Cuban companies are constantly exposed to exchange rate risk. However, in the vast majority of them, risk hedging techniques are not used as a tool to achieve efficient financial management and, consequently, reduce the losses generated by this concept; in addition to not having a procedure that allows them to identify, evaluate and manage the risks they face.
In this sense, the objective of this article is to make a diagnosis about the problems that Cuban entities present in relation to the administration of exchange risk.
Development:
As a consequence of the increasing volatility of the currencies, organizations that carry out forward transactions in currencies other than the domestic currency are frequently exposed to currency risk. It is also frequent that Cuban entities in this situation do not cover their positions in the future, letting out significant amounts of cash, an element that decreases the efficiency in the administration of their resources, which is a fundamental task in our economy.
I- Diagnosis of the exchange risk situation in Cuban entities.
Entities are constantly exposed to risks, in particular those generated as a result of fluctuating exchange rates. These, in recent years have had a great impact on the results of companies, due to the rapid development of technology, globalization and the internationalization of financial markets, which have resulted in increased competition and volatility. in the markets, all of which has manifested itself in increased uncertainty.
Cuba currently operates in conditions of an uncertain economic and financial environment, which makes it difficult to obtain traditional external sources of financing, from which derives the need for Cuban entities to have adequate knowledge of the risks to which are faced with each new transaction, in addition to the ability to predict and evaluate them, especially if they will have a direct impact on the results of the organization.
In the midst of these difficulties, any attempt or step that entities can take in terms of reducing risks and uncertainties, as well as raising business efficiency and administrative management rates is of vital importance.
Based on the study carried out regarding risk management in the selected Cuban entities, a series of insufficiencies that constitute the fundamental causes of exposure to exchange rate risk were detected, which will serve as the basis for diagnosing the situation of the currency risk. They are:
- No strategies are used to hedge the exchange rate risk in the operations carried out, which means that losses are obtained due to exposure to said risk. There are limitations that hinder the management of coverage in the country. There is no department in charge of risk management in institutions. The means available for market research are not being used adequately. Institutions do not have personnel trained in risk management. There is a short range of hedging instruments offered by Banking financial institutions. No systematization of hedging strategies by Cuban entities. Little use of internal hedges for exchange rate risk management.
Each of them will be explained below, showing the specific results in the corresponding cases.
1. No strategies are used to hedge the exchange rate risk in the operations carried out, which means that losses are obtained due to exposure to said risk.
One of the main problems presented by Cuban entities is found in the non-use of hedging strategies in operations that entail the presence of foreign exchange risk, obtaining large losses as a result of exposure to said risk. These losses are reflected as financial expenses and, therefore, decrease the total benefit that the entities may have.
The aforementioned shows the passive position that one has before this type of risk, associated with the author's consideration of three fundamental factors:
- Firstly, due to the lack of knowledge regarding the conception of exchange rate risk and the hedging techniques that exist to hedge it. Secondly, the regulations issued regarding the policies and positions that the companies to hedge foreign exchange risk. Third, the instruments for hedging foreign exchange risk offered by banks in the country, as well as their operations, are not known.
The following illustrates the losses obtained by selected entities from operations carried out in 2006, 2007 and 2008, whose contracts were basically made in euros, United States dollars and British pounds. Table 2.1 is first shown, where the entity, the contracting currency and the year in which the operation was performed are presented.
Table 1.1- Summary of the selected entities.
To better illustrate the results obtained, they have been grouped taking into account the similarity in terms of the nature of the operations with the presence of foreign exchange risk, and the year in which they were carried out.
Table 1.2- Results obtained by variation of the exchange rate in export and import operations.
As can be seen in Table 1.2, the main results obtained by the exchange rate variation are presented, associated with the import and export activities carried out basically by three entities.
The company that performs the operation is identified in the first column; in the second, the year corresponding to the completion of the operation; the third shows the total amount of exports or imports in the contracting currency, in this case USD and EUR. The fourth column reflects the total amount of these operations in EUR or equivalent USD on the contracting date. In the fifth column, the total amount received or paid in USD equivalent to the EUR on the date of contracting at the exchange rate on the day of payment, and in the sixth column the profit or loss due to variation in the exchange rate is shown in USD, which is determined from the difference between the amount at the time of contracting and the amount on the date of collection or payment.
The results reflect how of these entities, company B was the one that obtained total losses due to changes in the exchange rate, in the order of 143,437.00 USD, mainly associated with the variation suffered by the EUR / USD pair from the moment from import to date of payment. It showed an upward trend in the second quarter of 2007, a period in which imports in euros were taken as a sample. The depreciation experienced by the USD was estimated at approximately 2.5%.
An important element to note in the case of company B is that the total amount of EUR contracted includes products that are quoted in USD, but on the date of payment the entity must acquire EUR to make the transfer to the supplier.
In these cases, the entity and the provider set the amount in euros to be transferred in the contract on the payment date, at the exchange rate on the day of the contract. Thus, from a total amount of EUR 1 854 550.42 fixed on the day of contracting, if these euros had been paid at the exchange rate in force at the time of payment, foreseeing the upward movement of the EUR / USD pair, the entity will would have saved EUR 56 131.44, that is, the EUR that was set in the contract represents, at the exchange rate on the day of payment, EUR 1 798 418.98. Consequently, Company B incurs an opportunity cost equivalent to USD 75 696.36. Losses would have been reduced by this same value if the previous policy had not been carried out.
The remaining two entities, although they presented a total profit in the analyzed period, as a result of the favorable movement of the exchange rates, obtained losses at certain times.
Specifically in company A, monthly exports of coffee and honey in bulk in euros until August 2006 were analyzed. Prices were set in USD and were charged in EUR. In the months of January, March, May and August, losses were obtained due to fluctuations in the exchange rates, which total an amount of 45,910.00 USD.
Similarly, in company C imports in euros from January to September were analyzed, which represented 74.28% of the entity's total operations. The entity made losses in the months of January to April, amounting to 520,692.93 USD.
The results obtained in the financing received from abroad in different periods by financial institutions are also shown below.
Table 1.3- Results obtained by variation of the exchange rate in the financing received (Principal Payments)
Column 3 reflects the amounts in pounds sterling and euros corresponding to the financing received; the fourth column reflects the dollars equivalent to those euros or pounds sterling at the exchange rate on the date of financing; the fifth column shows the payments in dollars of the principal, and the sixth column shows the losses obtained by the variation of the exchange rate between the moment the financing is received and the payment of the principal.
As can be seen, the three previous institutions have obtained significant losses in USD, corresponding to the return of the principal, as a consequence of the variation in the exchange rate.
In the case of financial institution D, the results of two years are reflected. The year 2006 corresponds to a financing received from an Investment Fund, while in 2008, it corresponds to three financing received by two foreign banks with amortizations in the first quarter of the same year. The amounts reflected include interest to be paid.
Note how losses corresponding to interest payments were also obtained. They are shown in table 1.4 for the specific case of institutions E and F.
Table 1.4- Results obtained by variation of the exchange rate in the financing received (Interest Payments).
The results obtained above are a reflection of the position of “non-coverage” that entities adopt. As a consequence, they are exposed to the continuous movements of currencies in the market, obtaining benefits at certain times or significant losses in most cases.
2. There are limitations that hinder coverage management in the country.
If it is true that it is essential for entities to look for mechanisms to hedge exchange rate risk, on the other hand, there are limitations that hinder the management of coverage by companies.
An essential aspect to be addressed at this point is the existing contradictions between the requirements for coverage and the regulations issued in this regard. As it has been verified in these regulations, the mandatory nature of all entities to cover their risk exposures is raised. To this end, it is proposed that existing mechanisms should be used through Cuban banks.
On the other hand, when entities seek coverage, certain requirements are demanded by financial institutions. Among them are:
- The entity must have bank accounts in the currencies involved in the operation. The total amount of the operation to be covered must be at least 500,000 monetary units. Deposit a collateral as collateral. Generally this ranges between 10% and 15% of the total amount of the operation.
In relation to the requirements that are demanded, some considerations should be issued:
In the country, not all entities are authorized to have a foreign currency account. Therefore, the number of entities that can seek coverage is reduced, and the rest of the entities, which constitute the majority, must go to other financial institutions that offer this service.
On the other hand, by requiring as a transaction amount to cover a minimum of 500,000 monetary units, the company, if it does not go to another bank, where this is not an essential requirement, may be exposed to exchange risk in those operations whose amounts are are below the established limit.
In relation to the collateral that is required as collateral, this constitutes a limitation, in the event that the entity does not have sufficient liquidity to assume it, since it implies immobilization of resources, and associated with it a cost. Without a doubt, the lack of liquidity is a problem that is affecting the economic development of organizations.
For all the aforementioned, it is required to modify the legal resolutions and requirements that currently attempt against a more generalized use of coverage strategies in the country.
3. There is no department in charge of risk management in entities.
Associated with the problem of non-coverage, it is found that the entities do not have a department in charge of managing foreign exchange risk created in their organizational structure.
In these institutions there are other departments or divisions, in charge of analyzing and controlling the risks that occur in operations. Even more significant is the existence in these entities of a Credit Committee, in charge of the analysis, control, and decision-making regarding financing granted to state companies or banks; However, the committee has not established within its functions the analysis and management of the foreign exchange risk involved in financing received from abroad.
The risks to which more attention is paid are credit risk and operational risk, thus ignoring market risks, including exchange rate risk. Exchange rate risk, similar to the others, if it is not analyzed, controlled and managed properly and in a timely manner, can cause significant losses to the entity; even more so when the currency markets are characterized by instability and excessive volatility.
4. The means available to study the market are not used adequately.
Another factor that notably influences the exposure of companies to exchange rate risk is the improper use of the means available to entities to predict the future behavior of exchange rates in the market.
All the above entities have access to the Internet and the daily newsletter: "Today in the market", in addition to other daily reports such as: "Exchange market panoramas". All these means provide current information on the foreign exchange market; however, they are not used in such a way as to take advantage of the advantages they present, to analyze and evaluate the behavior of the currency market on a day-to-day basis, that is, to carry out an in-depth analysis of currency trends in the market through the methods currently used for this purpose, such is the case of Technical Analysis and Fundamental Analysis.
An essential aspect that hinders the forecasting of market behavior is that not all entities have access to the Reuters Satellite service, which would contribute greatly to a better analysis of currency trends, and in Consequently, adopt positions that reduce the exposure of the entities to the exchange risk.
5. Entities do not have personnel trained in risk management.
Another of the insufficiencies detected, derived from the previous one, is that there are no trained personnel in companies to face the issue of risk coverage, and in cases where there are people with knowledge of this subject, it is limited.
Although in all these entities there are indiscriminately specialists prepared on the subject of the Stock Market or who have a notion of risk coverage strategies, the knowledge and experience that these people may have is not used to evaluate possible coverage alternatives. to be used by the entity.
6. Little variety of hedging instruments offered by bank financial institutions.
The little variety of hedging instruments in contrast to the need that companies have of them, in order to reduce the losses that may be obtained as a result of exposure to exchange rate risk, constitutes another of the problems that arise in Cuba in Regarding the exchange risk situation.
From the foregoing, there is an urgent need for these institutions to perfect their risk hedging activity, updating themselves in international practice, so that they can offer combinations of derivative instruments and other hedging strategies, which allow them to obtain clients with whom they work better results.
7. Non-systematization of coverage strategies by Cuban entities.
There are entities in the country that have carried out external hedging strategies for different operations with the presence of currency risk. However, it has been possible to verify in these institutions that the lack of systematization in these operations has caused that the hedges applied have not always achieved the desired effect in correspondence with the general strategy of the company.
Only coverage strategies have been applied by the following institutions:
- Financial Institution G: The hedging activity was limited to only two operations carried out in 2005 and 2006, consisting of financing received from abroad in sterling. The strategies applied were forward and swap. Company H: Hedging operations are carried out through forward contracts and options once a year to cover the euro currency against the US dollar. Company I: From the financing received from foreign entities, they simulate, taking into account different scenarios, the possible results in the application of financial instruments: exchange insurance, plain vanilla (purchase of call or put), tunnel or cylinder, mixed or participative, forward plus.
The comparative analysis extends to the results of the use of each hedging instrument against the effects that non-hedging would cause, thus selecting the best strategy. A hedging operation was performed using the forward to a received financing, whose provisions included the periods from March 2004 to January 2005.
The results obtained from the application of the mentioned hedges are shown below.
Table 1.5- Results obtained in the application of hedging instruments.
Financial institution G case:
In 2005, a loan was received for GBP 1,450,000.00, settling as a maturity of one year, and the pound sterling as the payment currency. Debt amortization was quarterly, using a fixed interest rate of 8% per year. In 2006, the same conditions were maintained, except that the loan amount was GBP 1,500,000.00 and the interest rate used to repay the debt was 6.5% per year.
As can be seen in Table 1.5, when the entity used the swap as an instrument to cover the principal of the debt, income amounting to $ 2,566,500.00 and $ 2,827,500.00 was obtained in the years 2005 and 2006, respectively, when they were exchanged the principal of the debts in GBP at the spot rates established in the swap contract (GBP / USD 1.7700 and GBP / USD 1.8850 respectively).
At the end of the year, when these were exchanged again, in this case at the established forward rates (GBP / USD 1.7708 and GBP / USD 1.8860 respectively), the entity has had to disburse more dollars than initially received, incurring costs amounting to 1,160.00 USD and 1,500.00 USD in the years 2005 and 2006 respectively. Obviously, the costs incurred by the entity would have been higher if it decided not to contract the instrument and go to the market. Note in Table 1.5 that they amount to $ 175,015.00 (year 2005) and $ 173,100.00 (year 2006).
To cover the interest on the 2005 financing, it was decided to contract forward rates for the different payment periods of the same (quarterly), so that, from a total amount of GBP 120,000.00 to be covered, thanks to the coverage, the entity you saved 5,880.00 USD.
Despite the results obtained from the application of hedging strategies, insufficiencies were detected in the contracted operations that prevented obtaining better results. They were:
- The amounts of interest to be covered in each quarter (GBP 30,000.00) were below the risk limits established by the entity to carry out hedges (100,000 USD), which led to the incurring of additional costs for value of 5,880.0 USD in the operation of the year 2005. As the entity did not present an adequate procedure for the management of foreign exchange risk, and did not have the Reuters system, it was not possible to follow up on the operations contracted according to the movement of exchange rates, which contributed to higher costs being incurred in the case of the swap compared to the cost of the forward. No studies were made of other hedging instruments that could have been used, being evaluated with a cost-benefit approach.
Company case H:
The experience acquired by this entity, as previously discussed, is based on the use of forward contracts and options once a year. In 2004, a forward was hired to cover part of the maturities generated by three contracts signed for the purchase of parts, pieces and equipment. For this, a collateral amounting to USD 298,000.00 was required.
The total amount of the purchase amounted to EUR 2,386,000.00. By contracting a forward rate on the principal of EUR / USD 1.2495, the company manages to disburse 2 981 307.00 USD.
On the other hand, the option contract consisted of the purchase of a euro call for a value of EUR 5 000 000.00 at an exercise price of 1.2790 USD / EUR and a premium of USD 250 000.00, to cover long-term debt. The debt had a maturity greater than that of the option, with which it was intended to immobilize it in the period of validity of the option and at its expiration, to renew the contract.
These hedging operations carried out by the entity are only carried out to hedge the euro against the US dollar, ignoring in this way the rest of the currencies with which the company also operates and is exposed to exchange rate risk, although to a lesser extent due to the low volume of operations carried out on them.
Another insufficiency detected in the hedging operations carried out by the entity is found in the failure to carry out a study of market behavior, in order to make the best decisions in adverse situations. This is attributed to the lack of knowledge on the subject.
A very significant aspect to point out is that in these hedging operations the amount of the interest to be paid is not included, since it would increase the cost of the hedge. However, the decision made is not justified by studies that demonstrate the feasibility or not for the company in this regard.
Hedging contracts are only made to cover short-term operations, ignoring those long-term operations that can cause significant losses due to currency risk.
Company case I:
As reflected in Table 1.5, a forward was applied to the provisions of a financing destined to guarantee a commercial operation in USD of one of the subsidiaries of this entity. The value of the same is 20,500,000.00 EUR with provisions from 1/3/2004 until 1/6/2005. When contracting the instrument, it was intended that the euros received when they were changed to dollars, were sufficient for the payment of the commercial operation.
As can be seen in the table above, for contracting the forward, the company received less USD to face the payment of the commercial operation, as a result of the sale of the euros, thus incurring a loss of USD 186,068.08.
This strategy was applied for a long period, and since the trend of the two currencies involved in the operation was not closely followed, costs were incurred as a result of the mandatory nature of this instrument. If the forward had been contracted for shorter periods, the market trend could have been followed so that other more flexible strategies could be adopted.
8. Little use of internal hedges for exchange rate risk management.
Another of the problems detected in terms of risk management in Cuba is the limited use of internal hedging strategies by entities to hedge the exchange rate risk, namely:
- Netting: financial institution G and company H.
In the case of institution G, income and expenses are supervised by the position officer, who keeps track of the cash flow by each bank and in its different currencies. So, when obtaining the weekly payment schedule, we proceed to cover with collections on nearby dates in the same currency.
On the other hand, company H nets the part of the debts that are not going to be covered by derivative instruments with the balance of the bank account of the currency to be covered, in case the market shows favorable.
- Spot sale of the currencies with which it operates based on their availability: financial institution G.
From the multi-currency position that is made daily, the availability of the different currencies is determined. If you have a long position in a certain currency (the rights exceed the obligations), you proceed to sell it at the spot rate. This operation makes it possible to shorten the time between the purchase of foreign currency at the window and the closing of the position.
It is therefore of great importance, the need for Cuban entities to increase the use of internal hedging strategies to reduce exposure to currency risk; especially when the country has limitations to access international markets.
In summary, the main causes of exposure to exchange rate risk have been shown, which has allowed us to make a diagnosis of the exchange risk situation.
As it has been verified, the causes associated with this problem are not only internal to the entities, but are also found in the national environment, having their maximum expression in the different regulations issued regarding the issue of coverage, as well as the requirements demanded by financial institutions, which has greatly limited exchange rate risk management in the country.
Despite the existence in Cuba of entities that have carried out hedging operations, as has been evidenced, the experience acquired in this regard is very little, which shows the incipient nature of these operations, also linked to the lack of methods and procedures that allow efficient analysis, evaluation and management of risks.
Without a doubt, it is a challenge, a commitment and, at the same time, an imperative need for Cuban organizations to manage exchange risk, with the aim of minimizing the losses obtained as a result of exposure to such risk.
