Benefits of an established policy include senior management buy-in, clear guidelines to avoid misunderstandings, and fair evaluation of Treasury personnel performance. Additionally, it defines who will manage the risks and the latitude given to the risk manager, and the parameters for measuring their performance and effectiveness.
It may even define Board oversight responsibilities over Treasury risk management operations. The items included in this paper are not an exhaustive list, but provide examples and best practices. Interviews with Treasurers, reviews of industry surveys, and other sources have led us to identify 8 Key Success Factors which are common to all successful FX Hedging programs.
They should be codified in every companies policy. Centralize FX trading and risk management enhanced netting opportunities, efficient settlement, centralized third party foreign currency receipts and disbursements.
Manage forecast error for companies that hedge forecasts, hedge errors are most likely due to forecast errors. Measure hedge performance against metrics and related benchmarks. Company-specific policy content can be divided into 8 different categories. These categories are where a company customizes its policy to match its strategies and goals.
Limits FX risk, counterparty risk, derivative types and position size. The balance of this paper offers detailed examples, guidelines and lists for each of the preceding 8 categories to guide the company in the development of its own Policy. Hedging objectives Any hedging program should be guided by objectives. FX risk is found in many areas. The policy should specify which are important and should be hedged, and which are not. Performance Metrics and Benchmarks Establishing metrics for FX risk management is essential to ensure that risk management activities can be measured and changed if required, and to ensure the finance group does not suffer under unrealistic expectations.
A metric is a number which measures performance. A benchmark, or standard, is how we determine whether the performance we measured is acceptable. A metric is useless until it is compared to a performance standard. Specific purpose, Measurable, Achievable, Relevant, and Time-phased the value or outcomes are for a specific, relevant period.
Useful KPI concepts to consider when developing your own metrics include choosing leading vs. As a general rule, the fewer KPIs tracked, the better. Useful metric categories include i reducing operating flow volatility e. The latter is gaining wide acceptance, and often included in quarterly earnings reports.
Processes and Controls The FX risk environment is very complex - numerous exposure currencies, entities, contracts, forecasts, accounting periods, counterparties etc. To effectively manage FX risk, processes must be designed to manage the data. There should be a process for managing balance sheet risk remeasurement risk , utilizing best practices for forecasting the balance sheet including forecast revenues and cash deliveries , setting accounting rates, and functional currency liquidity provision.
There should be processes for managing income statement forecast cash flow risk, utilizing best practices such as layering hedged, variable hedge ratios, triangulation of cross-currency exposures, etc. Ideally, both balance sheet and cash flow hedging processes are integrated, repurposing cash flow hedges maturing in the current month into balance sheet hedges.
The policy should proscribe specific processes to avoid unpredictable results and chaos. In every trading environment, control procedures should be a fundamental part of the daily routine.
These measures will help catch honest errors, and reduce the likelihood of any improper trading activity. Controls need to address confirmations and record keeping, whether paper or electronic.
Most companies expect same day telephone confirmations for each trade, and specify that someone other than the original trader must verbally confirm the deal.
Written confirmations should be sent to a separate area from the trading function—usually a control or audit division of the company. They should obviously be sent to the attention of someone other than the initiator of the transaction. Both verbal and written confirmations must be checked carefully. Any discrepancies must be immediately resolved with the counterparty to the trade, to avoid major trading losses. Corporate control areas can monitor written confirmations to ensure adherence to foreign exchange policies and guidelines.
The confirmation process not only helps avoid or reduce serious trade disputes, it also provides a valuable internal check from a policy enforcement perspective. Who has the authority to authorize trades outside the system?
How are trades confirmed and compared manual vs. New bank product development poses additional issues. For example, hybrid products can pose definitional problems that must be addressed to avoid confusion.
For example, is a forward participation agreement a forward or an option for control and reporting purposes? These nuances may seem trivial, but they can produce serious problems for a treasury manager trying to explore alternative hedging strategies. Reporting Management should present regular quarterly or semi-annually reports to the Board detailing the net foreign currency exposure for balance sheets hedges, cash flows hedges, and speculative trading results.
A summary of the hedge trading metrics compared to benchmarks over the quarter should also be provided. In addition, the CFO might be required to certify a number of items, including: Limits Limits should be in place regarding a number of trading parameters, as well as FX Risk metrics.
Limits should be placed on total outstanding contract notional and tenors. This limit might be described in aggregate, or per trading counterparty. Here is a representative list: Limits and thresholds should also be in place for FX risk, as measured by Value-at-Risk, stress testing and scenario testing, according to established metrics.
Minimization of transaction costs A corporation has a duty to minimize costs, and that includes trading costs. The first place a firm should look for opportunities to reduce hedging costs is to utilize natural hedges offsetting revenues with expenses. Natural hedges reduce the need for derivative hedges. Another tactic is for the company to enter into FX risk-sharing contracts with its suppliers and customers.
After these and other alternatives have been exhausted, then derivative hedging must be used to manage risk. For smaller companies, it is truly a non-issue. It is anticipated that for most readers of this document, this section is irrelevant. However, for completeness sake, we include the following discussion. It should come as no surprise that ISDAs between corporations and banks have traditionally been rather one-sided. But even if a bank actually defaults on a corporate customer, the company will likely have no opportunity to collect any collateral.
The company may be able to operate for quite some time with a BBB rating, or even at a below-investment-grade level. The bank would no longer have sufficient capital to post collateral, and its cost of funds would have already increased to a level that makes operating as a bank problematic.
The bank would be much more likely to default at this same credit rating, so a CSA with these terms would provide a false sense of security to the corporate counterparty. What should a treasurer do to level the credit-risk playing field? For longer-term exposures, such as cross-currency interest rate swaps or long-dated forwards, consider posting margin utilizing the services of a third-party collateral manager.
Collateral managers accept and remit collateral based on the mark-to-market status of the outstanding trades to each financial counterparty. Companies and their banks need to spell out in their CSAs both the role of the collateral manager and the objective measures of risk that will be used to set collateral requirements for both parties. Hedge accounting Hedge accounting is a very complex subject. In addition, we are not accountants and unqualified to comment on hedge accounting choices.
We recommend that you consult with your accounting firm to write this portion of your FX Risk Management Policy. Conclusion It should be obvious by now that a FX Risk Management Policy is tailored to the objectives of each individual company, and that only guidelines and suggestions can be made to assist in the writing of the policy. It is also evident that a great deal of work and thought must go into the writing and approval of the document. However obtaining senior management buy-in, establishing clear guidelines, and ensuring fair evaluation of Treasury personnel performance is well-worth the effort.
Centralize FX trading and risk management enhanced netting opportunities, efficient settlement, centralized third party foreign currency receipts and disbursements Adopt uniform FX accounting procedures across entities Manage forecast error for companies that hedge forecasts, hedge errors are most likely due to forecast errors.
Some questions to address in the policy include: Who are the account administrators? Who approves the account administrator changes? Who has the authority to complete the trades on the system?
Electronic trading issues New bank product development poses additional issues. Newer Post 3 crucial FX rates. Older Post Key FX hedging metrics.More...