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Chapter 7. Forex from the Inside

Chapter 7. Forex from the Inside

In this chapter, participants in Forex—from multinational corporations to international banks, to FCM dealers, to retail traders—describe their roles in the currency markets.

Joachim Herr

Joachim Herr is the head of risk management at BMW International. In this interview, he discusses how BMW handles currency exposure and trading methodologies.

Whenever we sell a car—for example, in Thailand—we get Thai baht (THB), but our cost basis is to a large extent in euros. What we need to make sure of from a currency perspective is that the THB revenue we receive is worth more than our euro-denominated costs in order to stay comfortable. Without risk management, the large exchange rate fluctuations would lead to times of very high profitability (when the THB is strong) and times of low profitability (when the THB is weak). To ensure that this does not happen is the goal of risk management here at BMW Group. We make sure that the fluctuations of the currency do not impact our operating business, which is producing and selling cars. Therefore, the first thing we do on a weekly basis is review our risk positions. This is the most critical thing in currency management—know what your risk is. So we look at monthly, yearly, and 7-year-long ranges. We look at what the expected sales are—for example, in THB—and the currency flows that are involved so we know what our risk positions are. For the second step, I look at the currency market and the state of currencies. We have developed an internal model of the currency movements for a very long time since we have been using this model, which gives us a sort of long-term fair value of the foreign currency. It is derived from things like purchasing power parity (PPP), trend following models. What we have seen is that in the short term the exchange rates can deviate quite significantly from the fair value in both directions, but in the long run we see a mean reversion tendency. So the next step is we look at the THB in comparison to the euro right now compared to our fair-value analysis. If the THB is currently very strong, then we say, “Yes, that is a good opportunity for us to lock in that very favorable exchange rate for a long time.” Then we enter long-term hedge contracts to make sure for a very long time that the cars that we sell in Thailand are very profitable. In times when the THB is undervalued, we do not enter into long-term contracts but only short-term expirations to make sure in 3 to 6 months we don't have currency risks. But we would stay away from, say, 3or 4-year contracts. The effect of this is on the one hand we eliminate short-term fluctuations by short-term risk measures, and in the long run we make sure we have a sort of smoothing of the exchange rate that we achieve. In the long run we don't let the currency fluctuations affect the operational business of BMW.

Does BMW stay away from specific currencies, such as liquid or emerging?

Yes, it happens, but these are in the less-developed countries. Most of the markets that we operate in have a higher degree of development. In the less-developed countries there is often no substantial market for BMW Group products. So we usually work in countries with a little bit more development. Usually it goes along with developed currency markets. While these countries don't have such liquidity as, say, the U.S. dollar, we can still do something. And whenever we find a currency market with significant market participants, we try to adapt our model of long-term currency price hedging to this market as well.

How actively do you trade in the FX markets?

I'm reluctant to talk about trading because I don't see myself as a trader. A trader, in my view, is always trading both ways—selling and buying and trying to make a profit on it. That's not our goal. What we see ourselves as is hedgers, and what we do is for the very long term, hedges in a 4-to-5-year time frame, and this is not done on an hourly basis. So we analyze the currency very carefully. For example, in 2001 we saw a very large overvaluation of the U.S. dollar, so we entered into long-term hedging contracts. When it comes to short-term operational transitions or technical hedging, we make sure that currency volatility does not impact us in the next 3 months. I'm in the market for these shorter-term, smaller-scale transitions every day. But only on one side: selling the foreign currency.

What about BMW trading mechanisms?

Yes, we have five active traders worldwide. I have two on my team in Munich who do FX and commodities, two in New York for the USD area, and one in the UK for pound trades. In all other countries, because we have different approaches for the execution of the trade, the local treasurer has the responsibility. So, for example, the treasurer of BMW Thailand, as part of the job in the front office, regulates the local currency exposure. For the normal treasurer it takes about 10 percent of work time.

How does BMW transact its FX transitions?

We are allowed to use any electronic platform and all instruments available to us. Currently I would say we do about 90 percent of our trades over the phones, directly with the banks, and roughly 5 percent via trading platforms but closed trading systems. For example, we use the UBS system. We are currently not using any open systems like FX at all because all of these platforms, as good as they may be, have restrictions on the back part. We would only consider changing if it was a truly open system to all banks. That is better handled over the phone, since if you need a four-year forward you get a better price than an electronic system.

Take me through a trade.

There are two scenarios one must consider. Let's look at the USD. First is the USD overvaluation, and the other is the USD undervaluation. In the first scenario of the USD overvaluation, if the USD is overvalued at .90, like it was in 2001, I look at my model in the morning and say, “Oops, the USD is at .90.” Let's see. My risk position is 1 billion USD over the next few years, and I still have 50 percent open for 2008. The USD is favorable, so I want to close the position in 2008. When I decide in the weekly currency counsel, I call up the bank and I trade directly with the bank, 300m 50 September 2008. And that is a very long-term transaction and strategy. That type of transaction is not fit for a normal trade floor because of infrequency of trades. These trades are carefully studied and thought about.

There are times like in 1997 when the market becomes more dynamic. How do you adjust? That's case number two. If we are in the overvaluation of a currency, we are in a relaxed mood. Everything is working better than we have expected or forecasted. We are relaxed. But whenever the foreign currency is undervalued, like the USD right now [June 2004], you have a different situation. Obviously, if the USD is undervalued, you don't enter into long-term future hedges. I don't come in in the morning saying, “Let's think about 2008,” because at current USD rates, I wouldn't do any hedging for 2008. But I might have some open volume for next month [July]. Because whenever we hedge, we don't do 100 percent of the exposure or monthly risk. If you have a high level of certainty, you might do 90 to 95 percent. But still there is always a little open volume left. Like today [June 16, 2004], when I came in, we heard the rumors about the outlook for the CPI data, and we think about how that will affect the USD, which is a very short-term discussion. We look at technical charts, checking on whether the U.S. dollar is breaking a certain barrier or if inflation data is coming out on the higher end, because then the dollar will probably get stronger through the day. So let's not do the hedging of the June contracts this morning [German time], but wait for the CPI data in New York.

This is a typical short-term trade where market timing becomes very important.

In a nutshell, we have long-term strategic hedging, where we do very long, deep analysis on currency movements, and we have short-term technical hedging, where we decide how to cover the remaining open risk in the coming months, which is much more trading-oriented and where we look at technical charts rather than fundamentals.

What is your outlook for the U.S. dollar?

We don't have any outlook on the USD, since it is our view that the currency markets are a “random walk,” and you never know where the next movement will be—the next hour or the next day. You might get a small advantage with technicals, but in the long run PPP tends to hold true. Currency reverts to PPP in the long run. In the medium run—say, 1 month to 3 years—we have no indication whatsoever. What I am sure of is in the long run we will revert to numbers around 1.10, which is in our mind fair value. Whether that happens in the next year or in 2006, I don't know. I know that our company has a conservative long-term approach to currency hedging. We are very well prepared. And our trading approach is structured so that even if the USD stays weak for the next year or so, we are relaxed since we are not gambling on currency. We manage our currency risk and exposure diligently and have done so for the last 10 years quite well to make sure our company can do what it does best—producing the best driving machine.



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