Cost-effective
Foreign Exchange Risk Management
In more volatile
times, managing foreign exchange risk in a cost-effective manner requires
different strategies. How can treasurers adjust their risk management policy
accordingly?
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.
Derivative Hedging
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.
Moving Forward
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.
Article
by Ryan Heaslip is the senior product specialist for SunGard's AvantGard
corporations business. Prior to taking on that role, he was the risk
implementation manager for more than six years, where he was responsible for
the strategy, planning and implementation of AvantGard Risk solutions.
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