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Business year 2020 was a great challenge for Corporate Treasury. However, it was also a chance for the Treasury function to show off its essentialness: the ad-hoc identification of available group liquidity, fighting short-term liquidity shortages and juggling contractually agreed fixed covenants in financing agreements were just some of the items on an agenda brimful with emergencies due to Corona. No wonder it was challenging. Market price risk, somewhat of a back-burner issue, all of a sudden reared its ugly head again in view of significantly higher volatilities: the FX risk! As the saying goes: it’s only in a tornado that you find out whether your abode will stand up to the storm and the same is true for the FX risk management strategy. After years of low volatility, suddenly, the full bandwidth of a corporation’s foreign currency portfolio and its professional management were put to a real stress test, called forth especially by the Corona crisis. A good example for this in the course of 2020 is the USD, which, at its worst, experienced a deprecation against the SEK of about 22%.

The tornado finally abated towards the end of 2020 so that many corporations are just now coming out of this battering to take a look at their risk strategy, checking to what degree this is still worth its name to begin with. Now is the moment when Corporate Treasury finally knows whether its implemented FX risk strategy stood up to the very real stress test or whether it was just blather. It may see itself confronted with the following demands:

  • The external auditors review the treasury P&L accounts during the year-end audit and identify significant (un)realized effects on the foreign currency accounts compared to the previous years. Treasury is asked to take position in this respect and the statements made are checked for reasonableness by the auditors.
  • CFOs of subsidiaries report extraordinary currency effects arising from long-term contracted projects and require Treasury’s input and guidance.
  • P&L controllers identify the collapse of an operational margin for entities or business lines because of FX effects and inform the CFO and the Head of Treasury.
  • Treasury used a risk performance index to manage FX exposures (e.g. VaR in relation to EBIT) and now finds out that this KPI only reflects the volatility with a delay. The belated margining has become a Sisyphean task. The CFO and the Head of Treasury have a hard time explaining to Senior Management why they did not hedge these currencies with fixed rates.

In the examples shown above, the effect has already been realized by the corporation, i.e. the risk is not only nipping at your heels, it has already taken a sizable chunk of your foot. Often our clients only start taking FX management seriously (or more seriously) once they have made such an unpleasant experience. In the following, we have outlined the most important elements of FX management, which will help make your strategy practicable – even in tempestuous times.

Exposure: Does how you record exposure truly reflect the corporation’s business model?

Many corporations, especially smaller ones, often prefer to just record the so-called net currency positions as exposure depending on the company and the currency over a defined period. Currency exposures are then hedged with a fixed rate or with a layered approach. A significant advantage in creating an overall net currency position is the efficient management from a technical point of view. However, the glaring disadvantage is the jumbling up of exposure types, which may have different traits (validity, probability of occurrence, etc.), depending on the business model used. An advanced FX management approach would be to exactly match the types of exposures with the company’s business model. This essentially requires an intensive exchange with the responsible persons in the business lines, and thus a better integration of Treasury into the value chain. We recommend a general subdivision of the potential sources of exposure along their life cycle, i.e. planned, contracted, recorded. Specifically, this may mean that an exposure that has been recorded operationally with a roll-over approach depending on the average payment target is hedged to 100%. A planned exposure is hedged with layered hedging over a specific period (here, think planning security), increasing the percentage hedged over this period. Differentiating between exposure and hedging concept allows for a tailored approach of the risk in question and the accompanying monitoring of the P&L in consideration of the business model.

Do local CFOs have the necessary support and practical back-up anchored in policies when it comes to FX risk?

It has been some time now that corporate treasurers wish to make local entities virtually independent of foreign currency effects in the respective P&L by converting settlement currencies. However, numerous corporations have good arguments against centralizing currency exposures (such as natural hedging effects, sales strategies, a lack of transparency, fiscal or regulatory aspects), so that a local FX risk remains. As a result, such companies have a decentralized FX management, which is especially the case in regulated countries. Often, an employee from the local accountant or controlling department then handles hedging activities and the local CFO carries the responsibility for the results. If this is the case, HQ Treasury has to provide clear rules in the form of a practical FX policy because in general, the local crew is not competent enough for this task. The idea of such a policy is to create an awareness of the FX risk in the relevant entities, provide guidance and to give the local CFOs a sense of responsibility in order to mitigate the impact of FX effects on the P&L.

IT environment: can the existing system environment efficiently handle a sophisticated and international FX management approach?

In the past, more complex FX management strategies were rejected despite a high degree of effectiveness because it was deemed that there were too many manual steps to be taken, that these were untransparent and technical expertise was often lacking. However, sophisticated treasury management systems can carry out hedging with the corresponding hedging steps and follow-up processes in a completely automated manner either in their default setting or by tweaking the system accordingly. Specifically, this includes the process steps ranging from the deduction of the different exposures from various upstream systems, through the conclusion of derivatives for hedging purposes in accordance with the hedging strategy, all the way to internal and external settlement. This does not even require artificial intelligence, but clear and rules-based master data integrated into the systems. For instance, for very large tickets, the automated hedging may require manual steps when it comes to performing a preliminary counterparty check that may have to be blocked and the marking of significant changes in the exposure for certain entities. Lifting the existing treasury management system to an advanced level in FX management for all relevant entities is a major driver for centralization. It also protects the P&L from unwelcome surprises, especially if entities have been holding untransparent risk positions so far. As a result, local entities can focus on what really matters: operational aspects.

The three elements outlined above are important sub-components for an advanced FX management with the aim to protect the P&L against the realization of non-identified currency risks and to guarantee the planning security for all stakeholders. As the starting point of the risk life cycle, recording the exposure should be aligned properly with the corporation’s business model. A good approach is to subdivide the theoretical exposure lifecycle into separate hedging approaches. A practical FX policy ensures an adequate FX management in a group’s satellite entities. A succinct policy of about 15 pages usually covers it, naturally approved by Senior Management. Enabling an IT landscape used for a sophisticated FX management and centralizing and automating such activities even for international corporations has the positive impact of mitigating risks that so far had not been identified. Going the extra lengths to establish a robust and sophisticated FX management pays off in any case because one thing is sure: the next crisis is just around the corner.