When a company is considering whether or not to introduce an FX hedging program, it is important for the leadership team to understand their risks holistically and identify the true sources of revenue, expenses, and exposures so that the management team can make smart operational decisions. Generally, the company's CFO is responsible for approving the overall risk management strategy and communicating it to the Board of Directors, while the treasurer is responsible for providing visibility into the required data, developing an operational program, and ultimately executing the strategy. In both of these key roles, it makes sense to identify in advance the potential questions, concerns and information that the board may wish to address.
To better prepare the treasury team, this article offers key questions frequently asked by Boards when they are evaluating whether to implement an FX hedging program.
Question 1: What are other companies doing?
High level benchmarking information can be obtained through public financials, but companies often will not include details around specific exposures, types of hedging programs, or the extent to which they’re hedging (which currencies, what coverage ratios, what products are being used). Benchmark information by sector or client type can be a helpful start, but should be augmented with a more detailed understanding of market practices based on industry peers or service providers, when possible.
Most companies will evaluate and prioritize operational risk (forecasted margin risk and FX Gain/Loss impacts that both impact the P&L) and net investment risk (with impacts flowing through CTA) differently. Net investment risk can be material, but is often a higher priority when evaluating debt currency or contemplating an exit from an entity or region. Operational FX risk will often be monitored and managed with a regular rhythm based on the ongoing impacts to the P&L.
Most companies will prioritize natural/operational risk mitigation efforts wherever possible to better align currency inflows and outflows within the business model. This requires an accurate understanding of the exposure profile and risk drivers within the business model. Some exposures may not be intuitive, particularly if the ultimate payment currency differs from the currency that is used to determine pricing.
Question 2: What are the pros/cons of natural vs. synthetic hedging?
Creating natural offsets can reduce or remove net exposure to a currency, while derivatives will simply smooth the effects of the current market environment in order to buy time to adjust the business model or react to changes. A synthetic, or derivate-based, risk management strategy will incur external costs (trading friction, credit charge, bank profit) and will require administrative effort to execute and account for trades. However, derivatives offer the flexibility of a risk management overlay to manage individual or aggregated exposures if the business model, suppliers, customers, or competitive environment prohibits operational changes.
Question 3: What happens if there is a Black Swan event or material market move?
Technically, a black swan event is defined as catastrophic and unforeseen, but the term is often used to refer to statistically improbable events. In reality, these events often happen with a greater frequency than many statistics would suggest. At a high level, this is because modeling will often assume a “normal distribution”, when a more customized and dynamic model of reality would have “fatter tails” or a larger distribution of extreme outcomes.
While some companies will adopt customized modeling and analytics, most will utilize standard modeling techniques but adopt a more conservative risk tolerance level (99% or 95%) to better account for potential negative outcomes. There is an important balance between using enough analytical rigor to capture an accurate picture of reality, and ensuring that the results are actionable and can be replicated and understood by key stakeholders monitoring risk.
Some market shifts will reflect gradual movement over time (such as a steadily weakening economy in a given region), where the expected future changes will be reflected in updated market rates. Other shifts may be more immediate or unforeseen (such as the original Brexit vote outcome), where the market will react after the event rather than in anticipation of it. Routine monitoring allows for those outcomes that are priced into market rates to be modeled and reviewed, while statistical analysis will help inform sensitivity to unforeseen events.
If a company has operationally hedged, they’ve reduced their exposure to market rate movements. If they are instead using a derivative program, then they are partially locked in at the prior rate environment, but would be locking in new rates over time, effectively smoothing the impact of an abrupt market move. If they are entirely unhedged until after the market event occurs, a company would be locking in the new market rates. However, their ability to do so could be expedited if pre-trade preparation has already been completed.
Question 4: How quickly could we implement a more expansive FX hedging program if our exposure profile or the market environment changed dramatically?
- Access to Data: Data gathering is often the most time-intensive activity required to establish a hedging program, particularly the first pass at identifying the most relevant drivers of FX risk to key metrics. This initial process can often take several months. Once a rhythm is established to refresh this data, the process to update data inputs and analysis outputs to drive hedging decisions can be done in a matter of days. This is dependent on systems being used, access to resources, and reliability of underlying data.
- Hedge Accounting Feasibility: Any new hedging program that will be applying hedge accounting treatment (typically a program addressing forecasted margin risk) will require an initial deep dive to determine the capacity for qualifying exposures by type/currency, establish designation memos with appropriate flexibility, and obtain auditor sign-off. This process typically takes several weeks and can be completed prior to initiating any hedges, but generally requires dedicated internal or external resources to drive the process forward. Companies often initiate this feasibility review for those exposures that are most likely to be hedged with a derivative strategy before actively pursuing trade execution.
- Trading Preparatory Work: Pre-trade activities include negotiation of trading relationship documentation (ISDA agreements, any credit support documentation, Know Your Customer requirements, regulatory documentation, etc.), determination of trading entities, operational rhythm of the program, and policy establishment. These activities may take several weeks, but could be done in advance of needing to trade without committing to any course of action or active trades.
- Trade Execution: If data is accessible and hedge accounting and trading preparatory work has been completed, trades can be executed within a matter of days or even hours.
Question 5: What are the biggest challenges companies face in managing FX risk?
Forecast visibility (accuracy, aggregation, frequency) is typically one of the most material challenges companies face in managing FX risk, whether monitoring risk or actively hedging exposures. However, most companies will hedge only a portion of their forecasted risk, which allows for forecasts to be adjusted over time. Many companies will also hedge near term exposures at a higher ratio than longer term exposures, layering on additional hedges as forecast visibility increases.
Hedge accounting capacity is also a meaningful consideration, particularly for public companies with FX exposure and a desire to hedge, and may shape the strategy a company pursues. The effort associated with obtaining preferred hedge accounting treatment is typically front-loaded with program setup, in order to accurately define the exposures, draft a hedge designation memo, and obtain auditor approval on the strategy. Ongoing efforts may include effectiveness testing, valuations, and journal entries, but can often be automated or outsourced if the expertise is not available in-house.
For companies with extensive hedging programs (high trade volume, multiple programs, decentralized decision-making), program management can be challenging. However, larger programs will often utilize electronic trading platforms, policy guidelines, and/or automation tools to streamline activities and gain efficiencies.
Gain an edge in managing FX risk
Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Pairing the data, efficiency and support of our technology solution with the insight, experience and perspective of our expert team can give your business an edge in managing financial risks. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal/notices/. Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
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