Treasury Today Country Profiles in association with Citi

A year in the life... FX management

Birthday cake with lots of frosted icing

How would you fare as FX Manager of an MNC?

High FX rate volatilities are a big challenge for multinational corporations with complex international value chains. In this article we invite you to take up the challenge and imagine the obstacles you might need to overcome in your first year as FX Manager of XY International Limited.

Portrait of Alfred Buder

Alfred Buder

Treasurer

Alfred Buder, European Treasurer of Flextronics International Ltd since February 2009, is responsible for the advanced FX management approach by which Flextronics Treasury protects operating results of the worldwide organisation from FX market volatilities. Headquartered in Singapore, Flextronics is a leading provider of Electronics Manufacturing Services focused on delivering design, engineering and manufacturing services to original equipment manufacturers in automotive, computing, consumer, industrial, infrastructure, medical and mobile industries. In the third quarter September 2010 Flextronics generated net sales of $7.4 billion and an adjusted operating income of $213m. Flextronics helps customers design, build, ship and service electronics products through a network of facilities in 30 countries on four continents. This global presence provides design and engineering solutions that are combined with core electronics manufacturing and logistics services, and vertically integrated with components technologies, to optimise customer operations by lowering costs and reducing time to market.

Goals of FX management

Effective corporate FX management starts with well-defined targets and the establishment of well-defined processes for achieving each of these targets.

Typically these processes are distinguished by different accounting treatments under US-GAAP or IFRS. Highly automated data gathering, exposure recognition, hedge decision-making, trading and loading of hedge trades back into accounting systems are the backbone of a state-of-the-art FX process. Corporations can learn from leading international banks in that respect.

Over to you

Foreign exchange risks are an unpleasant reality for every corporation with worldwide operations. So how do best-in-class corporations handle FX risks in these days?

Imagine that you have been appointed FX Manager of XY International Limited. As such, you are responsible for handling the FX risks that are relevant to the international business model of this multi-billion dollar group.

Targets

Your board of directors has given you the following targets for the upcoming business year:

  1. No impact from FX rate variations on Group P and L (FX results per year, per quarter and even by month have to equal zero on a consolidated basis).

  2. No impact from FX rate variations on operating margins for each individual operating unit and each individual customer contract.

  3. No impact from FX rate variations on local production costs (net expenses in local currency) of every production and service entity all over the world.

We will look at your challenges in detail and go on to review your FX process achievements at the end of this article.

The bad news

Diagram 1: Models of FX risks in international business
Diagram 1: Models of FX risks in international business

Source: Alfred Buder

The first bad news comes from your strategy consultant, who has been assigned to support you in defining strategy, setting-up rules, and modelling processes to achieve your corporate targets:

  • Corporate FX risks result from the business model and structure of the organisation. Single cross-border transactions can be hedged but the structural set-up of business flows cannot be hedged in the long-run. The following model explains in more detail.

Exporting model

When you are an exporter, manufacturing goods in your country and selling these goods abroad, you cannot hedge the risk that the foreign currency depreciates and foreign consumers substitute your goods for others – in the long run.

Of course you will develop hedging strategies and sell your FX proceeds forward to secure your financials for the upcoming business year.

But what about the future, the time beyond your hedging period? Hedging – ideally – means shifting the FX rate curve forward by the time period defined as hedging horizon, be it one month, one quarter, one year or even three years. Hedging cannot neutralise risks that are inherent in the business model of a company beyond the hedging horizon.

Diagram 2: EUR/USD FX rates shifted forward by hedging activities by 12 months
Diagram 2: EUR/USD FX rates shifted forward by hedging activities by 12 months

Source: Reuters

Manufacturing abroad model

The same is true for a common business model of our time: the manufacturing of consumer goods in low cost countries overseas. Products are manufactured in China, for example, and are imported into Europe or the USA to be sold in the domestic market.

We do not intend to discuss China´s currency policy here, but it will certainly impact the profitability of this business model in future years. No company can protect itself from the risk of a rising renminbi beyond a defined hedging period. Due to regulatory restrictions, accounting process or hedging rationale the horizon for hedging cannot exceed one business year by much. FX risks inherent in a business model cannot be hedged in the long run.

Diagram 3: USD/RMB rate from 1st Jan 2007 to 30th Aug 2010
Diagram 3: USD/RMB rate from 1st Jan 2007 to 30th Aug 2010

Source: Reuters

Integrated internationalisation – a sustainable model

Integrated internationalisation is the only sustainable business model from an FX perspective. More and more international corporations think globally but act locally, including domestic value chains in their home markets. When the company’s markets are all around the globe, this model requires local entities to be available for production, logistics and services on a worldwide basis. In such a business model the FX manager has to fine tune foreign exchange flows to protect the international corporation from the impact of FX rate changes on a group level.

XY International Limited is one such an integrated international corporation. But are the above mentioned FX targets achievable within a corporation with a multi-billion dollar turnover and substantial worldwide activities involving complex value chains, vertical integration and business across all geographies?

Practical solutions

Your strategic consultant proposes setting up corporate treasury teams in every region, ie in Europe, Asia and the Americas.

In the first phase an FX exposure reporting process from all relevant local entities needs to be rolled out.

This reporting process needs to be replaced by an advanced FX exposure reporting system with direct access to all local accounting and financial planning systems, in order to provide data for balance sheet hedging and future cash flow hedging without human interference. All FX transactions have to be carried out via web-based multibank dealing systems, putting major relationship banks in competition for every single FX transaction.

From the dealing system, straight through processing into a general FX risk management or corporate treasury system automatically triggers confirmations to be sent out and effecting related payments to be made.

All hedging activities are divided into three hedging programmes. These dedicated FX programmes each target one of the FX goals set by the board:

  1. No impact from FX rate variations on Group P&L (FX results per year, per quarter and even by month have to equal zero on a consolidated basis).

    Standard hedging programme – targets hedging FX exposure on the balance sheets of all entities worldwide

    The programme is based on accounting treatment as provided by US-GAAP FAS 52 ‘Foreign Currency Translation’. Exposures are reported in a monthly web-based process. Hedging period is only one month. Hedges are adjusted and rolled over month by month. The ultimate target of this programme is: ‘Monthly FX result equals zero.’

  2. No impact from FX rate variations on operating margins from each individual operating unit and each individual customer contract.

    Customer cash flow hedging – targets FX clauses in customer contracts

    Sales has to agree quarterly re-pricing of products. Forecasted FX cash flows within these quarter periods are hedged from quarter to quarter. The programme is based on accounting treatment as provided by US-GAAP FAS 133 ‘Accounting for Derivatives Instruments and Hedging’. Standard hedging period is three months. Ultimate target of this programme is: ‘Protect margins from customer contracts.’

  3. No impact from FX rate variations on local production costs (net expenses in local currency) of every production and service entity all over the world.

    Local costs cash flow hedging – aims to hedge expenses in local costs from local manufacturing and local purchasing for entities that produce for non-domestic markets

    Local cost hedging requires a strategic approach defining the hedging period (from one month up to one year or even further), hedge levels (between zero and 100% depending on the reliability of expense forecasts) and strict rules to prevent ineffectiveness for hedge accounting. The programme is based on accounting treatment as provided by US GAAP FAS 133 ‘Accounting for Derivatives Instruments and Hedging’. The ultimate target of this programme is: ‘Protect margins of local manufacturing entities.’

Overall these FX programmes reflect a zero-risk approach so far. For future cash flows, hedge factors are defined only to leave room for inaccurate forecasting. To accept risk levels targeting at participation of favourable FX rate developments, a risk management approach based on value-at-risk is required. From a general board-approved ‘risk acceptance’ number, a limit system can be developed that provides limitations for all potential exposures.

Diagram 4: Example table of FX programmes of XY International Limited
Diagram 4: Example table of FX programmes of XY International Limited

Source: Alfred Buder

Technical requirements

Which information services and IT systems do treasury centres of companies like XY International Limited require?

  • For financial markets, news and real-time FX and interest rate quotations, services like Reuters or Bloomberg are essential.

  • A treasury workstation or risk management system is required to provide a market risk overview, monitor open risks and keep transaction details stored.

  • A state-of-the-art treasury system is linked to a trading system like FXall or 360T for straight through processing of all transactions with banks and internal counterparties.

  • On the other side, payments can be effected electronically through an interface between the treasury system and bank payment systems.

The challenge is to choose powerful services and systems, but to find the minimal required structure within those in order to keep costs at reasonable levels.

Secrets of your success

In your first year as FX Manager you may have experienced unwelcome FX results from unrecognised FX exposures. Appreciating currencies will have challenged the profitability of manufacturing in certain countries. Contracts from the past will have come to the surface, exposing your revenues to FX risks.

From the experiences of your first year with XY International Limited, here are the guidelines that made you succeed:

Ten principles of corporate FX management

  1. FX hedging is a defensive task based on corporate hedging policy.

  2. Structural shortfalls of the business model cannot be hedged by FX processes in the long run.

  3. Ultimate hedging targets are:

    • FX result = 0.

    • Protect sales margins.

  4. Balance sheet hedging is a recurring process which aims to off-set revaluations of monetary balance sheet items.

  5. Effectiveness of balance sheet hedging depends on the quality of data provided by an FX exposure reporting process from local entities or an integrated FX reporting system.

  6. Cash flow hedging is an ongoing, rolling-forward process hedging non-functional currency cash-flows for a future period of time as defined by the corporate hedging policy.

  7. Hedging future cash flows in a rolling process delays the impact from FX moves by x months. X is the pre-defined hedging period, which usually cannot exceed one business year.

  8. Speculation is human but hedging is divine! Banks make money from FX on short-term trading and sales. Corporations focusing on manufacturing and services should not speculate but avoid FX impacts on their profitability.

  9. Corporate hedging targets require spot and forward trades, and eventually simple options. Complex option structures aim to increase bank sales margins. Companies do not need them.

  10. Corporate FX processes involve a fair and reliable benchmark, an effective FX exposure reporting process or system, multi-bank online trading and straight through processing.