The FX budget rate is usually the corporate annual reference rate. Sometimes, the reference rate is a pricing rate for a period and a distinct type of activity or a specific project.
The budget rate reflects the company's work plan, which embodies the accepted and planned profitability. That is, the profitability inherent in the core activity, given a specific exchange rate. However, in practice, the exchange rate is an exogenous variable that can adversely affect the activity’s financial results. Therefore, risk management aims to reduce the effect of exchange rate changes on the company's work plan.
The reference rate must be protectable when determining it.
Calc fellows’ recommended technique for determining it is by calculating the forward rate’s weighted average to the mid-exposure duration and the weighted average hedging rate of the existing hedging transactions for that period.
Also, we recommend adding or deducting a confidence interval (margin of safety) element to the forward rate when determining the reference rate.
For example, if the exposure is to the major currency appreciation, add about 2% to the forward rate, and vice versa if the exposure direction decreases the exchange rate (deduct 2% from the forward rate).
Example:
An example for a formula that is suitable for a company that is exposed to the minor currency appreciation (Down direction exposure)
(Protected Rate * W) + [Forward Rate * (1-CL)* (1-W)] = Budget Rate
In case of exposure to the depreciation of the minor currency, then change to (1+CL) (Up direction exposure)
Annotations:
W: The exposure percentage for the relevant budget year that has already been hedged.
CL: Confidence Interval (margin of safety).