Case Study: Xerox Dynamic Layered FX Hedging Programme Cuts Volatility

Xerox wanted a systematic foreign exchange (FX) hedging solution across its multibillion dollar global business that was transparent and easy to implement, and would reduce risk while at the same time improve the hedge rates achieved.  

The aim of this project, which started in January last year and eventually led to a Dynamic Layered Hedging model in the first half of 2013, was to more closely align Xerox’s hedging programmes with its future FX cash flows thereby reducing the period-on-period impact of currency volatility on its bottom line.  

The main objectives of the project were to:  

  • Quantify the risk and the potential impact of FX volatility on earnings. 
  • Deliver more predictable earnings by aligning the corporate hedging programme to future FX cash flows in order to reduce the impact of currency volatility. 
  • Secure management buy-in to improve the quality of FX and cash forecasts, and thereby remove randomness from hedging decisions.  
  • Improve cost/risk optimisation.  
  • Increase transparency and the ability to measure results against pre-agreed benchmarks.  

The end result, developed in conjunction with Citi and supported by the bank’s FX exposure management software, means that the Xerox treasury now has a global systematic, rules-based framework which follows industry best practice and is clearly understood by senior management throughout the company. It eliminates much of the emotion and randomness in the hedging decisions now made, by introducing a pre-agreed set of metrics designed to optimise both the hedge ratio and the hedging instrument based on valuation and carry.  

How though did the corporate treasury achieve this? Citi and Xerox looked at several hedging strategies, testing them against 20 years of data to select one which would best improve Xerox’s FX risk management process. Xerox selected the innovative rules-based Dynamic Layered Hedging model only after careful consideration. Citi ran multiple scenarios, again back-tested over 20 years, for different currency pairs, long-term fair valuations, interest rate differentials and volatilities to get the bespoke solution. The model eventually developed over the year-long project is a matrix which recommends the best FX tenures, hedge ratios and financial instruments to use to maximize performance.  

How It Works

The key drivers of the Dynamic Layered Hedging solution adopted are relative valuation, which compares current levels of a currency pair to its fair value and cost of hedging, which is driven by carry (i.e. the forward point adjustment) and volatility, which dictates the option premium. Using these inputs, the model will select the maturity of each hedge and the optimum hedging instrument. For example, if a currency is overvalued and carry is in the company’s favour, the model will favour hedging more now and less later using forwards. If the currency is undervalued and carry is negative, the model favours hedging less now and more later via options. In between, the model selects the appropriate mix. Hence it provides the benefit of a systematic programme which guarantees a pre-agreed level of hedging, but allows the flexibility to adjust the maturity of the hedges or the type of instrument used according to prevailing market conditions. 

The next step was to design a system to deliver the product and track results. The result was the CitiFX exposure management toolset which is accessed through the bank’s corporate CitiFX Pulse portal. The initial version was released to Xerox early in 2012. Further improvements were captured in the FX Pulse 2.0 upgrade in January 2013 which provided a more seamless and effective FX risk management solution to Xerox, allowing the corporate treasury to input exposures, run its strategy, execute and confirm trades, and monitor changes on a single platform. The system links seamlessly to Xerox’s existing treasury management system (TMS), allowing forecasted exposures and existing hedges to be easily uploaded and disseminated.  

The Advantages

The economic and risk management benefits of the new real-time FX hedging model adopted at Xerox are significant, with risk reduction and improved efficiency and productivity this year soon convincing the chief financial officer (CFO) of the project’s worth. However, once you go for a more systematic approach you need to tighten up on the variables. All the corporate’s long-term hedges must now qualify for the cash flow hedge accounting treatment, which has meant an improvement in the quality of cash forecasting was also necessary. For a global business such as Xerox this is no mean feat, but the support of the CFO and senior management buy-in helped enormously.  

With the support of the boardroom, better control and compliance procedures are now in place and hedge rates have improved significantly, alongside transparency and the corporate bottom line, which now suffers from less volatility and benefits from improved financial control over global FX management.