View the latest FX Survey results

Treasurers need to move out of risk-management comfort zone

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: SContreras@Euromoney.com

By:
Paul Golden
Published on:

Cash flow at risk and earnings at risk can help ensure FX risks are reported correctly, but treasurers need to do more to convince senior management to move away from tried and trusted methods that are no longer fit for purpose.

goldfish_glass_780


Cash flow at risk (CFaR) and earnings at risk (EaR) have much to offer as techniques to test current assumptions and validate exposure forecasting to reflect a company’s FX risks

CFaR measures the extent to which future cash flows may fall short of expectations as a consequence of changes in market variables, while EaR assesses the amount that net income may change due to a change in FX rates over a specified period.

From a reporting perspective, CFaR and EaR allow treasurers to move to an FX risk discussion with the CFO and board and away from a hedging policy-driven approach. By reporting EaR and CFaR values to the board it is much easier to link up with key performance indicators (KPIs) around earnings and revenue.

Mark Lewis Bloomberg_160x186
Mark Lewis,
Bloomberg

The traditional percentage hedging approach, however, cannot be tied to these types of KPIs, which boards are now demanding.

It is a challenge to move away from an accepted practice, but treasurers cannot ignore the mounting headlines about public companies losing earnings or revenue due to FX rate movements, says Mark Lewis, corporate treasury product manager at Bloomberg.

"We need to accept that the current model – the percentage hedging approach – does not work, and switch to the CFaR/EaR model that ensures all risks are reported correctly,” he says.

In fact, one in three of the corporate treasurers, financial analysts and risk managers surveyed by Bloomberg during a webinar on corporate risk management said they were already using CFaR and a further 29% were considering using it.

But, when asked what obstacles stood in the way of adopting a CFaR-based hedging policy, two thirds of respondents cited the difficulties of explaining the policy internally and to the board.

Limited resources

In some cases, senior management have limited historical practitioner experience with CFaR and other risk modelling techniques.

Andrew Bateman FIS_160x186
Andrew Bateman,
FIS

Additionally, corporates often do not have the technological capability or staffing expertise to model risk on a regularly scheduled basis – and for those that do, the function is generally managed by a limited number of employees.

Risk modelling is often an area of the organization that, while strategically important, has a lower profile within the larger finance and treasury structure," says Andrew Bateman, EVP of capital markets buyside at financial services technology firm FIS.

At-risk concepts were originally developed to quantify risk at financial institutions, where managing risk portfolios is the core business. As a result these institutions benefit much more from advanced quantification techniques and have invested heavily in their risk management departments.

For many corporate treasuries, however, risk management is not the primary business.

Value-at-risk techniques took some time to gain acceptance even in the banking sphere, and it can be difficult to explain statistical simulation-based approaches to board-level members without a quantitative background, observes Sean Coyne, principal solution consultant risk and quant at financial technology firm Finastra.

At an organizational level, EaR demands a centralized risk management function and is best suited to multinational corporations that can derive benefit from diversified exposures where correlations offset risks.

Sean Coyne Finastra_160x186

Sean Coyne,
Finastra

“Smaller corporates exposed to a single commodity or FX risk will see less advantage from EaR, which requires sophisticated models and is typically beyond the capability of the corporate treasury to build out in-house,” adds Coyne.

“However, CFaR and EaR map directly to the KPIs of the board and in time will gain traction.”

CFaR and EaR models are most relevant for large corporations with significant exposure in multiple currencies and complex intercompany structures, where both liquidity and earnings risk at the consolidated level matter.

That is the view of Philippe Gelis, CEO of currency risk management solutions provider Kantox, who accepts that this type of complex hedging model may not be suitable for all companies. “It will depend on their risk objectives, on the number of currencies they use, and on other factors specific to each company,” he says.

Gelis suggests that to have a meaningful risk discussion, CFOs and treasurers need to avoid technicalities and focus on the strategic aspects of FX risk management. “In the end, what senior management is really interested in is minimizing the impact of FX volatility on their business.”

Technological conservatism

More than 40% of the Bloomberg survey respondents said their company was reluctant to change its current systems.

When asked what vendors could do to overcome this reluctance to invest in new technology, Henning von Tresckow, managing director of Trinity Treasury Management Systems, recommends making the digital transformation as easy as possible, with cloud treasury solutions that can be used end-to-end or plugged into an existing workflow, including APIs and interfaces to widely used ERP software.

Philippe Gelis Kantox 160x186

Philippe Gelis,
Kantox 

According to Gelis, solutions providers must focus on two key aspects, neither of which directly relate to cash flow at risk. Firstly, vendors should guarantee robust and easy connectivity with all internal systems (TMS/ERP) in order to improve data quality. 

Secondly, these complex projects should be implemented in stages, starting with the automation of hedging execution, as it usually has a very high return on investment and can be considered a quick win.

Sander van Tol, partner at treasury, risk and corporate finance consultancy Zanders, says that although technology can assist in making the required calculations, the most important requirements for adopting a cash flow at risk-based hedging policy are an advanced understanding of at risk techniques, willingness at board level to change the hedging policy and an understanding of the underlying financial exposures.

The last of these points is the real problem – many corporates still do not have full visibility on their FX exposures, van Tol concludes. “In order to have meaningful CFaR numbers, one should understand the relationship between the financial variable – for example, the FX rate – and the related cash flow.”