FX risk identification – Why does it matter? Why now?
Geopolitical instability has always had an impact on foreign exchange (FX) markets, increasing the volatility of FX rates. More recently, the rising tensions between the US and North Korea, as well as the uncertainty surrounding Brexit, have combined to create instability, making FX risk a top priority for financial professionals. Effective FX risk management strengthens corporates and makes them more versatile, so CFOs and treasurers have been looking for solutions to put in place sophisticated and accurate responses to currency pair movements.
Discussions about FX risk management typically revolve around two main topics: FX risk policy and hedging. Corporates tend to focus on elaborating and maintaining a wide-reaching, complete policy, comprising objectives, metrics and hedging strategies. Simultaneously, when considering tactics and execution, corporates firstly look at hedging strategies as a means of finding the most optimal mix of hedging instruments. Even though these topics are crucial in contributing to the successful implementation of the overall risk management process, they represent part of a broader picture that needs to be taken into consideration as a whole.
With this in mind, it is crucial to take a step back. Without a clear, detailed and reliable identification of FX exposures, there are no subsequent accurate risks to address, nor the establishment of policies and strategies that are ahead of the curve and respond to the ever-volatile multi-currency market.
The sophistication of FX risk identification.
Accurate FX risk identification enables the establishment of an in-depth understanding of the company’s susceptibility as a means of reaching a complete and encompassing overview of the frequency and magnitude of currency pair exposure.
On the other hand, a weak risk identification process can provide misleading assurance that FX risk is under control, with potentially harmful or even detrimental impacts on a company’s P&L account. For instance, during consolidation, the transaction currency (i.e. the currency that a business transaction took place in) is often lost. An example of this is given in the box below.
FX Identification – an example
A European corporate with EUR as its denominated functional currency has a large exposure to USD and HKD due to its sales operations. Both these exposures are recorded in the numerous corporate ERP systems in its functional currency. When the hedging decisions are taken on a monthly basis, these exposures are consolidated in an Excel spreadsheet to obtain visibility of the amounts of the FX exposure. If, during consolidation, part of the USD exposure is lost, showing the corresponding EUR value, the corporate would have the false impression that its only exposure is to HKD and it would enter into a FX forward to lock the future value of its HKD sales. However, when the USD payment is received, if the EUR/USD rate changed unfavorably, the firm would have to account for a realized FX loss in the P&L.
This can happen when corporates record their exposures in many ERP systems and there is no clear process to identify and gather exposure data. It may happen that some ERP systems are not considered or, if considered, the local currency exposure is lost because it is recorded in the functional currency. Had the corporate in our example had a sound FX identification process, it would have been able to identify and subsequently hedge its exposure to USD.
Having recognized the importance of an effective FX risk identification procedure, the current challenges corporates face in leveraging such process can be identified.
Firstly, there is often a lack of clarity in the definition of FX risk, as well as an occasional absence of clear grasp and segregation of different FX risk types. Within Zanders, FX risk is defined as: “Any adverse financial effect for a company arising from movements in the foreign exchange rate”. One then ought to understand which type of FX risk is being addressed. There are three types of FX risk that are usually identified, which require different treatments and pose different challenges:
- Transaction risk
- Translation risk
- Economic risk
Figure 1: Types of FX risk
Transaction risk occurs when a corporate trades, borrows or lends in a currency other than its functional currency. A transaction exposure can either be anticipated or committed. In both cases there will be a time delay between the anticipation/commitment and the actual payment of the transaction. During this time interval, exchange rates will most probably change and the company is exposed to a risk that could have a positive or negative financial impact on the P&L.
Translation exposure arises from converting financial statements expressed in foreign currencies into the group reporting currency.
Economic risk also known as operational or competitive risk, arises when changes in exchange rates alter the competitive position of a business.
As shown in the above example and FX risk definition, it is crucial for each corporate to start the FX identification with a clear understanding of the different types of FX risk.
Where is the FX information contained?
Another challenge for FX risk identification arises with the various and often complex landscapes of source and trading systems in which relevant information is contained. Such data gathering primarily involves deep understanding of internal and external flows, the underlying currency of these flows, as well as the identification of the systems where this information is stored. Consequently, FX footprint development requires the combination of data from several systems.
A few examples of systems that contain relevant data needed for FX identification are ERP systems with A/P and A/R functionalities, cash flow forecasting tools that gather cash flow information and analysis performed by local teams, treasury management systems with related derivatives and exposure management, and annual budget platforms with the planned expenditures for the financial year.
Considering the variety of these systems, the real challenge lies in puzzling the information together from all different data sources. A firm may either have a scattered, decentralized systems landscape, or a more consolidated structure with a single ERP system implemented by the main entity and subsidiaries.
For the scattered architecture, solving the puzzle for timely and quality assured FX data is a particularly crucial challenge, given the different systems and processes involved. Such data is often captured in Excel spreadsheets and sent from business units to the centre, providing room for discrepancies when the format is not the same as the one used for all the entities and there are delays in providing this information.
Apart from different source systems causing challenges in identifying FX exposures, other potential threats can undermine the quality of collected FX data, such as cases in which currency options are embedded in commercial contracts, cash flows from subsidiaries or local teams are received with a delay or are incomplete, or when information is only retrieved from a certain number of source systems within the wider architecture.
The challenges above show how potential negative impacts arising from a misleading or incomplete FX risk identification can be significant. Similarly, recognizing the importance of sound FX risk identification and addressing its challenges requires strategic and operational prioritization in the form of a structured approach. With such a framework, market best practices on FX risk identification can be understood by corporates and applied to their specific case to improve their risk identification processes. Additionally, the challenge of extracting accurate and timely FX exposure data can be addressed by leveraging the use of specific FX risk tools, which are able to collect data from the company’s financial systems in a reliable and innovative manner.
However, it goes without saying that the first step for successfully addressing and managing FX risks consists of recognizing the importance of the FX risk identification approach before developing policies and hedging strategies. In other words, prioritization of FX risk identification should be at the top of the CFO and treasurer’s agenda as a means to establishing a prosperous, long-lasting method for promptly reacting to currency pair fluctuations in line with a corporate’s systems and process landscapes.