Foreign exchange risk management policy

Sometimes, it's essential to return to the fundamentals. Whether you're deeply involved in FX risk management or just getting started, here are five crucial steps to establish an effective corporate FX risk management policy:

Top 5:

1. Define an FX Hedging Policy

2. Set Budget Rates or Reference Rates

3. Create a Cash Flow Exposure Forecast

4. Maintain a High-Quality Book of Executed Derivatives

5. Produce Consolidated Management Reports and Charts

1. Define an FX hedging policy

If you're reading this while still employed, it's likely because predicting exchange rate movements is uncertain—and that's perfectly normal. No one can predict them with certainty.

What is the purpose of a hedging policy, and why is it necessary?

A well-defined hedging policy ensures that everyone is aligned and understands the rationale behind your actions. It invites constructive input and fosters consensus. While the policy-making process can lead to extensive discussions, it's vital to stay focused and avoid overcomplicating matters.

Best Practices:

Most currency risk management policies share two common elements:

• Hedging Time Horizon: Define the duration over which hedging will occur.

• Hedging Percentages: Specify the proportion of exposure to hedge within each time frame.

For instance, a policy might maintain a one-year hedging horizon with decreasing hedging percentages over time, acknowledging that long-term forecasts carry more uncertainty. Alternatively, if exposure forecasts are reliable, a fixed hedging percentage might be appropriate.

Two-Dimensional FX Hedging Policy:

In more sophisticated policies, hedging percentages depend on two variables—such as time and the current spot rate at the time of executing the hedging transaction.

The logic behind this policy:

• When the spot rate goes up, it’s an incentive to hedge the exposure in higher percentages. A higher spot means higher profitability, in the case of the company in this example. The opposite is also true, and then the company will apply lower hedging percentages to not “lock-in” low profitability.

• Lower hedging percentages over the long term, mainly because of the uncertainty element.

2. FX budget rate ≠ wishful thinking rate

Excel can accommodate any rate you input, but that doesn't make it realistic.

Avoid relying solely on analysts or public figures; their eloquence doesn't equate to predictive accuracy. Remember, no one truly knows where exchange rates are headed.

What should you do?

Set a budget rate that is defensible at the time of establishment. This means selecting a rate you could theoretically secure through forward contracts based on projected exposures.

Adjustments may be necessary due to existing hedging transactions. In such cases, calculate a weighted average that considers both the rates of existing hedges and the forward rates for unhedged exposures.

For a conservative approach, some companies opt for a slightly less favorable forward rate than the current market rate when setting the budget rate—a strategy I personally endorse.

3. Forecasting Exposed Cash Flows

Creating a currency exposure forecast is an internal responsibility, best handled by the company's finance department.

Key Considerations:

• Net Exposure Forecast: Focus on the net exposure as the bottom line.

• Hidden Exposures: Identify payments made in one currency but linked to another, ensuring all exposures are accounted for.

• Customer Exposure Rollovers: If the company can transfer exposure to customers over time, this should influence the hedging horizon.

4. Derivatives book

Maintain a comprehensive record of all hedging transactions.

While tools like Excel or Google Sheets are commonly used, investing time in designing a robust system will pay off in the long run.

Tips:

• Utilize data validation features to minimize errors.

• Ensure the system is scalable and adaptable to future needs.

5. Consolidated Management Reports and Charts

Effective FX risk management requires clear communication with management.

Recommendations:

• Visual Aids: Incorporate charts and graphs to illustrate exposure and hedging strategies.

• Clarity: Present information in a straightforward manner, avoiding unnecessary complexity.

• Consistency: Regularly update reports to reflect current positions and strategies.