When members of The NeuGroup’s Foreign Exchange Managers’ Peer Group 2 met in mid-March 2015, the backdrop of a strong dollar highlighted the need for transparent messaging on FX impact and more flexibility in instrument choice to mitigate dollar headwinds. Anchor sessions served up a review of FX impact metrics and how they are communicated as part of a performance narrative to investors; a proposal to include options as part of the arsenal of hedge instruments to use in hedge strategies; and an overview of a recent implementation of an exposure-consolidation software called Whitewater Analytics. Our sponsors from Thomson Reuters weighed in on derivatives. Further highlights from the meeting included:

 1) The Impact of FX—Metrics and Messaging. After years of dollar weakening, its reversal has had negative effects on reported results. Companies need metrics and messaging to respond to external stakeholders. Treasury and FP&A should collaborate closely to proactively develop ways to communicate company performance independently of FX movements, as well as what negative effects FX fluctuations have, and what offsetting positive effects result from risk management and hedging activities.

2) The Pros and Cons of VaR Methodologies. In a round-robin, members discussed how they use at-risk metrics and whether they guide hedge decisions. While methods like CFaR and EaR can reduce the number of currencies hedged and consequently the cost of risk management, they are time-consuming processes. If they don’t drive hedge decisions, there may be easier methods to employ, like stress-testing at different currency levels, which are easier to explain to management.

3) Hedging With Options: Making It Happen. The session centered around a proposal at one member company to introduce options into the hedge program. The time is opportune to allow a wider choice of instruments to be used in a hedge program. With more FX volatility and a reversal of the long dollar-weakening cycle, the case for taking advantage of “upside” while protecting the downside is strong.

4) Systems and Resources. The implementation of Whitewater Analytics, an exposure consolidation software, at one member company, was the focus of the session. The software has enabled significant time savings and more accuracy in exposure consolidation at the company while keeping costs relatively low and the implementation short.

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The Impact of FX—Metrics and Messaging

A strengthening dollar challenges foreign earnings and translated assets of USD reporting companies. After a long time of little to no explanation to external stakeholders necessary (or desirable) as a weakening dollar benefited them, dollar appreciation requires proactive messaging and metrics to show that the underlying business is performing so investors don’t penalize the company’s stock unfairly for factors outside its control.

KEY TAKEAWAYS

1) Proactive messaging helps – especially if you are different from your industry peers/competitors. One member who presented in the session added metrics that measured the FX impact on EPS growth rate to its guidance messaging about a year ago, which has been well received by the Street. One reason was that this member is more international than some of its competitors so it needs to be able to explain the difference FX makes in a way that resonates.

2) Hold the FX rate constant. The external “filter” for this company is to show how EPS growth would have been affected if, for example, 2014 results had occurred at 2013 FX rates, including the effective hedge rate achieved in both years. Investor relations guidance breaks out revenue, COGS, EBIT and EPS.

3) Collaborate closely with FP&A. To get at the information, this company’s treasury works closely with FP&A in the budget process and monthly forecasting, both of which are part of the guidance and reporting of the actual results.

4) Clarify reporting ownership and automate the reporting when possible. The change in external messaging has prompted some process changes internally, including making sure that there is clear ownership of this reporting and efforts are underway to make it more automated.

OUTLOOK

When currency trends are favorable for reporting earnings in USD, there is little need for granular explanations of the impact of FX fluctuations to external constituencies. When the trends reverse, those who take proactive steps to separate out company performance from results that are a consequence of FX moves are one step ahead to stave off any adverse actions by investors or negative reports by analysts. It again highlights the importance of treasury’s relationship with other departments so that relevant metrics can be developed and reported, and those processes automated, while ensuring a consistent message around externally reported financial results and management commentary.

The Pros and Cons of VaR Methodologies

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, become more diverse and more sophisticated.

KEY TAKEAWAYS

1) What do you use VaR for? The goal of a VaR-based risk-management program (CFaR or EaR in the corporate world) 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.

2) Requirements for a CFaR- or EaR-based hedge program. For a program to be successful, the company should ideally be large, have exposures that benefit from diversification and correlation effects, and centralized risk management and treasury processes like intercompany netting and the like. Senior management should be thoroughly educated on the meaning of at-risk measures and the potential losses that can result from tail events.

One member noted that her company uses CFaR and has been able to reduce the number of currencies hedged from seven to three, saving significant transaction costs.

3) Some use at-risk as just another metric in risk assessment. Not everyone in the group who uses CFaR metrics necessarily use it as a basis for hedge decisions. This should at least prompt an examination of the work involved in producing the metric vs. other risk assessment methods like shocking exposure forecasts with dramatic currency moves (stress-testing). These may be easier and less time consuming exercises than CFaR—if the latter is not the basis of rigorous hedge decision-making—and easier to explain to those in management outside treasury.

OUTLOOK

In addition to the need for conserving treasury’s time and resources by not producing reports that are not used for decision making, also note that many use a layered hedge program in their cash-flow hedge programs to reduce period-over-period volatility in cash flows, for example, and that this goal can conflict with a CFaR reduction goal.

Hedging with Options: Making It Happen

One member at the time of the meeting was in the process of developing a proposal to introduce FX options in to the hedge program, and therefore sought peers input on his proposal so far and how to proceed. The company hedges its yen-denominated revenues with forwards up to six quarters out with a rolling layered, dollar-cost-average approach. At revenue recognition, the cash-flow hedge is de-designated and turned into a balance sheet until settlement (up to three months).

KEY TAKEAWAYS

1) Protect against a stronger yen, and get upside. After a yen-weakening trend over the last three years (with hedges providing offsetting gains to revenues), and near ten-year lows (in value), the presenting company at the time of the meeting saw a greater risk of the yen strengthening than weakening further (assumption of mean reversal), and was therefore proposing to add options to the instrument mix to participate in upside if the yen should strengthen. The process would be as follows:

• Buy a yen put with expiry in the middle of the quarter between revenue recognition and settlement.
• At revenue recognition, sell a yen put with same expiry, and enter a balance sheet hedge until settlement date.

2) Beware the spread on both sides of the trade. If these hedges are set up programmatically, the bank will know that you are looking to unwind options on a regular basis and may take advantage of this in its pricing. One way to get around some of this risk is to use different counterparties for the original long put and subsequent short put. Accounting may have issues, however, with the risk associated with using different counterparties for the same exposure.

OUTLOOK

The uncertainty of the FX scenario in 2015 may make this a good time to seek approval for adding options to the mix in hedging, since the dollar is in a strengthening trend but there is also more volatility on the horizon. In addition to approval for the use of the instrument itself, it may also be an opportune time to demonstrate the benefits of a premium budget, although in many cases, treasury has to either get approval on a one-off basis or use costless collars.