With over 25 years of FX experience, Stuart Kirk, Head of Global FX Risk Management, was able to identify some of the key areas of risk to the firm and potential shortcomings. “We needed to do three things,” says Kirk, based at Xerox’s Treasury Centre in Dublin. “We need to look at our exposures on a consolidated basis and quantify the total impact of FX volatility on our earnings; to increase the transparency of our hedging programme to ensure cost/risk optimisation; and to come up with a more systematic approach to FX hedging, which ensures we consistently meet the corporation’s risk management objectives. The project was about clarity, measurability, and the ability to benchmark performance against alternative solutions.”
Xerox engaged CitiFX Corporate Solutions to help design a rules-based programme which was transparent, easy to implement and which would more closely align its hedges with its exposures thus reducing the period-on-period impact of FX volatility on its bottom line. Treasury back-tested the solution against 20 years of data to demonstrate it improved Xerox’s profitability by reducing risk and minimising hedging costs. The economic and risk management benefits of the solution were compelling and convinced Xerox’s treasurer and CFO to adopt it. Xerox policy dictates that all long-term hedges must qualify for hedge accounting treatment so forecast accuracy was paramount.
“The solution has smoothed the impact of currency volatility on our results while enhancing transparency and cost effectiveness,” says Kirk.
The value of the solution has been particularly evident in the past 12 months as the yen, to which Xerox has significant exposure, has experienced some sizeable changes in value. The solution has enabled Xerox to successfully navigate through volatile market conditions while achieving a better all-in hedge rate and large cost savings.
The key drivers of this innovative dynamic layered hedging (DLH) solution are relative valuation, which compares current levels of a currency pair to its fair value, and cost of hedging, which is driven by carry, ie the forward point adjustment, and volatility, which dictates the option premium. Using both these inputs, the model will select the maturity of each hedge and the optimum hedging instrument. For example, if a currency is overvalued and carry is in the company’s favour, the model will favour hedging more now and less later using forwards. If the currency is undervalued and carry is negative, the model favours hedging less now and more later via options. In between, the model selects the appropriate mix. Hence it gives the company the benefit of a systematic programme which guarantees a pre-agreed level of hedging but allows the flexibility to adjust the maturity of the hedges or the type of instrument used according to prevailing market conditions. With regard to relative value, uniquely, the DLH strategy incorporates Citi’s World Exchange Rate Model (WERM), which is a new proprietary measure of fair value exchange rates.
The final piece of the jigsaw was to design a system which could deliver the product. Again Xerox and Citi collaborated to come up with the CitiFX Exposure Management toolset which is accessed via Citi’s corporate FX portal, CitiFX Pulse. This allows Xerox to input exposures, run its strategy, execute and confirm trades and monitor changes on a single platform. The system links directly to Xerox’s treasury management system (TMS), allowing forecasted exposures and existing hedges to be uploaded seamlessly.
The main benefits are:
Systematic, rules-based hedging programme which is closely aligned to underlying exposures and is clearly understood by senior management.
More effective risk management with built-in flexibility to provide potential for real economic benefit.
Robust relative-value model based on 20 years of back-tested data.
Simple to implement and track performance.
As Kirk concludes: “It eliminates much of the emotion and randomness in the hedging decision by introducing a pre-agreed set of metrics designed to optimise both the hedge ratio and the hedging instrument based on valuation and carry.”