The FX Hedging Cycle – How to Embed Best Practice Introduction For those that have been following our CFO Series…
The FX Hedging Cycle – How to Embed Best Practice
For those that have been following our CFO Series this year, you might recall from our 2018 Currency Market Preview that FX markets are ripe for some volatility. If you read last month’s article on ‘Why Hedge’, we might’ve challenged some of your thinking on why you should be hedging in the first place. This month, we’ll bring it all together as we introduce the FX Hedging Cycle. This article is suitable for any international organisation who is looking to manage foreign exchange risk and wants to ensure they’re on the right track.
The FX Hedging Cycle
There are numerous variations of the FX Hedging Cycle. Many are similar in nature, and if you peel back the layers, you’ll find they closely mimic most published risk management cycles (as a Google image search will attest to). Experience and common sense tells us that structure and process are useful when managing risk in one of the most volatile and unpredictable markets in the world. We’ll take you through our best practice, 5-step approach to help you create and execute a strategy that works for you.
Step One: Identify Your Exposure
The first step is to identify the total value of your business cash flows that are denominated in foreign currency. Given that foreign exchange exposure can result from many different types of international business, it is also a good idea to categorise your exposure, and you may even choose to treat each type separately. Categorisations can include:
There are endless ways to categorise exposure. In some cases, you may use sub categories. The cycle can be used to develop a strategy for each category or it can instead be applied holistically across the entire business.
It is equally as important to quantify the risk. This is notoriously difficult to do, as the risk is dependent on future exchange rate movements which are entirely unpredictable and susceptible to dramatic movements. There are incredibly complex and overwhelming mathematical models which attempt to do this, but as an alternative, you can dumb it right down by applying this rule of thumb: throughout the year, expect most major currency pairs to fluctuate by 10%.
To better demonstrate this risk, EncoreFX utilises a simple yet practical two-stage approach:
Implied Volatility Risk Multiplier
Implied volatility is the market’s own gauge for how volatile a currency might be in the future. It can provide a practical, measurable method of assessing market risk that is more targeted to your currency pair than the earlier ‘rule of thumb’. It is easily available from your foreign exchange provider and it is presented as a percentage. Put simply, you can multiply your foreign exchange exposure by implied volatility and use that number to score your risk.
A theoretical ‘volatility’ percentage in markets is typically two standard deviations of a normal distribution. The theory tells us there is a 95% chance that the asset will stay within that volatility percentage range over the given time period. The implied volatility theory for currency gets more complicated than this (but I won’t get into it any further here). It’s important to appreciate that the operative word here is theory and what this tool offers is a practical approximation of risk. However, as we know, there are many unpredictable elements in FX markets and a risk value on its own could drastically underestimate potential gains or losses.
We don’t have to look back too far in time to see just how dramatically markets can move: the Brexit vote, the Swiss National Bank’s move to cap their exchange rate and the Global Financial Crisis all contributed to significant swings in international currency rates. This is where a sensitivity analysis provides for worst case scenarios.
Sensitivity analysis, a simple tool, looks at the total value of your FX exposure in your base currency. It then shows you the change in dollar value for the ‘anticipated range’ and a ‘directional move’. The example below shows the AUD value impact on a $10.65 million exposure if there were a 5%, 8.95% or 20% move in either direction.
Now we have a picture of what financial risk to expect in statistically normal and abnormal conditions. We’re finally ready to move to Step Two: Setting Objectives.
Step Two: Setting Objectives
The first question on everyone’s mind is often, “Why should I hedge?”
Well, hopefully the tools above have prompted you to think about how severe currency swings can impact your business (more on what 2018 might bring here). If you’d like more background on why businesses choose to hedge their risk, you can read our “Why Hedge” article, here. In this earlier article, we introduced four of the most common objectives for FX hedging, seen below. Which of these are most important for your business?
This decision is the challenge, and often businesses will adopt multiple objectives. There might be more weight put on one over another, or there might be conflicting objectives where compromises are needed. At this stage it may be appropriate for you to begin thinking about timing – how long do you need to protect profit margins for? What period do your competitors hedge for?
Step Three: Plan, Strategy, and Policy
Now that we understand the exposure, risk and objectives, we can move on to creating a plan, strategy or policy. A good plan will allow you to meet your objectives while also protecting your business from risk. There are four common approaches to hedging which were also introduced in our last article, “Why Hedge”. The correct approach you take will be driven by your exposure and objectives.
Here are some examples using the four common objectives:
Hedge Ratios & Timeframes
Any plan, strategy or policy worth its salt will include hedge ratios with timeframes. A hedge ratio is the percentage of hedging contracts in place vs forecasted exposure. Timeframes for a hedge ratio are just as important as the ratio itself. A 50% hedge ratio out one month will yield vastly different results than if it was out twelve months. Studies have shown that a 50% hedge ratio is most satisfactory over time, but it is important to match your hedge ratio to your particular objectives.
Treasury or Foreign Exchange Policy
Larger businesses tend to implement a treasury or foreign exchange policy. A policy enables proper governance of the finance function, and provides the board with control. Typically, policies will lay out strict risk management guidelines for finance and treasury teams to execute on – including hedge ratios and timeframes to maintain. We’ll be writing more about policies later in 2018 (my contact details are below if you’d like to learn more).
Step Four: Execution
Execution is all about sticking to your plan. If your plan is well developed, then following your plan will allow you to successfully meet your objectives. This step is where a good execution partner is important – a bank or financial services provider who can help with the following:
Step Five: Report, Review, Optimise
Finally, it is time to report on your strategy, review and optimise. An annual review is a good starting point for any business, and any strategic review should be commensurate with the size of the business and the overall risk.
It’s easy to get hung-up on whether or not the market has “gone against” your contracts, but remember, the performance of your hedging plan should be measured against your plan’s objectives and not the FX market’s performance. Avoid giving yourself an undeserved failed report card by focussing on the objectives that you have protected from risk.
Optimising your plan is required from time to time. Perhaps there have been new exposures introduced, or a change to the risk profile of the business. If you think it’s time your business reviewed its approach to foreign exchange risk management, you can contact us today.
Using the FX Hedging Cycle allows you to put structure and process around your foreign exchange risk management. This structure and process is what leads to a better plan and better outcomes. I welcome you to reach out if you would like assistance in reviewing your foreign exchange risk management approach; my details are below.
I’ll leave you with a quote from Warren Buffet which sums up our key message nicely: “Predicting rain doesn’t count. Building arks does.”
Phil Lynch – Corporate Hedging Director – Asia Pacific
Next month we will delve into strategic hedging, with a focus on budgeted rates and hedging ratios.
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