There are a large number of well-known ways an FX hedging programme can go wrong, from inefficient netting across organizations' non-centralized trading, non-uniform accounting procedures and trading-risk failings, including trading and settlement separation.
What’s surprising is that the value of FX policies sometimes remains under-appreciated in treasury risk management.
According to Deloitte’s 2016 global foreign-exchange survey, more than 70% of respondents report only basic metrics such as quantum of FX exposures, hedged positions and FX gains/losses.
Fewer than one-in-four generate information such as performance against key benchmarks, variance analysis, value at risk or other at-risk measures, stress tests or scenario analysis.
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Paul Stafford, |
According to Synops chief engineer Paul Stafford, an effective FX policy should cover a multitude of hedging objectives using robust data. These include data to minimize hedge costs or volatility, performance metrics and benchmarks, management processes to accurately determine cash flow and balance-sheet exposures and minimize trading costs, and procedures to minimize counterparty risk.
Stafford also says other objectives can include special hedge accounting to eliminate income statement volatility from long-tenor cash-flow hedges by deferring hedge gains/losses until the hedged item materializes.
He says: “Metrics and benchmarks should be based on transactional exposures, translational exposures, intercompany transactions and contractual future foreign currency commitments such as multi-year capital projects.
“One metric might be reducing net revenue variance and EPS due to FX. Related benchmarks might be 2% variance due to FX, or less than .01 EPS. The timeframe would coincide with financial reporting dates. Risk-reduction metrics might refer to scenario testing, probabilistic earnings at risk or net gain/loss on contracts versus exposures.”
Possible cost metrics include total volume of hedge contracts, total points and premiums paid as a percentage of hedge notionals and FX counterparty bidding performance.
Cost of hedging is normally a distraction, says independent treasury consultant David Blair.
“The forward price is simply arithmetic, the difference between the two currency interest rates," he says. "The proper goal should be to minimize FX volatility in cash flows and/or in the accounts.
"Some corporates use hedge optimization, which seeks to minimize the number of hedge transactions based on the exposure portfolio value at risk, but this carries risks in so far as past correlations may not hold in the future.”
Design and implement
Understanding and managing costs is something that all corporates can do, but designing and implementing an effective hedging strategy is more complex, suggests New Change FX CEO Andy Woolmer. He adds that hedging decisions can only be made once the client knows exactly what its bank or broker is charging.
A well-designed FX policy will integrate seamlessly to cash-flow forecasts, hedging in a timely fashion and creating certainty in future non-base income streams, says Woolmer, adding: “Leaving cash flows unhedged might be an option, but as recent events have shown that could create some extreme outcomes.”
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Jan Vermeer, |
Basic mistakes are being made while creating FX policies, such as the use of cash-management techniques in risk-management functions, says Jan Vermeer, partner at treasury consultancy firm Treasury Services.
“For example, corporates often seek a natural hedge without considering whether the risk sensitivities of incoming cash flows are offsetting the risk sensitivities of the outgoing flows,” he explains.
“FX hedge metrics should be based on hedging risk sensitivities - strategic FX risk management, for instance, could have a time horizon of 10 years.”
Unless objective and meaningful metrics have been codified into a policy, management often takes the view that a hedge that made money was successful and a hedge that lost money was not, completely ignoring the effects of the underlying exposure, adds Synops' Stafford.
“Another unfair metric is whether a particular budget rate was achieved,” he says.
Treasury Alliance Group founding partner Daniel Blumen agrees that policies in themselves do nothing to reduce volatility or lower the cost of hedging unless the logic behind them is clear and accepted.
Independent treasury consultant Blair observes that corporates who hedge beyond balance-sheet risks normally use hedge accounting to minimize volatility reported under GAAP, while Treasury Services's Vermeer suggests the hedge-accounting directives from IFRS and FASB offer add value if they are implemented correctly.
“The ‘big four’ accounting firms focus on the accounting aspects of these directives, while actually the subject is risk management,” he concludes.
“I believe that this is why too many organizations are not using the hedge-accounting directives to their advantage.”
