The CFO of the various companies must be aware of all of the intricacies of the financial markets from a macro, micro, and industry specific perspective. In fact the companies can’t rely on the research reports, the news, the economic figures, the IMF, or the politicized marketplace. The credibility of the aforementioned sources is tainted by their own desire to profit from the market movements.
So that leaves us with the question of every CFO in the GCC, “What can we do to control the risks of volatility in commodities and currencies?” As per the research at The KIN Consortium, we have designed option strategies for every type of market. (For further information please search Amazon for my book called “Risk Management and Option Strategies” http://www.kinconsortium.com).
If we take a moment to review the basic assumptions, then we can later discuss the various options that the CFOs will have at their disposal. Let’s assume that the underlying asset can only do one of three things at any given moment (Go up, go down, or stay the same). The financial markets offer us tools that are designed to profit from a movement in any of the three directions with insurance products called Options contracts. Using them in different combinations can limit the risk of loss and offer opportunities for profit. In our book we mention the various strategies and describe the markets that are best suited for each of them.
For the sake of illustration let’s discuss the Japanese yen (JPY) as the underlying asset. Assume the CFO has to have $500 Million worth of yen in 6 months because he is importing automobiles from Japan. The background story is that the JPY is up 14.2 percent in 2010, while the US dollar only climbed 1.4 percent respectively. My favorite strategy is a capital guaranteed product that involves a fixed deposit and option strategies.
The fixed deposit is going to guarantee the principal amount. The balance of the funds available after investing the Net Present Value (NPV) is what we use in the actively managed option strategies. Assume we do not know whether the yen is going to go up or down. We hear stories in the news that are both positive and negative. An example on the positive spin; they are the best alternative to the euro and dollar because there is consistent demand for their products and subsequently their currency. On the other hand, there is an example of the negative spin; they have a great deal of outstanding debt, decreasing tax-paying population, and the Chinese are manufacturing similar products.
However, when we take a look at the chart we see a climbing trend since 2006. In this type of manic market environment, we at The KIN Consortium recommend either a “Long Straddle Strategy” or “Long Strangle Strategy,” the latter being more aggressive than the earlier one, simply because it relies upon extreme volatility in the underlying asset. When the volatility rises in the JPY and the currency begins to rise the client will profit, if the prices should fall then the client shall profit. The only way the client loses is if the prices stay the same. That’s why it’s imperative that the CFOs delegate the task of monitoring the markets to specific departments that are oriented toward these types of markets.
In Saudi Arabia, most conservative minded CFOs tend to rely on the various Treasury Department products like forward rate contracts, interest rate swaps, and structured products. From our discussions with the various treasury officers at the banks of the Kingdom, the trend seems to be that the various CFOs are taking a position in the markets and then waiting until the expiration of the options or the maturity of the fixed deposits. The opportunity cost of this strategy involves dramatic moves of the prices during the tenure of the fixed deposit and the options contract. The CFO did not monitor the news or the trends in the market. We refer to this type of mentality as the “Ostrich Theory” because they bury themselves in day-to-day issues that deal with the management of the core business. The chaos of the financial markets will demand the respect and attention of the investor with monumental swings in price volatility. The key is to capture the profits by predetermining profit potential target or loss potential target. The tools for this solution are called “Limit orders” on the outstanding option contracts.
The other type of businessman in the Kingdom is not hedging his foreign exchange risk at all. Let’s also assume in this scenario that the yen went up and suddenly all of his existing inventory is under priced. He literally could sell all his inventory and he still will not be able to cover the cost of purchasing the new cars for the next year. He lost money due to the volatility of the foreign currencies. While he is juggling his costs trying to stay afloat, the bank asks for its over due loan. The client has every intention of repaying the bank in order to maintain his credit worthy reputation. At the same time, the banks are reducing their credit exposure to clients across the board due to the uncertainty of the global financial crises. This client starts streamlining costs by firing employees. The working capital of the company dries up and they declare bankruptcy. The ramifications extend to the entire economy, because the company and its ex-employees were all consumers. For example, they were paying rent, electricity, water, food, and the list goes on about how they were a vital source of income to other local businesses. An educated investor must use all the tools in the marketplace to ensure maximum efficiency for the sake of his business, his customers, his employees, and the economy.
Stay vigilant.
(Khalid I. Natto ([email protected]) is chairman & CEO of The KIN Consortium.)