When it comes to foreign exchange (FX) risk management, visibility into business units and understanding how exposures materialise are as important as hedging itself. This article looks at ways in which exposure can be identified, quantified and managed, from inception of the risk through to hedging, execution and beyond.

Although many corporates run a sophisticated or professional FX execution desk, there are many instances when treasury has difficulty in identifying the sources of group-wide FX exposures and in some cases may still be collecting data on email or spreadsheets. There is a clear need to pay more attention to where and how currency risks arise in addition to developing suitable execution policies. Given this high degree of uncertainty there is now a clear case for focusing on those risks. It is necessary to look at how processes can be streamlined, from identification of exposures right through to hedging.

Corporates can find it extremely difficult to have visibility into all their currency risk. The problems can start as early as identification of when the FX risk is created, and may exist all the way through to how and when that risk is reported either to the regional or global central treasury. What the business does with that exposure once it has been acknowledged then becomes a challenge in terms of precisely which risk is to be hedged and how that hedge may be executed to best effect. In essence, although some businesses may have a sophisticated execution desk for FX, without a full overview of their group’s consolidated exposure, they may be missing the bigger picture in that their hedging programme may miss certain risks that would otherwise be hedged, which in itself may cause other unwarranted risks if hedge transactions need to be modified or unwound before maturity.

Steeped in history

For much of its 200 year existence, FX has been one of the defining businesses of Citi. FX at Citi can be traced back to 1897 when it opened a department to facilitate business conducted across international borders – inward investment from Europe and sales into China being just two examples. In 2007, its G10 and Emerging (Local) Market (LM) businesses were combined into a single global FX offering and today the bank trades over 140 currencies out of 83 centres. Against this backdrop of perhaps unparalleled experience, the philosophy of Citi’s Corporate FX Franchise is to guide its clients from the point that FX exposure is created, all the way through the value chain to execution and settlement. As part of its stock in trade, it has created tools, risk mitigation frameworks and thought-leadership programmes based in no small part on talking to its clients about the process.

As well as forecasting errors, faced by many companies – perhaps being derived from a technical deficiency, timeliness and accuracy around their data collection processes – balance sheet exposures may be rooted in silos of information, notes Russell Francis, Managing Director, Head of North American Corporate FX Sales at Citigroup. Data, says Francis, may reside in multiple platforms, different instances of an ERP or general ledger system distributed across the subsidiaries. If these are not integrated with head office, perhaps where M&A activity has led to various legacy systems not being able to talk to each other, it will, he notes, always be difficult to gain proper oversight. Without proper oversight, FX risk cannot be mitigated effectively.

Never take the easy option

But data is just data unless a business does something constructive with it, turning it into information. “Arguably some businesses go for the easy end of the FX spectrum where they try to hedge the straightforward elements already on their balance sheet – the accounts receivable (AR) or accounts payable (AP), for example,” notes Joakim Lidbark, Director and Global Head of CitiFX Corporate Solutions. But, he adds “FX risk may sit in various other areas such as procurement – these require the same level of attention”.

There are several other types of FX risk that can be managed to reduce a company’s overall exposure to changes in exchange rates.

An established manufacturer in the automotive industry, for example, will know that its main currency risk exists not in its receivables over the next month or two, but in whether or not it is locking-in its sales over the next two or three years; for a new model launch, it will have researched and planned everything right down to who will be buying it; and it will be confident with its forecasts. For others it is not so clear. “It is a big leap for many corporates but it is one of the most effective ways of reducing currency risk,” notes Lidbark.

But of course it is one thing to gather data on payables and receivables in the short term but quite another to gather the forecasts for two years’ time, and whilst some sectors may be at home with longer-term forecasting and hedging, such as the automotive industry, for others the longer-term view is difficult, even impossible.

The ability and the degree to which a business can forecast depends on its margins and required contract flexibility to a great extent, notes Sam Hewson, Director, Head of UK and Northern Europe Corporate Sales, Citi. A business with very tight margins, one for example in the electronics industry, he says will tend to adopt very short forecasting horizons “because it cannot afford to lock-in two years’ worth of FX rates as it could make it economically uncompetitive in two years’ time”. Conversely, the aerospace, the aforementioned automotive or even the general industrial sectors, where contracts are typically longer, can enjoy a far higher degree of forecast predictability. “Much of it comes down to the expertise and ability of the client, both in terms of technological resources available to identify and capture those forecasts – whether short or long term – and in what they do with those forecasts once they have them.”

It is evident then that not only can it be difficult to obtain the right data in a timely manner, but also that considerations will then arise around whether or not to hedge the full forecast amount and how to handle forecast error within that hedging policy.

The importance of forecasting

Notwithstanding sector variables, Holger Achnitz, Managing Director and Head of Continental European Corporate Sales, Citi, feels that many companies have improved their management and forecasting ability for exposures. “In the 2008 crisis many forecasts were called into question and ever since we have seen businesses exercising more caution in terms of the instruments they apply when they go further out.”

There has been, he notes, a greater degree of interest in hedging through options, in order to maintain flexibility and to not be caught out either by changing market conditions or variations on the original forecast. As transaction-certainty rises, conversion to more symmetrical hedging instruments – forwards – becomes more evident, notes Achnitz. The lesson of the last five years or so that he takes is that corporates value the flexibility in their chosen hedge instrument considerably more than they did before.

Technology’s role

Given the difficulties experienced by many corporates, technology – or rather the intelligent application of technology – is a vital part of an invigorated exposure management regime around FX. With a large swathe of the corporate community still collecting much of the relevant data on emails and spreadsheets, led by error-prone manual processes, accuracy and timeliness may be sacrificed; two elements that can ill-afford to be compromised.

But for many businesses, the business case for IT investment lacks punch. Jodi Schenck, Managing Director, Global FX eSolutions, Citi, acknowledges that treasury is not a bottomless pit of investment and that cost of IT may be called into question. It could be that a business knows the advantages but for commercial reasons is not able to deploy a solution in all markets and has to compromise on the roll-out of a platform because it is deemed too costly to deploy in local markets or all subs. Still, others believe that Excel is the most flexible tool. Although many users admit that it is prone to error and know that there are better ways, it is likely they do not have the means to progress. “I do believe they are trying to move towards greater models of efficiency,” says Schenck.

Of the systems that are in place, Hewson notes that traditionally, Treasury Management Systems (TMS) have been very good at handling the AP and AR, balance sheet and invoicing side of treasury risk management but that such systems have not necessarily been developed to tackle risk from a forecasting perspective. However, piecing together a solution can be something of a compromise in itself; anecdotal evidence (from a FTSE 100 company currently in selection mode for a risk system) suggests that risk tools tend to be very focused, in as much as there is no single offering on the market that covers the range.

Risk tools

Post-crisis, Hewson has observed an “evolution” of how treasurers look at their currency exposures, with more quantitative methodologies, such as Earnings-at-Risk (EaR), Cashflow-at-Risk (CFaR) or Value-at-Risk (VaR), being adopted. But within this toolset there is no one-size-fits-all approach. From a VaR perspective, some corporates have a VaR threshold for their portfolio of currencies and others have a threshold for individual currencies (others having no VaR threshold at all), he notes. Similarly, a number of treasurers have well-documented benchmarks which they are obliged to meet in terms of their hedging policy, whereas others do not work to benchmarks. “The degree of best practice in the corporate space varies considerably, as does the degree of sophistication, all the way from risk identification – through to risk mitigation,” Hewson comments. Variation is observable by sector, by client, by margins; “it all depends what is driving the corporate’s underlying challenges or business model”. Variation can also spell difficulty in meeting the needs of corporates.

However, by talking to different clients in different sectors, Citi’s FX group is acutely aware of the issues of diversity around risk management and knows that not only does the one-size-fits all solution not exist, but also that it is not possible to treat everyone in the same way even if it did. “That means we have to try to tailor each solution to each client because we just do not believe in a one-size-fits-all solution,” explains Lidbark.

An individual approach

Risk management for Citi is thus in the first instance based on understanding each client’s business model, trade flows and value chain from where the initial procurement or sale is made, all the way through the supply chain; so from where the FX risk is first created to when it first impacts upon treasury.

For Francis, this means identifying a number of timing mismatches which could exist between where risk is first created and then identified, between where that risk is first identified and subsequently reported to treasury, or perhaps between the point when treasury receives the forecast or the FX risk and when it executes the trade. “There may be a good reason for any of these but it may also be simply that the business does not have the systems, capability or the understanding to act on the information they receive,” he comments.

The point is that first it is essential to understand what is driving client-behaviour, what is generating risk in the pre-trade (eg pre-treasury) space, understanding the client’s risk management policy and then formulating a solution that fits the need. Opening up the conversation is the first port of call.

Getting to the heart of the business

It was noted above that businesses have generally become more aware and interested in quantifying and managing risk since the 2008 crisis, but not all risks are self-evident. In the second half of 2013 the emerging market sector has faced a “mini-crisis of its own”, notes Lidbark. As a result a number of corporates have woken up to the fact that they may be maintaining too low a hedge ratio for this sector. In one case, where risk was observed on a portfolio-basis, he reports that by collating the type of portfolio exposures the business had from a currency perspective, understanding the type of exposures the business had and how it hedged those exposures, it was apparent that the focus was on a single large exposure. This left a number of smaller exposures – many of which were in the emerging markets – totally unhedged; a stance that, given the decline of the emerging markets and the composition of the portfolio, ultimately proved counter-productive. Had the emerging markets not deteriorated, highlighting the fact that current policy had become so visibly ineffective, the conversation may not have even taken place which of course would have left that risk unmanaged. It is a sobering thought.

The motivation for the conversation around FX risk and hedging policy varies and even though a similar problem may be experienced by a number of different corporates, it is certain that not all will be trying to achieve the same end-result, suggests Achnitz. “Reduction of volatility and risk mitigation can mean a host of different things, depending on what is perceived as risk,” adds Lidbark. In seeking a greater efficacy, it is thus useful in the first instance to establish what the corporate sees as the worst-case scenario, and how this might be measured. “It gives us a good insight into how to measure risk, because it can be done in many different ways,” states Lidbark. The tools of the trade, such as scenario analysis and stress-testing, may have been deployed by risk professionals for many years but they are now becoming mainstream in the push to quantify risk.

In adopting such measures it is necessary for the corporate client to expose certain processes to the bank and to be honest about how it operates because only by understanding how the business operates can the bank formulate an effective response. Once the challenge has been identified and the end-point has been established, the solution design will focus on two key elements: technology and risk mitigation.

Establishing a framework

“We are trying to put in place a framework structured around how to control risk – as opposed to concentrating on the next trade the client should be doing,” explains Lidbark. By talking to clients that have exposures in a host of different currencies, it became apparent that many of their hedging policies were written “in a world that looks a little different from what it does today”, he notes. Such a policy would most likely be G10-centric, with most sales and assets in these countries, and hence preparedness only for G10-based volatility and exposure risk. “Today it is completely different; many companies have outsourced and have assets in Asia and perhaps have sales operations in that region too. As a consequence, these businesses now have to take emerging markets into account when managing risk.”

Indeed, for Europe and US-based corporates, the emerging markets have become so much more relevant in the past few years and so they do pay a lot more attention to hedging policy and execution in those currencies, notes Achnitz. “It used to be just one of the many markets in which they sold their products, but now it has become an essential business area demanding a lot more focus on the risk management process for those currencies.”

A single platform

On the technology side, Citi offers a web-based platform, CitiFX Pulse. The platform provides corporate treasurers with a whole host of pre-trade and risk management solutions, execution capabilities that are unparalleled in scope and a suite of post trade offerings to round it out. With CitiFX Pulse, a corporate treasury has the ability to deal spot, forward, swaps and options with access to 700 currency pairs, including restricted currencies, both onshore and through regional hubs in almost 80 different countries. Pulse has been built around the accumulated knowledge of the bank’s local markets trading business and its global footprint. A key part of the platform, re-launched in January 2013, is the revamped Exposure Management module. This functionality enables a corporate head office or group treasury to view and manage cash flow and balance sheet exposures in real-time in a visually engaging way. This data can subsequently be “sliced and diced” by subsidiary, region, country and so on. which then allows for netting and hedging across multiple entities, explains Schenck.

Getting the most out of Exposure Management begins with the client uploading details of its hedge policy; what can be hedged and how far out it wants to go, for example, by currency pair and entity, how much they can hedge and in what time buckets risk should be covered. This forms the rules for the system’s subsequent operation. All exposures must then be entered/uploaded into the system along with any associated hedges. This data is then checked against the policy which reports compliance. When hedging is deemed necessary, the platform generates signals based on actual treasury policy and, if outside of policy, clients may transact on pre-configured amounts to get back in line with predetermined policy.

The Citi team has worked with many clients to create a tailored, rules based approach to hedging. Through CitiFX Pulse, signals from some of the bank’s proprietary models can be monitored, generating additional information for corporate treasuries and taking away the discretionary ability to hedge. Over time, and informed by current hedge policy, the system will alert the user as to whether it is over- or under-hedged in a specific currency and how best to stay in line with policy.

While CitiFX Pulse is already an end-to-end solution and includes such features as streaming rates, order management (including algorithmic execution), confirmations and instructions, and end-of-day mark-to-markets on all positions, integration with the main trading and treasury management systems to deliver straight through processing is part of Citi’s roadmap for Pulse, says Schenck. The Pulse platform offers “a lot of assistance to our clients, from the beginning to the end of the process” but, she adds, Citi is committed to continuously improving the user experience and enhancing the functionality of the platform”.

Of course, adoption of CitiFX Pulse is not the end of the relationship and Schenck comments that “we regularly help clients evaluate their policies and decisions, back-test and assess how well they have managed to mitigate their risks”. Indeed, the CitiFX goal is to assist its multinational corporate clients in streamlining execution, enabling them to use their time and ever tighter resources for essential strategy discussions that, ultimately, yield better economic results from a holistic risk management process.