How Effective is Your FX Hedging Program?
by Scott Bilter, Partner, Atlas Risk Advisory, LLC
Today's finance professionals are typically well equipped to handle many complex financial problems. They are often experts with Excel and other finance tools, both inside their IT environment and in the cloud, and they are adept at creating various models that are helpful in understanding their business. Despite their extensive expertise, however, many finance professionals have a hard time wrapping their minds around issues related to foreign exchange (FX) risk.
This is largely due to the fact that FX issues are rarely the top concern of finance professionals who do not work in Treasury. Even for those who do work in Treasury, those tasked with managing FX risk are often learning on the job. They need to interact with and rely upon folks outside of Treasury who have other pressing concerns. When it comes to FX, many people are intimidated by "the markets" and fear they might make the wrong decision that will lead to a loss. Even folks who are comfortable making quick decisions elsewhere find themselves "passing the buck" or sticking with an out-of-date strategy when it comes to managing FX risk.
The result is that too many corporate FX hedging programs are reactive and not proactive. The poorly forecasted FX exposures differ significantly from the actual exposures, and there is little understanding of the interaction between income statement and balance sheet risks. The FX risk managers live in fear each month that the volatility in their hedging results will draw unwanted attention from senior management.
When the inevitable bad month happens, the FX team finds themselves under an unwanted microscope. They scramble to put together some ad hoc analysis to try and figure out what went wrong, and perhaps a tweak to the process is put in place in an attempt to keep that particular problem from happening again. Just like in the game "whack-a-mole," a different problem will soon surface, leading to another inevitable bad month and unwanted attention...
Be realistic about resources
Given the complexity of the problem, it's important to be realistic about your company's ability to adequately manage FX risk on its own. For a start-up company, there is likely a modest-sized finance team with no dedicated treasury personnel. A mid-sized company may have a Treasurer and perhaps one or two other treasury members, but no one dedicated entirely to FX. Only large, well-established multinational companies will likely have the scale to support a dedicated FX team, where there can be a reasonable expectation of retaining an adequate level of continuous FX expertise.
What follows is a discussion of some guiding principles and traits that should be present in a "world-class" FX risk management team. This is realistically only accomplished in a large enough organization where continuous FX expertise can be maintained – smaller organizations should use a combination of their limited resources and appropriate outsourcing to establish as many of these best practices as possible.
Don't let the accounting tail wag the dog
Like many finance topics, there are many accounting rules that are specific to FX. This paper will not go into the details of FAS 133/IAS 39 or FAS 52/IAS 21, which many FX professionals are familiar with, other than to make the following observation: Many FX related accounting rules are written with a fair amount of subjectivity and flexibility in their interpretation. This is important, as there isn't a simple "FX blueprint" that every company follows. Differences in functional currency setups for foreign entities, accounting rate setting methodologies, entity structures and relationships, and intercompany activities, to name a few, all impact how various FX accounting rules should be applied to any given company.
Because of this, it is crucial for the FX professional to play a significant role in interpreting the FX accounting rules for their particular situation. It is often the case that a company's auditors are more familiar or comfortable with what they may have seen at a different company, or perhaps a rookie auditor may not have much FX related experience at all. They may question something they are less familiar with or don't understand. We've come across many Treasury organizations that avoid having FX related conversations with their auditors; therefore, they don't push forward with an idea or solution that could be optimal for their company. World-class FX organizations don't let the "accounting tail wag the dog" when it comes to FX risk management. When they find an optimal solution to an FX related problem, it is typically the case that a valid interpretation of the FX accounting rules can support such a solution.