What is Benchmarking?
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The term benchmarking is popular with consultants and risk management advisors, but like many risk management terms, it means different things to different people. Some of the definitions of benchmarking include:
- A process of benchmarking your company’s risk management processes to the processes of other companies or specifically to other companies in your industry.
- The setting of benchmark exchange rates that are used either in the budgeting process or have some strategic importance for the company.
- The determination of a benchmark strategy that represents a hedged position that is optimal in terms of meeting the company’s risk management objectives.
- A process of performance measurement – comparing the actual hedge results against a benchmark – that provides enough information to a company’s senior management so they can judge the performance of its risk managers.
Despite the differences in the purpose of each form of benchmarking, they are all means of enhancing controls over the risk management process. From a best practices perspective, it is essential that senior management understand what their competitors are doing; understand how foreign exchange volatility impacts the company’s bottom line; identify and quantify risk and develop risk management objectives that reduce risk to acceptable levels; and gauge the performance of risk managers if their actions are intended to add value to the risk management process.
Perhaps the single most important benefit is the enhancement of transparency. For example, when treasury has an established benchmark strategy that is coupled with a defined risk profile and mandate, business units and senior management are able to gauge the performance of treasury and extract any nominal gains or losses generated by treasury from operations. Equally important is the transparency to both shareholders and analysts. A clearly defined benchmark strategy and a well-articulated FX policy facilitates the ability of a corporation to manage expectations around the firm’s overall performance. Of course, hedging exposures based on a benchmark strategy will not eliminate all potential risks. Every risk management program is usually constrained in some way by different factors – accounting, poor forecasting, the nature of the underlying exposures, or by unexpected market events. As we have seen on numerous occasions, many earnings surprises have been at least partially the result of ‘unexpected FX volatility’. An increased awareness of how foreign exchange impacts a company’s business at all levels, as well as a proper benchmark strategy designed around established risk tolerances, will significantly improve senior management’s ability to understand what factors are impacting business results and to predict future business results.
Another benefit of benchmarking is the enhancement of communication between the business units and treasury. Clear definition and communication of the company’s risk management benchmarks can help businesses better understand the importance of their role in the process, as well as increase their accountability. Ultimately this should enable treasury to adjust specific hedging strategies, and ultimately ensure that the hedging activity is in line with senior management’s expectations.
Another benefit of benchmarking is control. Using the appropriate benchmarking process helps senior management readily assess the risk profile of the hedging programs, as well as returns and deviations thereof. All are key factors to ensure that risk policies are properly implemented. Feedback from the benchmarking process enables management to evaluate if corrective measures to the risk management process are necessary, to determine whether the company’s risks are within acceptable limits, and in determining whether risk management objectives are being achieved.
The majority of today’s corporate treasuries are defined as cost centers. However, few have specified benchmarks that properly encompass and quantify all aspects of treasury risk management. One plausible reason is that historically very little attention has been given to assessing the true business risk a treasury manages, or identifying treasury activities as valued added. However, recently many treasurers have instigated a review of the existing treasury function. Although motivation varies from firm to firm, the necessity to quantify and identify corporations’ treasury risk profile is becoming more broadly recognized. It is, therefore, increasingly important to measure the performance of hedging programs. This measurement cannot be effective without the definition of references, both in terms of expected performance as well as hedging strategies. To achieve this goal, it is important to take into account not only the company’s constraints and specifically defined hedge objectives, but also industry-specific parameters.
Although most corporations’ ultimate goal in risk management is to reduce volatility to earnings, benchmarking is not a ‘one size fits all’ concept. For example, a UK company’s strategic concerns over the fluctuating value of a manufacturing plant located in the US will most likely be very different than short-term exposures such as FX-denominated cash flows. The benchmarking process for both types of exposures will, therefore, also be different.
Benchmark Rates versus Benchmark Strategies
Prior to examining the attributes of a sound benchmark and various strategies, it is critical to define what a benchmark strategy entails and how it differs from benchmark rates. Although closely tied, the two concepts, both in terms of methodology and goals, are often perceived as being one-and-the-same. This could not be further from the truth.
Benchmark rates
Benchmark rates are essential tools in performing variance analysis of business performance. The primary purpose of a benchmark rate is to establish ‘stake in the ground’ exchange rates for evaluating the performance of business results of foreign operations. For example, benchmark rates would be used for any of the following purposes:
- Evaluating revenue growth in a particular quarter to the same quarter from the previous year based on a comparison of average exchange rates is an important analysis tool. Discussions of financial performance in annual reports are usually based on this type of year-on-year comparison.
- Some companies have been able to determine a level of exchange rates that are of strategic importance to the company’s performance. For example, a company may determine that ‘we are not profitable selling our products in Europe at levels below €1.1500/US$, or, current product pricing for the next quarter is based on an exchange rate assumption of €1.2300/US$.
- The balance sheet rate for re-measuring existing FX-denominated monetary assets/liabilities is an important benchmark rate since re-measurement gains and losses are recorded directly in earnings each accounting period. Success in the hedging of these exposures is very often based on the degree to which changes in spot exchanges rates are offset from period to period.
- The budgeting process depends on setting budget exchange rates to translate forecasted business results of foreign operations. These rates are extremely important for many companies since they are often the basis for making earnings forecasts to equity analysts and shareholders. They are also commonly used for measuring the performance of business managers of foreign operations and are often a major driver behind executive compensation.
How these rates are determined vary from company to company. For example, budget rates may be set based on bank forecasts, average outstanding hedged rates, current spot and/or a weighted average forward rates, or are set after internal negotiations between treasury and the business units.
It may also be easier for some companies to identify these strategic exchange rates than others. For example, a company that has a single foreign competitor in a market where the currency exposures are readily identifiable may have an easier time of identifying a strategic level of exchanges for its business than another company with more complicated exposures. A company that fully integrates FX risk management into its business strategies is more aware of how FX risk impacts its underlying business since hedged rates are an important factor in how products are priced.
Benchmark strategy
A benchmark strategy, on the other hand, can be defined as the combination of hedge instruments that best achieves the reduction of risk within set limits as described in the company’s policy. Typically, this strategy should be passive in nature but the characteristics of the business may decide otherwise. In most cases, a benchmark strategy should be the best strategy you could possibly implement if you had to walk away from it and let it mature without being able to touch it. It must take the characteristics of the risk into account, such as:
- The cash flow implications of the underlying risk.
- The uncertainty around the exposure from a notional and tenor point of view. For example, a business where revenue streams are volatile should consider a greater proportion of options in its benchmark strategy than a business with historically consistent cash flows.
- The business pricing process and how it affects the company both from a competitive and a performance point of view.
More generally, taking the characteristics of the risk into consideration means that several benchmark strategies may need to be defined depending on the nature of the exposure that’s being managed. A benchmark strategy should also reflect the corporation’s risk/return tolerance level as quantified via the methodology defined in the policy.
- It must meet the objectives of the hedging guidelines.
- It must represent an actionable alternative.
- It should respect the list of instruments permitted in the risk management policy, provided that risk profiles have been identified appropriately.
- A sound benchmark strategy must be replicable and its performance easily measurable.
Beyond these very specific attributes, a benchmarking exercise should also take other variables into consideration. Factors should include the quality of earnings, the stability of cash flows, the existence of negative debt covenants, and the entity’s credit rating. A corporation with a strong credit standing will be less sensitive to foreign exchange volatility, can facilitate higher risk thresholds and hence enable a more flexible hedging and benchmarking approach. A company that is a weak credit and has restricted credit lines may not have access to a broader scope of risk management tools and may be prohibited from entering into hedges of longer-term exposures. Equally important, the cost of capital associated with hedging will be significantly reduced for companies with strong credit compared to a lesser credit-worthy corporation. Commonly applied measurements include, for example, weight-adjusted cost of capital (WACC), internal return on equity (ROE) and risk free rate of return.
A corporation’s size, competitive position, industry-based volatility and peer practices should also be considered. It is important to recognize that a company’s benchmarking process should not only be based solely on ‘competitor practice’, but encompass the corporation’s individual goals and objectives as well. In fact, the exercise of defining a benchmark strategy should be instrumental in helping a company define its competitive position from a business perspective.
When setting a benchmark it is important to have a clear and transparent organisational structure and a format for making policy decisions. This mechanism is often in the form of a foreign exchange or a financial risk management committee. Traditionally, the committee will comprise both the CFO and treasurer, but should also include representatives from the strategy and control departments, legal, finance, and the controllers group. Input from the strategic department is particularly important since it is essential that the FX risk management process include insight to the corporation’s short-, as well as long-term strategic objectives, business risks as well as possible peer practices. All are key components when implementing a benchmark strategy.
The controllers group is also an important member of the risk management committee. They should be independent and ensure all trades, quantification of risks, and reporting standards are in line with corporate guidelines. The advent of Sarbanes-Oxley has been a catalyst, in many cases, in this process (ref. section 404 of Sarbanes-Oxley) particularly for US listed companies.
Using a Benchmark Strategy
In practice, companies usually use benchmark strategies in one of two general ways:
- As a hedging guideline that drives the company’s hedging program. These risk management programs are usually implemented passively and in such a way to achieve a level of risk reduction as defined by the benchmark. In this case, the company’s actual risk management results will be equal to the results of the benchmark strategy.
- As a means of comparing the results of the actual risk management program – that may differ entirely or in part from the benchmark strategy – to that benchmark strategy.
A company’s actual risk management program may differ from the benchmark strategy for a number of reasons. For example, a company may use market timing and market views to drive hedging decisions. How much the actual hedge program differs from the benchmark position varies from company to company, but a best practice would be to limit the amount of risk taken to defined levels.
The benchmark should be able to provide senior management with enough information to determine whether the strategies based on taking a view are effective in adding value over time. If the answer is ‘yes’, then this would encourage senior management to continue this strategy going forward. If the answer is ‘no’, then senior management should be forced to rethink their objectives or to change their strategy. The most important characteristic of a benchmark is that it needs to be actionable; the benchmark is actually a hedged position that the company could and would enter into as a passive alternative. If the benchmark is unrealistic, then the performance evaluation will result in meaningless results.
Conclusion
In this article, we have defined the various concepts that form the overall notion of benchmarking as well as identified the benefits of implementing such a process. With a clear understanding of what all the moving parts are, we can now more confidently tackle some of these aspects in further detail. In a follow-up article, we will explore how to choose a benchmark strategy as well as how to incorporate peer practices in that decision. We will then be able to take this issue to the next level and set the stage for implementing benchmarking in the context of an active currency management program.