FX risk management programs will need to improve predictive capabilities and review plans to face new and recurring challenges.
The NeuGroup’s fifth FX Summit, a combination meeting of both FX groups, took place in March in New York City, hosted and sponsored by Thomson Reuters. Members revealed that their bosses are increasingly focused on FX, so they are faced with many challenges this year, including regulatory constraints, bank-driven reductions of available liquidity, and the cost of hedging against volatility and the strong dollar. To deliver on their objectives, members agree that they will need to:
1) Look at the Next Chapter in Holistic Risk Management. Build a currency index for your FX exposures and use it to educate management on how volatile your exposures really are.
2) Examine Indirect FX Risk and Its Impact on P/L and Mitigating Actions. Indirect risk from USD pricing requires innovative solutions to maintain sales in tricky countries.
3) Review and Redesign Revenue Hedging Programs. A hedge program’s underlying assumptions need periodic review and agreement on objectives, their hierarchy, and constraints.
The Next Chapter in Holistic Risk Management
In recent years, members of both FXMPGs have discussed a variety of approaches to bringing a more holistic approach to risk management and what feasible ways they can be implemented. With the aid of Peer Group Consultant John Byma, an old hand at exposure analysis, diversification effects, and VaR/EaR modeling, this session took a fresh look at this topic. His background includes putting in place and maintaining the EaR model which underpins the risk management program at Procter & Gamble.
Key Takeaways
1) Where is the real risk in your FX portfolio and could you measure it if management asked for it? Mr. Byma posited that the job of an FX manager is to develop the most profound insights into the financial market risks facing the company over a meaningful time horizon and using the best available tools, translate those insights into a set of views that senior management can understand and recommend a set of actions that correspond to their risk tolerance.
2) Build a volatility index. Volatility is high relative to recent years, but far from historical highs. Instead of getting too worked up about volatility in general, and perhaps emerging markets in particular, Mr. Byma recommended that members build a currency index for FX exposures and use it to educate management on how volatile your exposures really are. “Take your own mix of FX and run historical vols on them and see,” he says. If your index spikes, you can use it as an early warning signal to take action (or change course).
3) Don’t do business with yourself. Manage to the highest level, i.e., be global in the sense that you look at your company as one unit. Avoid practices such as back-to-back hedges, and other intra-company transactions that are primarily accounting- and not value driven, especially if they at intervals involve real money flows and hedge/trade requirements. Incentives matter and can often get in the way here.
Outlook
It may be helpful to attempt to view risk in different ways that have not yet been attempted “at home.” What scorecards and charts work best for you? If you’re not happy with them, where do you think they fail? What are the “best pictures” for illustrating risk to your management, and are you employing them yet? From time to time, members of the two FXMPGs share ways in which they communicate with management to help them better understand risk and current and potential approaches to managing it.
Dealing with Trouble-Making Currencies
A subset of emerging markets, though increasing their share of revenues and becoming increasingly important for members, are proving to be time consuming to manage. Here are member recommendations for dealing with them:
- Start gathering data on emerging market currencies. With so many citing emerging markets as one of their top concerns, and with FX generally getting extra scrutiny, take stock of the currencies out there and break them into those that do and those that don’t matter to your company.
- Make sure you have an updated China contingency plan (and Asia contagion plan). China’s plans for long-term internationalization and growth aren’t a guarantee. And what happens there is sure to spread through Asia. Send your plan around to the relevant business and finance people and vet it (again, if you already have one).
- Sit down with both procurement and sales to make sure contract pricing is in the appropriate currency. Whatever the pricing currency, you likely have an exposure anyway. Take on the direct risk and manage it internally to avoid the situation described in “Indirect FX Risk—Impact on P/L and Mitigating Actions.”
Indirect FX Risk— Impact on P/L and Mitigating Actions
An FXMPG member, a group manager for a multinational computer technology corporation, shared his story on the indirect FX risk arising from pricing and collections in USD globally, how that manifests itself in current USD markets and volatility levels, and what his company is doing to mitigate the business effect and P/L impact. He highlighted the areas where they help the business, the thought process on identifying the correct solution, and what it means for the subsidiary and customer.
Key Takeaways
USD pricing brings indirect FX risk. It may sound like FX-risk avoidance to price products in USD, but the member company’s customers and local partners are confronted with price uncertainty and a hit on margins, causing them contract bidding problems, and their distributors and channel partners may hesitate to place orders (e.g., Brazil, Mexico). In countries with FX controls, they are unable to access USD and cause the company to deal with overdue accounts receivable and being forced to put a hold on the partner’s credit for further purchases (e.g., Egypt, Argentina). The company’s treasury tries to deal with these two types of issues by helping to resolve payments issues, mitigate credit risk, and approve exceptions to established credit and collection policies. Mitigating steps include:
- Price protection: Offer a guaranteed FX rate to partners and hedge it via options or forwards.
- Allowing local currency offshore: If the business is negatively affected by an inability to access USD, the company can respond by transferring the FX risk to the sub or local business, and the cost of hedging falls on them. The customer pays local currency against a USD invoice.
- Collect on behalf of: Similar to the above, when access to USD impacts the business, one of the company’s onshore entities collects on behalf of the offshore entity (the preferred collecting entity). The collection amount is up to the commission amount due to the onshore entity and the rest becomes an intercompany payable. This is a temporary solution when there is no access to USD. One of the drawbacks is that it takes several weeks, usually, to open an onshore account.
Outlook
USD pricing does not protect companies from FX risk when customers in countries with weaker currencies face uncertainty about the cost of buying the product and restricted access to dollars to pay. As long as the USD stays strong relative to trouble-maker currencies, the situations the member described will continue to manifest themselves. Some problems may go away over time as governments change or economies improve, but likely others will take their place. Companies need to be open to innovative ways of dealing with these problems to maintain or strengthen their market position.
Market Volatility and Choosing the Right Hedge Instrument
Market volatility brings the performance of different hedge instruments into sharp relief and highlights the pros and cons of options vs. forwards depending on the circumstances and the appetite for risk —or tolerance for the range of outcomes that come with these choices. This session looked at some of the considerations underlying the choice based on relative value in different market environments.
A continued strong dollar (it’s strong but central banks are pushing it—and volatility—higher). Britain’s looming exit from the EU, and an unstable Middle East with low oil prices will keep pressure on FX managers to deliver consistent risk reduction at reasonable costs, such as by hedging short USD positions. Electronic platform and/or market data providers continue to develop ways to provide actionable data, as the relative values in the currency markets highlighted on Thomson Reuters’ EIKON heat map demonstrates. If FX managers have flexibility in instrument choice, trade timing, tenor and hedge ratios, there are many ways of analyzing market conditions to trade within that range of flexibility in ways that maximize risk-reduction value for the available hedge budget.
Case Study: Revenue Hedging Program Review and Redesign
Even a well-functioning program needs periodic review—certainly after 20 years. The FX trader of a member company in the global healthcare industry shared a complete review and proposed redesign of his company’s revenue hedging program, with the analysis and thinking that went into the process. He went over the key shortcomings of the old program, noting that analysis of the company’s exposures as if no program were in place was performed and that he aligned senior management on objectives to determine the nature of the new program. He and his team then performed a Monte Carlo analysis of currencies and different instrument choices and hedge levels. Finally, he discussed the company’s readiness to select a reasonable solution and to accept certain trade-offs on cost- and risk reduction.
Key Takeaways
1) Time to dust off the assumptions of your hedge program? Clocking in at 20 years, the program wasn’t working badly, but a lot of things change in 20 years, not least the exposure currency mix: The previous “top five” currencies now account for less than 50% of exposures, and many emerging markets currencies have been added to the mix. Also, a merger changed the profile of the company, and a new CFO adjusted the program’s objectives somewhat.
2) Agree on the objectives, their hierarchy and the constraints. The company’s previous program was an options-based multi-year protection of cash flows up to five years out. The new CFO’s top objective is minimized volatility of quarterly reported earnings, as measured by the FX-driven standard deviation of (1) quarterly earnings and (2) quarterly year-over-year earnings growth. Other key (but subordinate) objectives included protecting annual budget volatility and gain from upside while protecting the downside. The new program also must operate with certain constraints on maximum hedge ratio and at a program cost similar to or lower than the current program.
3) Use the help of two banks with the analysis, and do your own. The FX manager used the help of two banks with the analytics supporting the new proposal to bring more objectivity to the analysis. He also found that one was very good but the other was superficial and simplistic by comparison. Therefore, it’s good to take the help of more than one. He also put his modeling experience to work in parallel.
Outlook
Continuing management focus on FX-related volatility coupled with economic troubles in many significant markets around the world bring the impact of FX on P/L and margins into sharp relief. As a result, many members started initiatives last year or this year to review how their FX programs perform in these market conditions. This kind of review becomes all the more important if a program was launched under different market conditions, if the business or exposure mix has changed significantly through acquisitions or divestitures, or if management’s risk appetite or objectives have changed. We expect to hear about more such reviews over the course of 2016.
FX Markets and Electronic Trading— What’s Next?
Several trends, most notably the transaction reporting for the Markets in Financial Instruments Directive and the updated market conventions in the Code of Conduct and Practice, are resulting in market conditions where the corporate segment will encounter a squeeze on liquidity and, consequently, trouble executing necessary trades mandated by their FX risk management policies, according to Head of Relationship Management – Americas for Thomson Reuters, FXall Karen Phillips.
- A squeeze on liquidity: Should you reduce your trading, and if so how? Regulations are driving banks to increasingly take an agency approach in the markets, increasing the buy-side’s exposure; and rising volatility and spreads have made liquidity conditions tougher. Thus, trading reductions may be in order, or netting may help you do all the trading your hedge program requires.
- Or should you just execute better? There are several reports in the FXall execution quality analysis (EQA) reporting suite that may help an FX team pick the right time of day to do a trade, best trade sizes, and other useful analysis. And, according to the pre-meeting survey results, a small but growing number of members are using algorithmic trading.
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