With KPIs increasingly demanded by boards when it comes to managing cash flow and earnings volatility – and no shortage of volatility to test existing metrics – the time may have come for treasurers to seriously consider moving away from percentage hedging modelling, to a more revealing risk management approach.
Some treasurers are already exploring the use of more complex risk management techniques to better balance liquidity and earning risk and minimise foreign exchange losses, according to a recent Bloomberg survey. The results indicated that Cash Flow at Risk (CFaR) and Earnings at Risk (EaR) are gaining recognition as effective risk management solutions.
Companies taking a modelling approach to risk management have three core options: CFaR, EaR and Value at risk (VaR). Some treasurers use VaR specifically in the context of their derivatives portfolios but it was actually developed in the banking world where the primary focus is on overnight or short- term risks. In a corporate world, the focus is on managing the risk on financial statements and transactions, which are longer term. VaR thus has some serious issues in the corporate context.
A model is needed that can measure longer-dated risk, revealing the interaction between cash flow and the P&L on a consolidated level: not every currency exposure is a cash flow risk, and not every exposure is a P&L risk. The aim should be to more accurately model exposures into financial statement risk.
CFaR measures possible shortfalls in forecasted cash flows due to currency fluctuations. EaR exposes the impact of FX rate movements on earnings. Mathematically, these are relatively simple calculations, offering a plus/minus band of movement that can then be hedged as required, potentially down to zero with a 100% hedge (at a cost, of course).
Currently, percentage hedging is seen as best practice. This is based on confidence in forecasts from the business units; hedging is judged, in percentage-terms, on the probability that the figures provided will be achieved. A judgement call is then made on where the FX markets will head and then hedging on that basis. As an example, an 80% confidence level in the cashflow forecast may arbitrarily result in hedging 80% of that figure, leaving the remaining 20% open to market movements. These percentages are often fixed according to policy.
Justifying hedging activity by debating the efficacy of the reports and the advice used to inform it, and then applying arbitrary rules, is not the best approach, argues former treasurer Mark Lewis, who is now Corporate Treasury Product Manager at Bloomberg.
Cash flows can be looked at as anything that is a financial asset or liability, and whether looking at these from a re-valuation or conversion perspective, for example, these can materially impact the P&L, says Lewis. Failing to look at risk at a consolidated level creates unexplained volatility in earnings; looking at all cash flows, it is possible to understand their impact on earnings. And by running simulations across the board, taking into account volatility, forward prices and correlations, it allows the treasurer to begin creating natural offsets for some of these relationships.
“It’s not something that would normally be spotted in a percentage hedging model,” notes Lewis. Indeed, he says, “by comparing the percentage of unhedged actual cashflows to the actual results of the P&L impact this action had, it may be apparent that the two sets of figures show no correlation”. This effect is demonstrated in this case study with Constellation Brands. Its treasury wanted to be able to explain to senior leadership what the risks were to their cashflow and P&L, but a strategy based on fixed hedge percentage targets was failing to make the connection.
What’s more, Lewis believes that many companies are not even thinking about KPIs in this context. “Few CFOs are handing down to treasury a targeted number for the impact on earnings of FX rates. If they were, these companies would be thinking differently about how they manage risk.”
Strength in numbers
CFaR and EaR have been in use for decades; they just needed to be “optimised”, says Lewis. “By looking at cash flows on an earnings basis at group level, and then on a liquidity basis across the group as a whole and for each entity, it enables treasury to get the best of both approaches.”
As an example of possible benefits, a European holding company has a UK entity, long on USD. It also has a new loss-making US entity with a short USD position. If treasury hedges the UK entity’s USD position, it still leaves itself with a short USD position in the US. If it doesn’t hedge, but instead offsets its long USD position in the UK against the US entity, it allows treasury to reduce its overall risk. By making the link, it is creating a CFaR figure for the UK entity, but from a group and investor perspective, it is still managing its EaR.
Constellation Brands’ work in this space with Bloomberg (the solution is delivered though the terminal as a managed service) is unique. Using Gaussian variables (with two inputs and prior probability), it is possible to simulate risk for both EaR and CFaR, enabling the company, through hedging, to reduce its earnings at risk and cash flow at risk metrics simultaneously.
Although the outcome for anything other than actuals can only ever be a probability, the combined model opens up a holistic view of the currency impact on earnings and cash flows, where treasurers can acquire a better understanding of the underlying risks.
A move towards this approach creates a “completely different discussion with the board”, says Lewis. “Rather than one about percentage hedging, where banks offer their opinions on exchange rate movements, it becomes a risk discussion.” This, he concludes, puts the treasurer in a position more akin to “strategic advisor to the business”.