Predicting foreign exchange rates – a hopeless business that serious corporations should avoid
Anyone who can predict outcomes for different foreign exchange rates can earn considerable amounts of money. The problem is just that research shows there is no such thing as reliable exchange rate forecasts. This according to two leading LUSEM researchers in foreign exchange risk management.
“It’s like looking into a crystal ball – with a little luck your prediction will be correct. Perhaps once, perhaps twice. In the long run, however, you will be wrong and that can have devastating consequences for your company,” says Lars Oxelheim, professor emeritus of Business Administration at Lund University School of Economics and Management and one of the authors of the book Corporate Foreign Exchange Risk Management.
Along with the book’s other authors, Håkan Jankensgård, associate professor of Business Administration and corporate executive Alf Alviniussen, Lars Oxelheim wants to reach those who encounter and manage foreign exchange rates in their work. This is because there are more value-creating aspects to focus on in foreign exchange risk management than making it imperative to forecast coming foreign exchange fluctuations.
“With this book we want to try to reach professionals at both small and medium-sized companies in Sweden and globally. It rapidly becomes complicated when working on foreign exchange and consequently a need arises for control,” says Håkan Jankensgård and continues:
“Just look at how it is today. We see large fluctuations in foreign exchange rates and this is turbulence which in itself shows that it’s not possible to make forecasts. Who had reckoned that the new coronavirus would appear and turn everything upside down? No one. However, there are other ways to exercise control and that is what we want to show.”
Focus on understanding your risk exposure
The book is clearly divided into ten instructional chapters, which cover the different factors in foreign exchange risk management. It begins by looking at why companies need to manage risks caused by risk exposure to foreign currencies, continues via the balance sheet, derivatives and hedge accounting to the importance of centralising foreign exchange control, integrated risk management and communication.
“Risk management should primarily consist of understanding your risk exposure and what happens when different exchange rates change. What are the possible impacts on the company? How will the company’s financial position be affected? Will we be able to achieve important goals? However, we know that many people don’t work this way. Instead, people at companies have different tools for beating the market. It is an activity that is regarded as completely natural and it’s not called into question. However, the problem is that research shows that it doesn’t generate any excess profits. It’s therefore a waste of the company’s resources and there are often surprises, as the company’s vulnerability has not been fully charted,” states Håkan Jankensgård.
If the authors were to send four key messages to managers, controllers and others out there, it would be these:
- It is not possible to successfully forecast or predict foreign exchange rates.
- Focus instead on understanding your risk exposure at different levels of financial performance and how these are connected.
- Develop foreign exchange strategies in a strategic context that helps the company to achieve important goals.
- Companies need to be better at communicating risk management in their accounts.
Is this controversial? Yes and no, say Lars and Håkan. It depends, perhaps, on who you ask.
“There is, of course, a whole sector that we are undermining with this book. Bank economists smugly predict dollar rates down to decimals, but it is pure luck the whole time. There is no evidence that you can beat the market,” says Lars Oxelheim and continues:
“We consider that it would be wiser to redistribute the energy, and instead direct part of the energy devoted to forecasting in an attempt to beat the market to developing in-depth knowledge about your risk exposure and constructing models for decision-making based on this knowledge. It’s important to take it seriously, as there may be consequences for the company’s key financial ratio and how well the company succeeds in implementing its business plan.”
Why do people work this way if it does not work?
“It’s human nature. Hubris and optimism are well documented traits. All this affects decision-making, not least in companies. In addition, it’s common that people conceal failure somewhere out of sight. And so, we interpret everything in a positive light instead and believe that we will succeed next time,” says Håkan Jankensgård.
Use a strategic long-term approach
Håkan Jankensgård and Lars Oxelheim consider that at present there is too much focus within foreign exchange risk management on imminent transactions.
“It is human nature to fix attention on what is verifiable and happening around now, because it is something that you can see and almost touch. The strategic approach, however, would be to look at the longer term, such as one year ahead, and try to understand how foreign exchange impacts may disrupt the value-creation process,” states Håkan Jankensgård.
In addition, Lars Oxelheim and Håkan Jankensgård consider that companies overall fail to communicate via their financial reports.
“Many reports are in principle totally incomprehensible and it’s difficult to see how foreign exchange risk management relates to the company’s operating profit or loss. Consider how the share analysts feel when they are to interpret these. They experience it as complicated and perhaps a little threatening – derivatives have, of course, been linked to many mishaps. There is a risk that people begin to query the company and its activities when there is something that is not understood,” says Håkan Jankensgård.
Instead, he would like to see financial reports that were not only produced according to accounting regulations, but also contain a clearer narrative, focusing on how and why foreign exchange control helps the company to achieve its goals. With this approach, the reports may actually help the company to increase trust and reduce the cost of capital.
With the new book, the authors want to show there is a “golden mean” based on academic models that emphasise principles for optimal risk management, but ones that are adapted to the reality of practitioners and the need to fit foreign exchange risk management into the overall financial governance of the company. Co-author Alf Alviniussen has 42 years of practical experience from having built up and refined the finance department and risk management at Norsk Hydro. He has witnessed the benefits of integrated risk management and the improved basis for decision-making that it provides.