Round table: FX Risk management
In September 2018, Zanders organized and hosted a round table session on the topic of Advanced FX risk management. Leading practitioners from various multinational companies actively debated a selection of topics varying from the challenges in FX identification to the different hedging strategies. This article summarizes the discussed topics.
Why should you have a solid FX risk management approach?
FX risk management remains an important topic for most companies for various reasons. First of all, the increased volatility in financial markets due to geopolitical events, such as Brexit, trade wars and local political tensions (e.g. in Turkey) can result in adverse financial results when FX exposures are not managed properly. As an example it was mentioned that when companies communicate that they are surprised about the financial impact of FX headwinds, this might indicate that these companies are not fully in control of their FX exposures.
Next to the increased volatility in financial markets, we also identify a relatively new phenomenon in the FX market; the existence of a material basis in the cross-currency basis swap with respect to several currency pairs compared to the USD. The basis is created due to the high demand of USD and persists due to the increased costs for banks to hold capital and consequently the costs for banks to resolve this arbitrage situation. As a result, the existence of the basis could increase the USD hedging costs for corporate companies.
The geopolitical tensions, increased volatility in financial markets and specific FX market abnormalities trigger the need for a structured approach towards FX risk management.
Financial risk management
To manage FX risk in a structured manner, the Zanders’ Financial Risk Management Approach (see figure 1) is a proven tool. The approach consists of four concrete steps and provides a solid structure for managing financial risks.
The initial step in the Zanders’ Financial Risk Management Approach is the Identification & Measurement step. In this step it is important to first identify the FX exposures that are specific to the company. During the round table we discussed three different types of client models for companies with regard to FX risk:
- Trading company: For a trading company, protecting the profit margin on individual trades is the main objective, therefore it is vital to have (almost) real-time exposure information to be able to manage FX risks on a transactional and back-to-back basis.
- Run rate company: These companies manufacture goods or provide services based on annual plans. The annual or budget plan already contains assumptions around FX to determine sales forecasts, set price lists or intercompany deliveries. For a run rate company the main objective can be to lower the volatility of the FX impact on the projected EBITDA. FX exposures can be anticipated in advance and the hedging strategies can be based on the total net exposures to reduce the volume and number of hedging transactions.
- Project company: For a project company, the objective is to protect the profit margin of an individual project that might be won. Due to the high value/low volume business profile the company can be exposed to considerable uncertainty with respect to the (anticipated) FX exposure. For project companies we can distinguish the FX risks in the tender phase and the execution/delivery phase. In particular, the FX risks to which a project company is exposed in the tender phase are unique. To ensure a target project’s profitability, the estimated hedging costs should have already been taken into account during the tender phase of the project.
We concluded that a company’s type of client model would in the end play an important role in how FX risk management is organized within the company.
Figure 1 Zanders’ Financial Risk Management Approach
Definitions of different types of FX risk
There can be a lot of miscommunication about the FX exposure classification itself. The textbook exposure classifications of FX risks are economic, transaction and translation FX exposures. Transaction exposures can be further classified as anticipated (forecasted) exposures, committed exposures, unrecognized and recognized (on balance sheet) exposures.
The different FX risk exposures are not standalone categories; rather, they are interrelated over time. For example the economic exposure becomes a forecasted transaction exposure once the sales are forecasted. Then it becomes a translation exposure when the P&L of the entity generating the sales is translated into the group functional currency.
At last, the exposure becomes again a transaction exposure when the intercompany dividend is declared. Figure 2 gives an overview of the different types of FX exposures and how they are interrelated over time.
Figure 2 FX exposure definitions
Capturing FX exposures
The Zanders’ Financial Risk Management Approach starts with the identification of FX exposures (see figure 1). For companies this can be a challenging task due to issues such as a scattered system landscape, embedded options or currency index references in contracts, differences in reported exposure currencies and the true exposure currencies, etc.
For companies with a decentralized company structure (and related scattered system landscape) it can be challenging to get an accurate and complete overview of the FX exposures. It can be a time intensive and cumbersome process and commitment is required to arrive at the envisaged destination. To make the transition towards increased insight in the FX exposure possible, the process can be split up in smaller, more manageable steps.
It is better to start with a limited proof of concept to understand the measured FX exposures. The proof of concept can be limited to a specific division, or to recognized transaction exposures only, or to all exposures captured in one ERP instance. To conclude, one should be careful not to make the FX exposure identification model too complicated to develop, use and maintain.
Tooling can facilitate the FX identification process by capturing the aggregate FX exposures. However, it should be realized that the “garbage in, garbage out” principle is applicable for tooling support in the FX identification process. When FX exposures are inaccurately and/or incompletely identified companies can even increase FX exposures by hedging the ‘wrong’ currencies. Companies can use different tooling solutions to capture FX exposures. Companies can either use off-the-shelf solutions (an example is shown in figure 3) or develop an in-house developed database solution.
During the round table, several companies indicated that they developed their own proprietary data warehouse solutions to capture FX exposures. Companies are also exploring the added value in the FX identification process of developments in the field of exponential technology, such as artificial intelligence. The potential of artificial intelligence is not yet discovered but could in the future lead to significant improvements in the visibility of the underlying FX exposure. In the end, the decision to buy or develop a tool depends mostly on the company’s requirements and the ability of vendors to meet those requirements.
Once the FX exposures are identified, it is crucial to analyse and interpret the results. This often requires discussions with different departments in the organization. Treasury can even act as a bridge to bring together different internal departments such as procurement and sales to align FX details in contracts and thereby reducing the FX profile of the company. A result of such discussions can be that specific rules need to be set up to improve the accuracy of the FX exposure identification, for example: “exposures from supplier X are always in currency Y, while they are reported in currency Z”.
In most companies, the forecasting process is the responsibility of the FP&A department, so it’s paramount that FP&A and treasury work closely to identify (anticipated) FX exposures. The organization of the accountability and responsibility of this process differs from company to company. It should, however, be clear for each company how this is internally organized. It is important to continuously monitor the effectiveness of the FX identification process and keep a constant dialogue with the different internal departments.
Figure 3 Example FX exposure capturing tooling
What do ‘at-risk’ techniques imply for a treasurer?
After the FX exposures are identified and measured, the next step is to quantify the risks. Different techniques can be used to quantify FX risks, from the simpler techniques such as sensitivity analysis to the more advanced ‘at-risk’ techniques. A debated discussion was about the usefulness of ‘at-risk’ calculations. In normal market conditions, ‘at-risk’ calculations give a good insight in both the probability and impact on the financial results of movements in FX rates. Another advantage is that ‘at-risk’ calculations can be used for a portfolio of currency exposures whereby one takes into account the dampening effect on the aggregate FX position as a result of imperfect correlations between currencies.
Despite these advantages, one should be cautious in the interpretation of the ‘at risk’ results and have a good understanding of the major assumptions, including the standard deviations, currency correlations and holding periods.
When companies are unable to interpret ‘at-risk’ outcomes this can result in significant unforeseen exposures when financial markets are under stress. The past has taught us that, in times of stress, the statistic variables used in ‘at-risk’ calculations do not always hold. Especially for companies exposed to currencies that are pegged to a strong currency such as the USD, the financial impact, when the peg is removed in times of market stress, can be severe.
To improve the usefulness of ‘at-risk’ techniques, treasury can evaluate and amend the main assumptions underlying the calculations. These include the assumption about the (normal) distribution, volatilities, and term of ‘at-risk’ calculations.
Another way to measure FX risk is by the creation of heat maps. Heat maps indicate the risk of significant FX rate movements based on a number of qualitative and quantitative indicators such as geopolitical stability, demographic conditions, trade balances, etc. When the heat map alerts a change in the currency’s risk profile, the hedging strategy can be re-evaluated by adjusting the hedge ratio or instrument, for example.
To conclude, ‘at-risk’ techniques can be valuable for companies when interpreted correctly. Some round table participants indicated that ‘at-risk’ calculations are used in their company. They explained that the calculations could facilitate discussions with internal stakeholders such as the management board and local entities to determine the hedging strategy. The combination of scenario analysis, stress testing and use of heat maps provides treasury with a good insight into the company’s FX risk profile.
Ready for FX portfolio hedging?
When FX risks are quantified, the optimal hedging strategy can be determined. The hedging strategy highly depends on the business profile and currencies to which the company is exposed. Companies apply different hedging strategies per type of currency. For example, a company can alter the hedging strategy for currencies with the following characteristics:
- Currencies with low hedging costs are hedged with FX forward contracts;
- Currencies with ‘medium’ hedging costs are hedged with FX collar structures;
- Currencies with ‘high’ hedging costs are not hedged or with out-of-the-money options;
- Some currencies cannot be hedged.
The hedging costs are often determined by companies by calculating the forward points of a forward contract and if options are used by the option premium. Hedging costs are an important factor in choosing a hedging strategy; to reduce the costs of hedging, companies can enter into ‘out of the money’ option strategies. To analyse which hedging strategy adds most value to the company, treasury should relate the hedging costs to the lowered volatility.
Different hedging strategies can be plotted and the treasurer can subsequently determine which hedging strategy is likely to add most value to the company, taking into account the company’s risk appetite (see figure 4). By means of an FX Sharpe Ratio, where the average expected cash flows, corrected for the hedging costs, are divided by the volatility of the cash flows, different hedging strategies can be quickly compared. The higher the FX Sharpe Ratio, the more favourable the hedging strategy is expected to be.
Figure 4 Examples of different hedging strategies
Treasurers are obliged to advise the organization on (FX) risk management. It is important that hedging costs are presented in the correct way and that the consequences of different hedging strategies (e.g. between 100% hedging or not to hedge) are clearly outlined. It was mentioned that hedging costs should be perceived as insurance costs for more predictive financial results.
Suitable FX risk management strategies are dependent on the type of the business, but always start with a strong foundation. Without a clear insight into the currency exposures of a company, treasury is not able to make an insightful decision about how to effectively manage FX risk. Treasury is responsible for managing the financial risks of a company and should be aware that FX risk management is all about stakeholder management, the most important stakeholders being senior management, operating companies and FP&A.
As treasury does not always know what the business will do, a solid risk management approach is vital with proper tools to ensure that knowledgeable people have the right instruments available to make insightful decisions with respect to FX risk management. In other words: “I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” Jimmy Dean