Risk Management

Don’t be afraid to look through the hedge

Published: Sep 2021

Getting a complete picture of a company’s exposure to foreign currencies is no simple task, but well worth the effort.

Hole in a hedge, looking out to beautiful landscape

Foreign exchange is a significant cost for many businesses. A recent survey by Australian fintech Fluenccy suggested that SMEs in the UK paid more than ten times as much as corporates for FX when using their banks last year and lost an average of £17,000 on their international payments through a combination of excess fees and bad trades.

Fewer than 10% of the small businesses surveyed had access to a system that allowed them to monitor and control the impact of FX on their business. Fortunately, there are a number of steps companies can take to establish a full understanding of their exposure to foreign currencies.

FX risk can be divided into primary and secondary categories, the first of which being the actual cash flows of foreign subsidiaries and the second being the supply chains and macro risks driving FX exposure. An example of the latter is how exposure in Brazil can be affected by events in Argentina or Chile.

“In order to catalogue such risks, treasury teams need to think through the data they have on their outlays and receipts globally,” says Bob Savage, Head of FX Sales North America at BNY Mellon.

Companies should take the time to understand the main types of risks across their industry and identify best practices across their peer group to ensure alignment with competitors, suggests Standard Chartered’s Global Head of Financial Markets Sales, Sharad Desai.

“A global review of exposures at parent company and subsidiary level will ensure accurate understanding of group exposure,” he says. “Companies should also assess the hedging risk generated by foreign investments.”

Companies with multiple divisions, each with different pricing criteria, will have multiple sources of FX exposure. Within an industrial engineering firm, for instance, machine production, spare part provision, and service delivery will all generate different exposures.

Another important consideration is the forward discount/premium of the currencies involved. “European exporters typically sell in currencies with higher interest rates than the euro, such as the US dollar or the renminbi,” explains Antonio Rami, Co-Founder of currency management automation software provider Kantox. “In this case, currency hedging entails a forward discount that must be effectively managed.”

The scale of the company will also determine its ability to mitigate FX risk. A large corporate is likely to have a dedicated treasury management team with in-house experts as well as external partners, allowing it to implement a variety of risk management protocols.

“For a small business it is better to focus initially on the areas that are likely to affect the business the most and build from there,” suggests Laurent Descout, Co-Founder and CEO of treasury services platform Neo. “Integrating a modern treasury management system into the business operations is the next important step.”

Atlas FX is a provider of foreign exchange risk management services. The firm’s Vice President, Strategy and Operations, Scott Bilter, says corporates need to go beyond the data readily available from their ERP system, create a forecast of future FX exposures, and put proper results analytics in place to understand the sources of FX variance.

“Getting each of these steps right requires a lot of expertise and treasury teams are often understaffed and highly rotational,” he warns.

Case study

EA logo

California-based Electronic Arts has almost 10,000 employees worldwide and annual sales in excess of US$5.5bn. International revenue accounts for more than half of its sales, which means it is exposed to the effects of fluctuations in exchange rates across a number of currencies.

Strengthening of the US dollar relative to the euro, sterling, the Australian dollar, Japanese yen, Chinese yuan, South Korean won, and Polish zloty has a negative impact on its reported international net revenue but a positive impact on reported international operating expenses – particularly when the US dollar strengthens against the Swedish krona and the Canadian dollar. The company hedges a portion of its foreign currency risk by purchasing foreign currency forward contracts that generally have maturities of 18 months or less.

The company’s treasury department processes around US$1.5bn every quarter across all transaction types, explains Grace Antonio, Treasury Manager. “We review all exposures – balance sheet and cash flow – via our exposure management system and our financial planning and analysis forecasting tool,” she says. “We use spots, forwards and swaps to minimise our underlying exposure to currency.”

Antonio adds that the company reviews its FX hedging strategy with its FX committee every quarter.

“We evaluate the types of hedging product we use regularly, but based on our strategy we don’t often make changes,” she says. “We have a rolling layered approach to our programme and even with changes in the market, we typically stay the course.”

This strategy has worked well of late, with foreign exchange adding US$78m to the company’s capital resources in the last financial year.

Accurate forecasting – supported by a competent treasury management system – and centralised treasury enabling netting of foreign currency exposures are steps corporates can take to establish a full understanding of their exposure to foreign currencies agrees Ruth Bellinger, Head of IRFX Macro Sales UK at BNP Paribas Global Markets.

Options for minimising corporate exposure to FX volatility in current market conditions include adhering to a treasury hedging policy. A ‘layered’ approach remains popular whereby as certainty of forecasting increases in the shorter tenors, the amount hedged increases.

Borrowing in the currency of the asset or hedging via derivatives (such as cross currency swaps or rolling FX swaps) is another option.

“Highly structured derivatives may offer preferential exchange rates but will have additional restrictions whereby the hedge notionals may change on maturity or the hedge may fall away – usually at a time when market rates have moved adversely,” says Bellinger. “Hedge accounting is also more challenging for these structured derivative hedges.”

For cash flow hedging, the rule of thumb is to use forwards for highly predictable exposures and options for uncertain cash flows. Corporate treasuries with long-term emerging market currency exposures face the choice between hedging at the expense of significantly affecting the return on the investment, or bearing the risk of significant currency devaluation.

“For balance sheet exposures, once the net exposures are determined companies should use a rolling programme with forwards with matching tenors as they provide the best offset from an accounting perspective,” says Desai. “For long-term exposures including foreign borrowings, term hedges such as cross currency swaps can be used to mitigate the FX risk.”

Companies should also assess the hedging risk generated by foreign investments.

Bob Savage, Head of FX Sales North America, BNY Mellon

Companies need to keep up with a last moving market in order to buy and sell the necessary currencies (or their derivative products) quickly, efficiently and at a low cost. This is almost impossible to do successfully without access to the right data as well as real time FX market rates and execution capabilities.

“The fact that there still are many manual processes around FX risk management is pushing corporates towards further automation to improve efficiency and internal controls,” states Descout.

Customised analysis of an organisation’s FX exposures can also make a crucial difference. Minimising exposure requires an understanding of what could go wrong from all potential sources of variance and applying a stress test to each one, suggests Bilter.

“It is ultimately accomplished by properly hedging, but the devil is always in the detail,” he adds. “Reducing forecast deviation, having properly timed hedging workflow to avoid unnecessary slippage against accounting rates, and being able to interrogate any re-measurement inconsistencies are all necessary elements in minimising FX volatility.”

According to Desai, corporate treasurers have increasingly turned to options this year in response to pandemic events. The need to react to external events demands constant monitoring of currency hedging strategies.

“Hedging strategies require constant review and removing hedges when there is no longer a need for them is a clear principle for lowering FX ‘noise’ in the balance sheet,” says Savage. “However, while this seems simple some exposures end quickly and the unwinding of hedges takes time – balancing liquidity against spreads is more art than science.”

Desai refers to a significant shift this year with a growing number of so-called ‘black swan’ events prompting corporate treasurers to increase the frequency of their hedging strategy reviews.

These strategies should be continuously reviewed to reflect the diversity of pricing criteria and the widespread adoption of flexible pricing in many industries, adds Rami. “As expectations for short term interest rates shift, so does the situation firms face in terms of forward points,” he says. “That calls for continued assessment of hedging strategies.”

Descout reckons any strategy designed to monitor FX exposures and hedge against risks should be monitored at least every day and ideally in real time.

“Relying on spreadsheets is simply unworkable and outsourcing this important task can result in slow decision-making, poor service and high costs,” he says. “Recent advances in technology mean it is possible to access all of the key services corporates need – such as real time data and analytics, access to live FX rates, execution and hedging capabilities and multi-currency accounts to make and receive payments – via a treasury management system.”

Removing hedges where exposure is minimal is fine if the administrative burden of hedging is greater than the stress-tested risk of leaving the exposure unhedged.

Scott Bilter, Vice President, Strategy and Operations, Atlas

Significant volatility in an unhedged currency or from a hedged currency with a hedge percentage below 100% might indicate a need for a change in strategy.

“Significant volatility from ‘spot slippage’ would indicate the need for either an improved workflow, an improved hand off between income statement and balance sheet trades, or improvements to how FX liquidity trades are managed,” says Bilter. In this context slippage refers to the difference between the expected price of a currency trade and the price at which the trade is executed.

A sizeable market shock or heightened currency volatility could require an immediate review of a programme that was running fine. In the case of cash flow hedges where the business units are involved in their specific strategy, it is important for treasury to review these hedges with the business unit at least annually as some key aspects of the business may have changed.

“Removing hedges where exposure is minimal is fine if the administrative burden of hedging is greater than the stress-tested risk of leaving the exposure unhedged,” adds Bilter. “Understanding why the exposure is limited is important though. Was it larger before and is only temporarily smaller? It may still need to be monitored, even if left unhedged.”

Bellinger also suggests a hedging strategy should evolve as the company changes, whether this is a strategic change in the company’s direction or as a result of disposals or acquisitions.

“The merits of removing hedges for currencies to which the corporate has limited exposure depend on the currency – the limited exposure may be in an emerging market which has much greater volatility and a small position may create a significant P&L impact from market movements,” she says.

The ability to forecast future exposures has been the subject of much conjecture among treasury teams over the last 18 months. The pandemic has seen many companies experience unexpected impact on their order books with major discrepancies in what was forecasted and hedged.

With this uncertainty likely to persist for some time, corporates would be well advised to keep their FX risk management options open.

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