Nowadays, most technology ventures are international in some shape or form, whether it be by supporting international customers, leveraging overseas developers, managing supply chains, or foreign investments (just to name a few). This means that most businesses are exposed to currency risk, often in multiple areas, and how that risk is managed could be the difference between success and failure.
This graph above doesn’t just show the daily change against the USD, it shows the daily change in your revenue and expenses. When those numbers accumulate to put you 30% in the red, your bottom line is going to feel it.
That’s why we wanted to take a look at how the “big boys” manage their Foreign Exchange (FX) Exposure—an approach that should be no different to any start-up operating globally.
The CFO of a Fortune 500 company is continuously fighting a battle of risk and reward. Like any general before a battle, a great CFO creates plans (and backup plans!), executes, and generates an “after-action report” to review his performance. To start planning, he must be clear on the company’s objectives.
Objectives should be defined in the FX Policy. Is the goal to protect the balance sheet or the P&L? Should accounting results be prioritized over cash flow impacts? Clearly defined objectives help develop strategies to achieve them and help the CFO defend his finance dept when ill-conceived performance measures are proposed (e.g. were the hedges profitable?).
Sample objectives might be: eliminate FX risk, minimize hedge costs, hedge to obtain a competitive advantage, minimize FX volatility over the multi-year horizon, or add value through active hedging or speculative positions. If the objectives include adding value through active hedging or speculation, guidance is needed to allow or disallow specific risky actions: closing out hedges prior to maturity, leaving positions open; keeping successful hedges on even if the original forecast underlying exposure disappears; increasing a net position with a derivative; and reversing a net position with a derivative (e.g., making a net long position short).
The policy should specify which risks are important and should be hedged, and which are not. The list of risk categories is long: third party booked transactional exposures; intercompany booked transactional exposures; third party or intercompany debt; contractual future foreign currency commitments (e.g., multi-year contracted capital expenditure payments in foreign currency); anticipated but not yet booked future foreign currency revenues and expenses; foreign unit earnings (i.e., P&L translational exposures); foreign unit booked and anticipated dividends; and foreign unit balance sheet equity. Once the objectives are agreed to and documented, the CFO can devise the strategies for achieving them.
Developing a strategy to meet objectives involves three “sub” steps. The first step is to measure risk and identify the material bits. For example, an aerospace mfg firm may have multi-year lead times, during which FX rates may vary significantly. There are numerous tools for estimating risk, the most common among them being Value at Risk (VaR). This metric makes assumptions about future market volatility and distributions by calculating a single number that represents the upper limit of loss with a specified degree of confidence. VaR is specific to one local currency and one tenor.
Another metric that nicely complements VaR is Expected Shortfall, which quantifies the losses beyond the VaR confidence interval.
The second step is to devise hedging strategies that minimize material risks. In our aerospace mfg firm example, managing its future cash flow risk might be done using layered hedging (Fig. 2). This technique can reduce effective year-over-year volatility by 70% or more, but requires managing a large number of open hedges.
For firms with long cash cycles (i.e. Accounts Receivable or Accounts Payable remaining on the Balance Sheet for many months), managing remeasurement risk may be necessary to minimize impacts to the Income Statement. While conceptually simple, developing a reliable Balance Sheet, forecasting methodology, and integrating balance sheet hedges with maturing cash flow hedges is non-trivial.
Firms with foreign entities may be exposed to translational risk as opposed to transactional risk as above. Both FX policy and regulatory requirements dictate whether these foreign entities are deemed local currency functional or reporting currency functional. That, in turn, will drive a hedging strategy (i.e. centralized at the group level or locally). Generally, group-level hedging of exposure against the reporting currency offers the most comprehensive opportunity for netting exposures and minimizing total hedge volume.
Now that the hedge notionals and tenors have been determined, the third step is to decide how to hedge them. Forward contracts are the simplest to understand, manage and account for, and in many cases are cost-effective. If the local currency is in a long-term trend or volatile, the high cost of option premiums may be justified but may cause issues if Special Hedge Accounting is elected. Monte Carlo simulations may be used to good effect in identifying the optimum combination of options and their parameters (tenor`s, strikes, notionals).
Lastly, if a firm is exposed to emerging markets where forwards are either unavailable or prohibitively expensive, other alternatives (such as proxy hedging) may be necessary.
Now that the hedges have been fully defined, the CFO can execute.
After the CFO has set a strategy, he can focus on efficient execution. To begin a determined strategy, CFOs need to know the state of the FX market so they are protected from bad deals when negotiating international transactions.
The FX market is large, opaque, and not a place for the uninformed. Due to the large information asymmetry, companies are at a disadvantage when negotiating the fees on international transactions. Especially since banks generate the majority (58%) of their derivative profit from the FX market, they are incentivized to charge companies as much as possible in this area. Because there are so many pitfalls, many CFOs use a Bloomberg terminal or gain competing quotes that keep their banks honest.
Smart CFOs also employ Transactional Cost Analysis (TCA) (Fig. 4) to evaluate the spread they are paying on both spot trades and forward trades and leverage this information to negotiate rates commensurate with trade size and currency pair.
Further to this, a CFO will maximize their capital by using counterparties that require little to no initial or variation margin. By minimizing the upfront and ongoing margin requirements when booking hedging transactions, the company can drastically improve their returns, simply by putting all their money to work.
Establishing key metrics for FX risk management is essential to ensure strategies are effective. The right metrics provide data to guarantee a solution is the optimal one and they can highlight areas that require change. Not to mention they might someday ensure the finance group does not suffer from unrealistic expectations.
Once key metrics are determined, benchmarks must be set to decide if the performance measured is acceptable. For example, in sports cars, one performance metric is the 0-60 mph time and its benchmark time might be 4 seconds. In FX risk management, one of the objectives might be the minimization of volatility. Thus, the metric is earnings volatility. A corresponding benchmark might be “less than 5%”.
After he’s gathered the measurements and analyzed their performance, he can now make data-driven decisions about any successes or failures.
The CFO is now prepared for battle as well as any Fortune 500 CFO. He has objectives that have been determined and agreed to by the BoD or C-suite and documented in an FX Policy for his department and his successors. Knowing which risks he is responsible for, he and his team can devise strategies that should meet those objectives.
Having set the strategies, and determined the precise nature of his exposures (tenors and notionals), he may utilize computational methods such as Monte Carlo analysis to select the optimum hedging instruments. He carefully selects his counterparties and holds them accountable for execution costs using Transactional Cost Analysis.
Lastly, he measures how well he and his team did. In FX risk management, using the correct metrics and benchmarks provides him with objective feedback on whether his strategies are working, or need modification to meet objectives.
Deaglo is a cross-border advisory company providing the next generation of FX risk management and execution solutions. We educate and empower Finance teams at international companies and investment managers to take control of their FX risk and manage their cross-border transactions more effectively.
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