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Increasing Standardization and Transparency...

Increasing Standardization and Transparency

... in the Risk Management of FX Risks

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Different corporations understand their exchange risks (FX risks) differently. This is somewhat surprising as the FX markets are mostly the same for all market participants. Sometimes, there may be company-specific differences in risk interpretations or differences in the background, but upon closer inspection, these can often be generalized. In special cases, usually the specific context is invoked or the complexity of reality is ignored at various places. In fact, eliminating the complexity of real life often makes sense but the robustness of the assumptions this is based on should nonetheless be challenged regularly.

A good example for a situation where context is a key differentiator for FX risk management would be a company planning long-term (de-)investments in another company with a differing functional currency. Investments often take place through the contribution of equity to the target company or through the lending of funds but where no repayment is expected contractually and financially (net investment into a foreign company). The extent of de-investments may differ greatly: it may range from the full liquidation or a sale, or far-reaching decisions concerning dividends up to the withdrawal of capital. Once net assets belonging to a corporation leave their original currency zone, this generally causes a real currency (FX) risk. Such cases may therefore be generalized. However, usually, the risk management policy of a company does not cover such incidents, which is why the topic will have to be looked at on a case-by-case basis and decided on by Management.

Moreover the measurement and management of operational FX risk is a question of philosophy. Whilst many expected cash flows are hedged, many companies only hedge an FX risk once finalized contracts define this risk. There has been a great move towards standardization when it comes to measuring and managing operational risk. In the meantime, relatively secure planning is part of FX risk, as there is hardly a legal option to “stop production” or to “wait with hedging” or this would be more like casino gambling.  

Another point that most companies these days treat the same is to no longer consider the budgeting period as the be-all and end-all when it comes to hedging decisions for FX risks. A few years back, there were still quite a few companies that planned their foreign currency payments in Q4 for the next year, then hedged these with derivative financial instruments and then only reacted if there were any changes in the planning. In the meantime, hedging decisions have become clearly more dynamic. A relatively easy way to handle this is to define a period in the future as risk horizon. This risk horizon mostly depends on the exactitude of the company’s planning in each currency (for instance, 15 months are a good time horizon). It hedges all of its FX risk changes as it goes along (for instance, at the end of every quarter for the following 15 months). This view can also apply to companies that generally plan with a yearly budget. However, the hedging rates are then already parametrized in the budget process to some degree. In such cases, Controlling and possibly also Management should be involved in the hedging decision because the hedging rates realized with derivative financial instruments or at the market generally may have some far-reaching consequences for the company. It seems that most treasury departments are still hesitant to use the concept of value-at-risk. The reasons for this are not clear. However, the volatility-based procedures that foot on modeled assumptions and parameters, such as the normal distribution function, the correct interpretation of confidence levels as well as beta errors, cause some skepticism and are deemed unsuitable for intuitive conclusions. 

Of course, a volatility-based view onto risk can be quite valuable however in view of the additional complexity, it may not be enough to convince potential users. On the other hand, it seems that scenario planning (e.g. for sensitivities) has found a niche in risk assessment. Naturally, scenario planning is not immune to errors and often depend on the selected scenario. However, the underlying assumptions are quite evident and interpretable for every decision-maker. The risk assessment should show the extent of the FX risk and define an action plan (e.g. “no hedging necessary” or “hedge the exposure up to a certain value”).

Once the risk has been defined, measured and assessed, a decision has to be made which hedging measures should be applied. Generally, FX risks are hedged with FX forwards or FX swaps. FX options and FX collar structures (often as risk reversals) may also come into play. In the past, heavily structured products have turned out to be rather expensive in comparison with standard products. This is also true because FX forwards can be traded rather cheaply on transaction platforms. 

Apart from these legitimate financial considerations, companies should also think about how they will have to recognize the hedge in the balance sheet. Whilst the hedging philosophy can usually be determined in advance in order to aim for a certain amount of financial protection, the accounting usually comes in hindsight, when the hedge has already been put in place and a posting becomes necessary. Ideally, the hedge accounting should be implemented immediately after determining the hedging strategy, otherwise the representation often does not conform to the accounting rules. In many ways, IFRS 9 has made the application of hedge accounting easier; nonetheless, it is often impossible to represent the hedge in a way that makes sense from an economic viewpoint.

Over the last few years, the topic currency hedging seems to have undergone a certain journey to be become more standardized. Basically, such a standardization should be welcomed, as it makes things a lot more objective. At the same time, the realizable hedging rates depend very much on other corporate decisions. Decision-makers inside and outside the company will come to expect of internal treasury departments a more and more transparent presentation of FX risks and the relevant risk management, made possible to some degree by this increasing standardization. The presentation of the currency hedge should therefore reflect these developments both in internal controlling as well as in external communications. The basis for this presentation should be a professional reporting package and an expert concept which shows the current developments in currency hedging.

Source: KPMG Corporate Treasury News, Edition 95. October 2019

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