Managing FX Amid Dollar Strength

The dollar’s surge has brought forth many challenges for companies, including how to protect earnings and adjust cash-flow hedges to be more effective. 

A dollar-strengthening cycle has recently tested CFaR and EaR assessments, and prompted FX program changes and assessments of hedging efficacy. Against this backdrop, FXMPG members and guests convened in March for the winter 2015 meeting, sponsored by Chatham Financial. Topics spanned the philosophy and business conditions that underpin a successful earnings-at-risk-based risk management approach; changes to cash-flow hedge approaches; and hedge-program efficacy assessments. Chatham Financial weighed in on Value-at-Risk, rules and regs and hedge accounting considerations. More detailed discussions from the meeting included:

1) The Pros and Cons of VaR Methodologies. Company-specific factors like very sizeable and diversified exposures, coupled with intercompany netting and centralized risk management are paramount for the use of cash-flow or earnings-at-risk models to drive hedge decisions. Some companies use “at-risk” measures only for internal reporting and risk-monitoring purposes, but not as a basis for hedge decisions.

2) Systems and Resources. One system may not be capable of everything you need it to do and exactly how you want your output or processes to function. When more systems come into play and IT resources are scarce, many shift the onus to a SaaS provider, which are becoming more accepted, especially as regards security.

3) The Cost/Benefits Calculation of Hedging. There may be as many methods for assessing the efficacy of hedging as there are companies, but key components allow for continuous tracking so business forecasting can be improved over time, and back-testing from time to time to allow a look at how various approaches stack up and whether the existing approach should change.

4) Reducing Earnings Volatility with Cash-Flow and Profit Hedging. Transitioning from a cash-flow focused hedge program to one that targets profits instead is underway at one member company. For hedge accounting purposes, it is still important to closely monitor cash-flow exposures, however. In a dollar-strengthening cycle, front-loading the hedge layers of short dollar exposures mitigates some of the negative impact of that trend.

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VaR the Most Challenging

A member anchored this session on value-at-risk methodologies and reviewed how FX losses in certain years may prompt attention and skeptical questions about the hedge. But, “what works all the time” depends on what you expect your risk management program to achieve. Hedging notional exposures by currency or by individual exposure, depending on the underlying business, is still the common approach to managing FX risk, but taking a portfolio view of exposures is gaining ground, especially as companies grow and become more diverse and more sophisticated; the goal is to manage the company’s true exposure while reducing the total cost of hedging by eliminating unnecessary hedge transactions and allowing a certain acceptable level of risk to go unhedged. Key considerations of at-risk models include the appropriate time horizon and what kind of exposures are included, e.g., FX, commodities and interest rates, or some subset where diversification effects and price-movement correlations can be determined.

As part of the session, Joe Siu and Amol Dhargalkar from Chatham Financial provided a few case examples of corporate use of the methodology and illustrated how choosing to hedge only a few, but the most impactful, currencies can reduce CFaR significantly and that there are diminishing returns from additional hedging. Another example involved “netting, folding and flattening” balance-sheet exposures to allow greater reduction in balance-sheet hedging.

KEY TAKEAWAYS

1) A centralized risk-management function. The presenting company’s treasury, by policy, has central control over all risk management. This facilitates netting of exposures across entities and businesses to further reduce the already diversified exposures. This company has a specific tool it uses and it enforces centralization of risk management. Business units do their sales planning/revenue forecasting which also serves as a rough P/L forecast for each business, and BUs manage their profit targets in the tool as well.

2) Maintain continuous education and C-suite buy-in. Diversification and centralized management are, crucially, combined with the internal buy-in and understanding—built over years and constantly reinforced—that in most cases any losses will fall within the established risk tolerance. Post-facto reviews of actuals have borne this out. The company’s management’s commitment to its approach also extends to standing up to internal complaints about fairness; it does not “compensate” or credit units for gains and losses resulting from the risk management program.

OUTLOOK

Taking a portfolio view of exposures is gaining ground in the corporate community, and more and more of The NeuGroup’s FX members incorporate the methodology in their programs, but to varying degrees with regard to actual hedge-decision making. However, with the strong dollar and higher predicted volatility as central banks diverge on tightening vs. easing on interest rates, and while the economic outlooks of different regions also diverge, some caution may be in order, as correlations may shift or break down.

Making Sure Systems Allow You to Do What’s Needed

The systems round-up yielded the usual compare and contrast about systems and their drawbacks and benefits.

KEY TAKEAWAYS

1) Systems can hold you back from what you want to do. Systems development sometimes lags behind what companies want to use it for, and can stall a transition to something that might be desirable from a risk management perspective. For example, at one member company, FX managers cannot yet use it TMS for long-haul hedge accounting on options, which holds treasury back from using options more than they currently are. If the system is not capable of certain supporting calculations, spreadsheets are the go-to method, which of course may be seen as vulnerable from a SOX control and audit perspective.

2) One system is not best at everything. As illustrated by a systems table presented at the meeting, members use a hodge-podge of different special-purpose systems that can require some effort to work together seamlessly. On the flipside, what functionality are you willing to give up to have just one (or as few as possible) system to work with? IT resources and “who they belong to” (dedicated to treasury or a corporate IT department?) are also considerations.

3) “I pay for your added capability.” Software-as-a-service or SaaS users, who are the first to request a certain capability, will often be the ones to pay for the development of it. Cutting-edge treasury departments may see themselves paying for something that then gets rolled out to all customers at little or no additional subscription fee. It may also provide an opportunity to negotiate the development cost as a pilot client, especially if it’s a functionality that enhances the provider’s competitiveness and isn’t just a one-off special request.

OUTLOOK

Systems projects are the gifts that keep on giving (continuous work) to treasury. SaaS delivery of TMS functionality is a trend that is catching on in the corporate market, as internal IT departments become comfortable with them and, importantly, their security.

The Cost/Benefits Calculation of Hedging

A strengthening dollar is an opportunity to review how well the current approach is working and whether any of the levers (hedge ratio, tenor and instrument) can be adjusted to better mitigate the effects of an appreciating USD. One member gave an overview of his company’s continuous tracking of its various global projects, along with another member who reviewed her company’s program and the results of a recent 25-year back-test.

KEY TAKEAWAYS

1) Margin management and net equity are key metrics. For the first presenter, the objectives of the hedge program are to achieve financial-return targets set at the beginning of each project (the project original budget), and all results are measured in USD. “Peg rates” for each project are established at inception to convert non-USD revenue and costs to USD. The company hedges forecasted cash flows (not revenue, cost or margin), using forwards. The company is more sensitive to margin impact than cash-flow timing and does not prioritize hedge accounting.

2) Economics vs. hedge accounting vs. peer comparability. The second presenting company uses a combination of forwards and options, although the latter are sold back and replaced with forward 3-6 months before maturity. While this program and its choice of a 12-month hedge tenor is borne out by the back-test, there are opportunities for fine-tuning. Longer tenors would provide more tail-risk protection but may not be suitable for the tech sector, which rarely goes beyond 18 months. Keeping a similar hedge tenor to competitors also allows easier peer comparisons, and the treasury team can better explain differences in results vs. peers.

OUTLOOK

There may be as many methods as there are members for assessing the efficacy of the hedge program and whether it can be improved. The recent dollar trend reversal has put the spotlight on treasury’s ability to both mitigate the negative impact as well as explain it internally and externally to improve on factors that are under business units’ purview (forecasting) and treasury’s (hedge decisions on timing, tenor, hedge ratios and instruments).