Recent currency volatility throughout Europe and South America has led many treasurers and chief financial officers (CFOs) to carefully consider their foreign exchange (FX) management and risk policies. Hedging strategies that worked in the past may no longer be adequate and simply increasing hedge ratios may not be the answer when considering the impact of sovereign debt issues surrounding the euro, or considering the recent strength of the US dollar and the general increase in currency volatility. As companies look to adjust their hedging strategies, the goal of FX risk management policy should not only be to reduce risk, but to mitigate FX risk in the most efficient and cost effective manner possible. Some questions to ask are:
- Are you currently able to gather a complete dataset of exposures?
- Is exposure information provided in a timely, detailed and accurate manner?
- Is there an operational focus on reducing exposure?
- Are risk factors used to rank exposures?
- Is there a strategy that prioritises the types of risk to hedge (e.g. balance sheet, short-term forecast, long-term forecast)?
- What type of derivative strategies will be used to hedge, after operational considerations?
Achieving a goal of not only managing risk, but also doing so in an efficient and cost-effective manner may require changes to the risk management policy of an organisation, or at least, a change in focus of the policy. Greater emphasis on the gathering and consolidation of exposures is required. The policy should include goals in achieving a timely and complete exposure dataset, as well as direction on what exposure data takes priority.
In most cases, exposure gathering should start with balance sheet exposure and then move into the collection of all forecast exposures. Balance sheet exposures are known and provide insight that will improve the gathering of forecasted exposure data. Also, assuming you have all of the exposure data gathered – and it is timely and with enough detail to properly analyse – an FX risk management policy should consider operational methods of reducing risk and not look to derivatives as the only tool available by default.
What are Operation Methods of Managing FX Risk?
Operational methods of reducing risk can include cash conversions, adjustment to concentration structures, restructuring of the intercompany process, and contractual considerations, potentially reducing exposures caused by trade receivables or payables. Cash conversions and concentration structures both have the goal of reducing non-functional currency cash balances on each entity’s ledger, by means of FX spots or wire transfers. Structuring a cash position worksheet, with rules to identify possible transfers, should become part of a regular routine of FX exposure monitoring.
Intercompany balances have the ability to create exposure or perform as a natural hedge. The treasury team should look at the intercompany process from the standpoint of FX exposure management. Moving from a high-volume, term loan approach to an in-house bank (IHB) structure can simplify, as well as mitigate, FX exposure management.
Central treasury maintains an IHB position with each participant (division/entity/business unit) in the functional currency of the participant. Each participant maintains an IHB position with the central treasury. By ensuring that there is one statement between the central treasury and the participant, and ensuring the position is in the functional currency of the participant, all currency exposures will be pushed to the central treasury, allowing a natural netting of exposures at the central treasury and making it very easy to isolate the net FX exposure to hedge.
Multi lateral netting is another method of managing FX exposure by means of intercompany flow. Intercompany invoices are netted, creating a single payment or receipt between the netting centre and participant, and like the IHB structure, is settled in the functional currency of the participant.
With the detailed gathering of balance sheet information, any weaknesses in accounting processes may misstate exposures. Accounts may be incorrectly categorised for revaluation; accounts may not be reconciled in a timely manner, resulting in on-going exposures; or an improper clearing of non-functional receivables and payables could occur. These examples could see an exaggeration of real exposure.
Achieving Systemic Reduction in Exposure
Focus on exposure gathering will make operational risk mitigation possible, which will result in a systemic reduction in real exposure and provide treasury with a better understanding of how risk flows through the organisation. This will lead to an overall reduction in derivative volume and a more effective application of derivative strategies. The result is a hedging strategy that achieves risk mitigation goals in the most efficient and cost-effective manner possible.
Operational risk mitigation requires a complete data set of exposure information. The data set must be available in a timely fashion, as well as provide a level of detail that provides an operational understanding of the exposure. To achieve such a data set first requires an increased focus within a company’s FX risk management policy. FX risk management policies typically focus on the types of derivatives and strategies that can be applied and the overall objective of these strategies. For example, the strategy may be to hedge 90% of all balance sheet exposures. The strategies will focus on reducing, mitigating, even eliminating FX exposure and the means to do so. As already discussed, the means should include operational methods of risk management and goals around the collection and identification of FX exposure.
The policy should include guidance as to what is acceptable, in terms of visibility, transparency and completeness of exposures. An FX risk policy could not hope to be effective without such a focus. Risk management policy has a tendency to focus on how to mitigate FX risk, with an assumption that the exposures have properly been identified. This places emphasis on proper execution of hedge strategies, but does nothing to improve the collection of exposures, and can ultimately lead to FX volatility and the improper application of derivatives.
Communication between treasury and operations is key to achieving a timely, detailed and complete exposure data set, but there are also many tools that can be used to gather this information. Extracting exposure balances directly from the accounting system and applying run-rates and other statistical measures on actuals is a valuable way of identifying exposures. Providing standardised tools for operations to submit exposures is also key to improving communication and the collection of exposures.
It is also important to view the exposure data at the right consolidation point within the organisation. Netting of exposures, where the long and short positions are consolidated by currency pair, is a powerful method of naturally hedging. The higher the view of the data, the more natural hedges can be utilised. At the company level, all natural hedges have been taken into account, and the derivatives required to hedge net exposures will be minimised, resulting in a very effective and efficient application of hedging strategy.
With a complete data set of exposures and after an operational review to mitigate risk, the focus can then turn to an efficient and effective application of derivative strategies to reduce remaining risk and achieve the risk mitigation goals of the FX risk policy. The timely, complete and transparent data set, along with the operational review, will provide greater insight into how effectively and efficiently to hedge the remaining exposures to meet risk guidelines.
Viewing exposures by currency pair and looking at a risk measure, such as value-at-risk (VaR), is one method of determining an effective approach to hedging. Hedging the largest notional balances or the ‘main’ currencies may not be the best approach. VaR considers volatility and correlation between your currencies. A relatively minor exposure, from a notional perspective, may have a significant risk exposure associated with it.
In light of the recent currency volatility and turmoil, CFOs and treasurers are looking at ways to manage their FX exposure in the most efficient and cost-effective manner possible. Incorporating goals into risk policy that emphasises the importance of collecting complete, transparent and timely exposure data is key to a successful risk policy. In addition, placing greater focus on operational methods of mitigating risk, as a way of systemically reducing reliance on derivative strategies, is also important to a successful risk policy. Focus on exposure gathering and operational risk management will result in a stronger risk policy, which achieves its goals in a more efficient and cost-effective manner, and leaves the organisation in a better position to handle the next currency crisis.
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