What if you had an FX program design do-over?
Whether or not an FX hedging program “did what it was supposed to do” during the financial crisis and its aftermath – in most cases, to protect against earnings volatility due to FX gyrations – many risk managers were prompted to review their hedge programs. The goal was to identify opportunities to tighten up the risk-management policy and approach, or at least to validate its effectiveness quantitatively.
Motivated not only by a more volatile environment but also by a shift (a) in the revenue mix to one of majority non-USD revenues and (b) in the shareholder base to one that emphasizes reasonable growth more than earnings stability, one company grasped the chance to take this review a step further: wipe the slate clean and look at its cash-flow hedge program (primarily for non-USD royalties) as if one had never been designed before.
The end result is that the program goal has changed from dampening the effect of FX on reported earnings to a dual goal of (1) protecting cash flow from adverse FX movements; and (2) maintaining the ability to meet minimum cash requirements. “[The former FX program] was just targeting the corporate level – not the supply chain or the operational level,” said the company’s head of financial risk management who spearheaded the review.
Focus on earnings. So, how was it done? One of the first things the team did was to challenge the focus on reported earnings by seeking the opinions of institutional fund managers. “We got an honest opinion on how they look at currency risk as it relates to multinationals” and found, for example, that these fund managers either don’t focus particularly on swings due to FX (on the assumption that it all “evens out” over time), or actively seek out investments with FX exposure to balance out their portfolios. This is consistent with what The NeuGroup has previously heard on this topic in peer group events featuring panels of institutional investors. The team also took a look at how well hedge activities protected the business and not just earnings, and compared 15 years of historical hedge results against the goal of protecting earnings.
The risk spectrum. Finally, the FX team sought to place the company on an FX risk spectrum. At one end, the company would be able to take hedge actions “opportunistically” (not speculatively but with more discretion) and on the other end entirely for “risk reduction” purposes along very conservative lines. The placement along the spectrum would depend on a number of factors to be reviewed periodically (every six months) for a dynamic response – and possible adjustment to the hedge decisions – as the factors change in magnitude and relative importance. Those factors are:
- Level of cash-flow commitments (dividends, capex, share repurchase, interest expense).
- Access to capital/credit markets.
- The company’s operating performance.
- The company’s aggregate currency volatility.
This means that the risk appetite – the position on the spectrum – could vary over time depending not only on internal company-driven factors, but also changes in the market environment. That said, the head of financial risk management said that the exercise did not put many specific FX strategies into place, but the company will now be able to quickly evaluate – and act on – market conditions in a way that the previous program did not allow. Another important effect of the new framework is that it forces discussion: those involved in FX will meet every six months with the CFO and the treasurer to reach consensus on how to view the factors and approach hedge actions accordingly.
International Treasurer hopes to explore this theme in further detail in the near future.