Bancorp Treasury Services Limited

Make Risk Count.

OPTIONS – A CHOICE INSTRUMENT THAT TOO FEW CHOOSE

24 August 2010

Widespread apathy towards one the most useful financial risk management tools is hindering New Zealand business success, according to a foreign exchange risk management expert.

Bancorp Treasury’s Client Advisor, Cliff Brown says options are often the ideal risk management tool but New Zealand businesses are too slow to make use of them.

“Despite the efforts of banks and advisors over the years, many businesses still don’t understand the value of options or how to get the most from them. They dismiss them too readily, and won’t invest time or money in getting up to speed.�

Mr Brown, an experienced foreign exchange and derivatives risk manager who has worked with clients worldwide to minimise their risks to complex currency exposures, says New Zealand exporters and importers are overly reliant on forward foreign exchange contracts that lock them into a specific rate.

“That’s fine if one is happy with the rate and needs certainty. Current market volatility, although it creates a lot of uncertainty, also creates a lot of opportunity, which is why options are often the best choice,� he says.

“Options provide a win-win outcome in risk management situations. You get protection without commitment - like a pre-nuptial with a fixed cost get-out clause should a better model come on the scene.�

Mr Brown explains that hurdles to using options fall into four main areas: understanding, systems, accounting and pricing. “There are some basics to learn but hedging risk using foreign exchange or interest rate options is not actually that hard.�

Internal systems adjustments should only be a one-off change to implement, in many cases involving just a few spreadsheet changes. Accounting can be a little bit trickier, but accountants ought to be able to address this matter easily enough.

Mr Brown says accounting should not be an excuse for avoiding using options to manage real risks to the business: “That is akin to the tail wagging the dog.�

He acknowledges that pricing is another barrier: “Paying an option premium, like insurance, is often a grudge purchase.

“Rather than resenting the cost, the option’s value should be appreciated, along with the empowerment of choosing exactly how much risk the organisation is prepared to bear.�

He notes that options structures can be put in place to cut or even eliminate the cash outlay.

Using options requires businesses to be comfortable that their bank’s pricing is sharp enough but banks sometimes struggle on this front.

“Unlike the more common forward foreign exchange contracts�, Mr Brown says, “options are still seen as exotic in New Zealand, yet they are virtually a commoditised ‘vanilla’ product in other countries.

“Low volumes make banks reluctant to commoditise options pricing and this has a flow-on effect to their fees,� he says. “It’s a vicious circle.�

Mr Brown would like to see banks making a leap of faith to grab the opportunity to help their customers more by making their options products more attractive. Ensuring that their customer’s risks are managed in the optimal way is in the bank’s own interests too, as it helps minimise the bank’s overall exposure to that customer.

“We know that banks are increasingly analysing profitability of the whole relationship rather than by product.�

Mr Brown believes companies can play their part too by exploring options more frequently and shopping around to ensure a competitive market.

“Most companies deal only with their one bank. But not everything necessarily needs to be transacted with the same one. As with all commercial relationships, it’s worth ensuring that complacency hasn’t set in.

“It comes down to good treasury risk management practice: review options along with all other treasury accounting and foreign exchange costing policies. Then plan to allow sufficient budget for options premiums, just as for any other expense.�

He says that options are a product for a sophisticated economy and that our economy’s small size is no excuse.

“New Zealand banks and businesses have the wherewithal to use options to mutually maximum advantage, and the country will benefit overall. Now all they need is the will.�

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