Economic Uncertainty Brings FX Risk Into Focus

The importance of FX risk management is accentuated over periods of uncertainty, which is a reason for its rise in prominence of the past few years. But what constitutes FX risk?

For the purposes of this feature, FX risk is made up of the following elements:

  • Transaction risk: The risk of value changes when a transaction executed in foreign currency is measured in the functional currency.
  • Translation risk: When a company has subsidiaries with assets or liabilities denominated in a functional currency other than the reporting currency of the holding company. Most multinational companies (MNCs) are heavily exposed to translation risk.
  • Economic risk: The future impact on cash flows and earnings of a company as a result of long-term changes in FX rates.

Typically, the management of transaction risk has been the main focus of corporate treasurers. Transaction risk tends to be comparatively easy to identify and manage using traditional hedging instruments, and often generates a high degree of management focus due to its visibility in terms of creating profit and loss (P&L) volatility.

Translation risk receives less focus, according to Kevin Lester, director of risk management and treasury services at Validus Risk Management, and gtnews contributing editor: “Translation risk is an area that is often overlooked, at least in terms of the implementation of FX hedging strategies, largely due to the fact that it does not directly impact cash flow, and as a result hedging translation risk can lead to cash flow mismatches between hedging instruments and underlying exposures.”

Despite its low profile, translation risk can have important repercussions, particularly in terms of lending covenants, which are measured using accounting metrics that are impacted by currency volatility. As such, it is often the case that the issue of translation risk deserves greater focus than it currently receives in many companies, particularly in situations where a high degree of leverage is employed and there is significant risk of breaching lending covenants.

Vikram Murarka, founder of Kshitij Consultancy Services, agrees, but sounds a note of caution. “Translation risk can be given more attention, but then it is correspondingly more difficult to hedge balance sheet items in a cost-effective manner,” Murarka notes.

Economic risk is also an area which deserves more attention, as it represents the long-term risk that currency volatility poses to the value of the company, and “is arguably the most important category of FX risk,” says Lester. As the impact of economic risk goes far beyond the reporting of FX gains and losses, and can relate to more fundamental strategic issues such as competitiveness and geographic expansion, the more abstract nature of economic risk can pose a challenge for corporate treasurers. However, the significance of economic risk to commercial strategy can also mean it is an area in which the treasurers can add considerable value to the business.

Tools for Treasurers

When it comes to the tools available to treasurers to help manage FX risk, these can be divided into two main categories:

  1. Internal risk mitigation tools.
  2. External hedging tools.

Internal risk mitigation tools involve minimising the exposure or impact of FX risk on the company by adjusting internal business processes. These tools include intercompany netting programmes, risk-sharing pricing or supply contracts, and developing natural hedging opportunities (either through capital structure adjustments or commercial adjustments).

According to Lester, companies are becoming more focused on maximising the use of internal risk mitigation techniques (and this trend will likely continue over the next 12 months), as it allows them to:

  • Minimise hedging costs.
  • Maximise credit availability (through a reduction in FX credit line usage).
  • Reduce the complexity of hedging implementation (e.g. hedge accounting requirements).
  • Eliminate risk substitution (i.e. exchanging FX risk for counterparty risk or liquidity risk).

External hedging tools (FX forwards, options, structured products, etc) remain essential tools for managing residual FX risk (after internal tools have been fully exploited). “The popularity of structured products, particularly those involving complex derivatives or leverage, has certainly waned since the onset of the financial crisis,” explains Lester. A key reason for this is that many of these structured products contained ‘short volatility’ components, in the sense that they involved writing options to subsidise the cost of hedging. As such, they were disproportionately impacted when volatility spiked as a result of the financial crisis, and many hedging programmes did not perform well as a result.

“Such products seem to be slowly re-emerging as FX volatility has begun to decrease, and this trend will likely continue as long as volatility remains contained,” says Lester. “This could be a dangerous trend, and treasurers should ensure that hedging products are robust enough to manage risks effectively in highly volatile markets.”

Looking at strategies treasurers are currently employing in this area, André de Klerk, financial risk manager at Moneycorp, suggests corporates are using of a blend of financial products with different weightings over different periods. “Most of the companies we advise use a combination of spot, forwards and FX options to achieve an appropriate result for a particular requirement,” says de Klerk. “Every company has a unique set of circumstances and different market views – using the right products at the right time is important.”

FX Hedging Strategies

With these tools in place, treasurers need to ensure that they have efficient hedging strategies in place. The main areas that treasurers need to pay attention to include:

  • Establishing clear hedging objectives.
  • Establishing quantifiable and visible risk key performance indicators (KPIs).
  • Ensuring hedging performance is regularly benchmarked against KPIs.

“The setting of risk KPIs and hedging performance measurement is an area which could often be improved,” comments Lester. “In the absence of such benchmarking activities, hedging programmes will often be judged on the basis of whether or not the hedge made money, thereby ignoring the original hedging objectives, as well as the performance of the overall portfolio (including the underlying exposure). Such an approach will often lead to hedging activities that actually increase FX risk, rather than decrease it, as the focus becomes the hedging P&L, rather than the achievement of risk management objectives which are aligned with overall corporate strategy.”

In this case, it is essential to have quantifiable risk KPIs that are regularly monitored, and used to recalibrate hedging activity as necessary to meet the company’s risk management objectives. Kshitij’s Murarka adds: “We think that treasurers need to re-look at their preference for the ‘natural hedge’. They can increase the profitability of their companies – without changing the risk profile – by asymmetrically hedging both payables and receivables.
A natural hedge is a lazy hedge, producing lazy results.”

Mark Warms, general manager, Europe, Middle East and Africa (EMEA) at FXall, suggests that the main area for treasurers to pay attention to in their hedging strategies is assessing which trading methods they are using for a specific situation. “Electronic trading provides treasurers with a choice of execution strategies and it is important that choice is based on a thoughtful process that is appropriate for the specific trading situation,” Warms explains.

Treasurers have often required complete end-to-end workflow solutions that encompass all aspects of trading and reporting to meet global compliance standards and thus manage their risks. “Execution quality analytics tools are becoming increasingly important for treasurers, providing them with a comprehensive trade performance overview, as well as metrics to measure the effectiveness of their trading strategy, while at the same time enabling regulatory compliance. End-to-end integration of treasury management and hedge accounting systems with trading and settlement tools is a best practice for both risk management and operational effectiveness,” notes Warms.

The Role of Technology

FX risk management technology can be divided into five main categories:

  1. Market data.
  2. Dealing systems.
  3. Transaction/position management.
  4. Risk analytics.
  5. Risk reporting/accounting technology.

According to Lester, there is significant overlap among providers within these categories. “Most of the major TMS [treasury management systems] vendors do incorporate FX risk management functionality within their core systems, which facilitates everything from operational process management, such as deal capturing and basic reporting, through to more analytical functionality, such as risk measurement and sensitivity analysis.”

There are also specialised technology providers who focus on specific aspects of the risk management process, such as hedge accounting, deal life cycle management, exposure visibility and risk management dashboard development. “The current trend is moving away from ‘all-in-one’ providers, where a single system is used for all aspects of FX risk management from operational to strategic, and towards an integrated solution where best-of breed providers are selected for their specific core competencies,” suggests Lester.

When it comes to the more analytical or strategic elements of FX risk management, the preferred tool for many corporate treasurers is still the traditional spreadsheet (ideally populated with data extracted directly from their TMS or accounting system to minimise data entry requirements and errors). Lester suggests that this is likely to remain the case, despite the advancements made by systems providers, due to the need for flexibility when performing FX risk analysis. “Different corporate treasuries have very different approaches and requirements when it comes to risk measurement and analysis, making it very difficult for a third party system to meet the diverse needs of the corporate treasury market,” he adds.

Murarka agrees that the spreadsheet model is here to stay, but that technology providers can look at that as a starting point for the more complicated solutions they develop. “The most important technology that treasurers need is a software that can track and collate all their FX exposures on the one side and all their hedges on the other side. The software should look and feel like Excel, but should work internally as a supercharged database management system,” he says.

Regulatory Environment

Looking to the future of FX risk management, regulation is a key ‘unknown’ that corporates will have to pay particular attention to, according to Moneycorp’s de Klerk: “The greater regulation of OTC [over-the-counter] derivatives is certainly a concern for corporate treasurers. The biggest fear is that it will make hedging more expensive.”

New rules outlined under the Dodd-Frank Act in the US and the European Markets Infrastructure Legislation in Europe, are placing new requirements on OTC derivatives to be secured with cash collateral. Although corporate users of hedging instruments thus far secured an exemption from both regulations, they will still be required to report their hedging activities, monitor positions and provide detailed information to prove that their hedges are constructed to cover commercial risk as allowed by the rules.

Over the past few years, the credit crisis illustrated some of the limitations of current hedge accounting regulations, and accounting bodies are working on replacement standards. Unfortunately, accounting rules have been one of the things that caused treasurers to avoid hedging. “When these accounting regulations were first introduced, they became so important that they superseded the business rationale for hedging. I am glad to see a seismic shift after the financial crisis and rightly so,” says de Klerk. Economic and financial drivers are now far more important in determining a hedging policy than the accounting implications.

Conclusion

FX presents a highly visible risk that treasurers need to manage as part of their daily responsibilities. These challenges come in a variety of forms, and with the OTC regulations looming, it is a risk that will remain of critical importance in the future. There are tools and techniques available for treasurers to mitigate and manage FX risk, and it is important for every treasury department to give a thorough evaluation of what their needs are in this area, and to select the appropriate tools for the job.

Click here to download the free gtnews 2011 Buyer’s Guide to Risk Management Systems.

11 views

Related reading