed a stomach-turning climb and plunge against the greenback, you'd expect business bankers to be reporting unprecedented demand from exporters and importers alike for currency risk management advice.

In fact, they say, the squealing has been muted compared to the last rollercoaster between 1994 and 2000.

The consensus explanation, encouragingly, is that comp anies are now a great deal smarter at managing their exposures.

"Businesses have got a lot better at managing their cost structure," Jeff Greenslade, director designate of the merging corporate and institutional banking arms of ANZ and National Bank says.

"Looking across the wider portfolio we're not seeing any signs of stress in terms of the exchange rate."

Nigel Williams, National Bank's director of institutional markets, points out the economy no longer does the majority of its trade in US dollars and now has a more diversified basket of exposures, particularly to the Australian dollar and Asian currencies.

"There's also a more benign interest rate regime," Williams says.

"The last time around in 1996 and 1997, the Reserve Bank wasn't accommodative of a high currency."

After three good years, company cash flows are strong, debt levels are low and managers have learned how to deploy more dynamic hedging strategies. The questions are: where now and how to safeguard your earnings?

Most banks expected the dollar to peak at around 70USc in January or February but few if any foresaw the rapid slide back to 60USc.

In any case, they say, the last things companies should do is to try to pick currency movements and hedge against them.

"Currencies don't go flat for a year the way sharemarkets sometimes can," Westpac Institutional Bank general manager David McLean says.

"Don't try to predict movements, look at protecting your business in different scenarios."

Exporters in particular can get caught out whichever way the dollar is moving.

State-owned coalminer Solid Energy, for example, got caught with heavy forward cover when the dollar plunged in early 1997 from its high of 72USc.

The fall put the miner's hedge book, at much higher US dollar levels, so far out of the money that in 1998 it was showing unrealised mark-to-market losses of $138 million.

The following year it booked $33.5 million of hedging losses with more to come, the entire board of directors got the sack, and the government had to provide a $42 million loan.

One of the problems was that, at that time, it wasn't uncommon for companies to be hedged five years forward.

In the wake of the well-publicised losses, businesses went far shorter very quickly and it wasn't until 2000 and 2001 that positions one to three years forward became the norm.

Some companies don't hedge at all, arguing the practice can only delay the evil hour, and costs them money.

"Sure, you can do that," BNZ foreign exchange manager Mike Symonds says.

"But to survive the really big swings you'd need a lot of capital in the business."

The rapid rises of 2002 and 2003 have produced happier stories. Hedging gains last year saved Carter Holt Harvey's bacon in tough commodity markets, adding $178 million to profits.

Sanford's $47.2 million 2003 profit included $35.7 million of foreign exchange gains.

Westpac and BNZ both recommend companies now consider using currency options as well as forward cover even though, because of the volatility, options are expensive right now.

These essentially protect against the downside that is, further rises in the value of the New Zealand dollar while providing a benefit if the dollar weakens.

"You're not locked in," Westpac's McLean explains.

But focusing solely on the exchange rate, bankers warn, is probably missing the more important point.

The New Zealand economy is still a big importer. For many exporters, the lower cost of imported raw materials, fuel, or capital equipment can directly or indirectly make a big dent in the effect of lower export returns when the dollar is strong.

"In some industries you'd be surprised what their net position is," National Bank's Greenslade says.

"We say, 'look at what your total exposure is, including commodity prices and interest rates some cancel each other out.' "

There is no such thing, Williams adds, as a perfect hedge strategy.

"It's not a question of improving, but of evolving."

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