Top 10 Mistakes Companies Make in FX Risk Management
by Jono Tunney, CFA and Scott Bilter, CFA of Atlas Risk Advisory
The problem of how to best manage foreign exchange volatility has plagued multinational companies for decades, and is usually cited as one of the top concerns amongst Treasurers. Rapidly changing business models make life especially difficult for those who are tasked with managing a company’s foreign exchange risk, and many pitfalls await those who are ill-prepared. What follows is a “Top 10” list of some of the most common—and costly—mistakes multinational companies make when trying to manage their FX risk.
1. Maintaining the status quo
FX groups often have a lot of inertia around their current practices, and fear of change can be a major obstacle. Because the stakes can be so high, the perceived “safety” of maintaining any current approach “because we’ve always done it this way” can be prevalent. The problem with this is that many things have likely changed since a certain practice was established, and various assumptions that may have been true many years ago are no longer true today. FX policies tend to be implemented or updated over time in response to huge FX losses generated by exposures that weren’t previously considered or well understood. You wouldn’t wait until to your house burned down before buying insurance, so why wait until your company suffers a significant FX loss before putting in place the proper processes and procedures that could have prevented it in the first place? A world-class FX organization will think and act proactively, learn from the mistakes of others, and seek qualified expertise.
2. Taking a view on the direction of currencies
Do you or your business partners take views on currencies in order to determine your revenue or expense hedging strategies? Chances are that if you ask five different banks where they think a currency rate will be in a year, you’ll get five different forecasts, and the average will be pretty close to the current spot rate. If there happens to be widespread agreement by the banks on their directional views, this actually has a better chance of being a contrary indicator than a good forecast. A successful hedging program shouldn't be influenced at all by directional views, or by the most recent trends that have occurred. Too often a hedging program is terminated because it's “losing money” just before the underlying exposure begins to lose value and the hedges (now non-existent) would have had offsetting gains. The success of a hedging program needs to take both the underlying exposure and the hedge into consideration when determining its effectiveness. Trying to guess what would happen to only one side of the equation is not effective risk management.
3. Not engaging enough with business partners
If you hedge your company’s local currency revenue exposure, do you understand the competitive environment in the various geographies where you do business, and the specific pricing dynamics? Do you have any pricing power if there is a huge move in FX rates?Whether your primary exposures are revenue or expense related, there are several factors that would influence how much and for how long you should hedge, whether to use options or forwards, whether to layer in hedge rates, how to interact with sales/procurement in terms of quoting/purchasing in local currency, and other considerations. A company may also need multiple strategies for differing product lines or businesses. A good way to test if a hedging strategy makes sense is to “stress test” it with different “What if?” scenarios, which should include some modeling on how you and your competition, suppliers, and/or partners would react. If you can’t live with the results of a significant currency shock in either direction, chances are your hedging strategy needs some adjusting.
4. Having an aversion to locking in losses
This problem often occurs with balance sheet hedging. Let’s say you receive new information on an exposure a week after you set your monthly accounting rate. The nature of this information is such that you should enter into an outright forward to adjust your hedge. But if the currency has moved out of your favor compared to the accounting rate, the adjustment hedge will lock in a loss.Too often in this scenario, no adjustment is made, and an excuse such as “our forecasts are never accurate” is used to avoid locking in the loss. An FX policy needs to be in place that takes the emotion out of risk management (i.e. if the exposure as identified by a certain process is beyond a minimum threshold, it is hedged—period). Volatility is a function of time, so a week’s worth of unfavorable volatility can turn into a month’s worth of far more unfavorable volatility. “Hope” is not a strategy. If an exposure is material, hedge it.
5. Having a poor balance sheet forecasting process
Forecasting is inherently difficult, but forecasting the non-functional currency portion of a balance sheet is especially problematic. Many companies make this more difficult than it has to be by having a decentralized process with people around the globe attempting to forecast various entities’ balance sheets line item by line item. There is often limited accountability or ownership of the balance sheet actuals, which is a big problem. The best way to derive the relevant balance sheet exposure is to take the latest known actual exposure and build upon it with income statement inputs, which tend to have more ownership and accountability and should therefore have improved accuracy. This is ideally done in a centralized manner, and is based on legitimate forecasts as opposed to “stretch goals” or consistently, overly optimistic views. Any forecast input that doesn’t prove to have a fairly equal chance of being too high or too low over time may need to have a “haircut” or “markup” applied.
6. Creating unnecessary volatility from liquidity management
Forecasting and hedging the balance sheet in an optimal manner can help avoid unnecessary volatility from spot or forward trading during the month, when managing a company’s liquidity needs. The local currency balance sheet of a USD functional sales entity, for example, is unaffected by EUR Accounts Receivable turning into EUR cash, as these are both Net Monetary Assets (NMA). If a company wanted to convert any excess EUR cash to USD (which WILL affect the EUR NMA), an ideal balance sheet hedging process would result in an equal and offsetting adjustment to the outstanding balance sheet hedges. This utilizes an “even FX swap” as opposed to only a spot trade or an outright forward. Whether this activity occurs on a company’s “netting day” or any other time during the month, using even swaps to manage liquidity needs avoids unnecessary spot rate versus accounting rate impact, and eliminates the need to guess on collections or payables timing.