Managing Currency Risk: How Do Mid-Size Companies Meet the Challenge?
Large, global enterprises may manage currency exposure over dozens of currencies and hundreds of subsidiaries. Fortunately, while the challenge is great, so are the resources and expertise. These companies have invested tremendous resources over many years to develop in-house knowledge on the unique aspects of currency risk. They have systems to automate the tracking and reporting of exposures. For some, sophisticated measurement systems such as value-at-risk are employed to evaluate risk and establish derivative trading parameters. Additionally, there are specialized software applications that track and account for outstanding hedges and their underlying risks.
For mid-size companies in the US, those enterprises just below the Fortune 1000, the picture is entirely different. These companies may be on a rapid growth trajectory that has taken them to overseas markets for the first time. Even for those companies that continue to operate exclusively within the US, they may have moved their supplier relationships offshore. At the very least, these companies are recognizing that they now compete in a global marketplace. For these companies, there is an emerging concern that foreign exchange exposure presents a real and present danger. The question is, when treasury resources are stretched already, how do you meet the challenge?
One such mid-sized company contacted Treasury Strategies earlier this year regarding establishing a currency risk management program. This company, a US$500m revenue generating telecommunications software company, was expanding rapidly in Europe and East Asia and needed to set up a currency risk management program. The project was to perform in-depth interviews with peer companies to ascertain how other mid-size, growth-oriented organizations were facing the challenge of currency risk. For the several weeks that followed, Treasury Strategies interviewed 14 US-based companies with average revenues near US$1bn. Most companies came from growth industries offering high-growth trajectory, high value-added products. These companies provide products such as advanced medical devices, scientific instruments and encryption software. Though too small to be in the Fortune 1000, respondent companies were experiencing strong growth in the European, Asian, and Latin American markets.
Our interviews encompassed the entire risk management cycle. Beginning with questions such as “How do you define currency risk?” and ended with details of FAS 133. Between those end points, we were able to develop a complete picture of how a growing company approaches the issue of foreign exchange risk. Frankly, the results surprised us.
We had expected that these companies, new to the currency risk management challenge, would be struggling to develop a logical framework for addressing currency risk. What we actually found was quite to the contrary. Mid-sized companies have their bases covered with respect to trading, accounting for derivatives and so on. Their biggest frustration is in large part a practical challenge – obtaining accurate and timely exposure data.
For companies reviewing their approach to currency risk management, one option is a five-step approach. This begins by defining the type of currency risk to be managed. If treasury, executive management, and the business units don’t agree on which risks are important, you will not have a strong foundation for the program. Next, determine how to measure the risk. In essence, this determination will identify what treasury reports to executive management on the weekly dashboard. Then, establish an efficient process for gathering exposures in a timely fashion. Information gathering is an area with which many companies struggle. Once the exposure level is understood, the next step is to determine a strategy to manage this risk. It’s important to note here that staying exposed can be just as wise as hedging. As an example, McGraw-Hill employs a sophisticated process to measure value-at-risk on its FX exposure, but doesn’t hedge them, having determined they are comfortable with the enterprise-level risk created by these positions. Finally, if a company is going to hedge, it must have an efficient and compliant process for executing, tracking, and accounting for hedges.
Currency risk is in the eye of the beholder. For some US companies, it is the risk of reporting foreign exchange transaction losses that is the sole concern. Other companies view financial statement translation under FAS 52 as an important exposure. Others take a broader, economic view of the effect of exchange rates on long-term business performance. In our interviews, we defined four categories of currency risk and asked these companies where they placed the highest priority:
The majority of study participants viewed transaction risk as the highest priority. This ranking did not surprise us, as transaction risk is clearly measurable and its effects are reported directly as gains or losses in operating income. The second priority was forecasted risk. We found nearly all companies recognized that forecasted transaction risk is equally important as booked exposures. However, only a few respondents were fully comfortable with accurately forecasting these exposures. Translation risk was identified as a low priority. Finally, economic risk was viewed as a high priority for very few companies. Although we found that these treasurers think economically about currency, they do not have the resources or senior level support to develop the analytical models needed to capture complex exchange rate relationships.
Our mid-size companies were using the traditional methods of gathering exposures. Most common was a monthly spreadsheet with booked and forecasted transaction exposures that each business unit e-mailed to the treasury department. A few companies were able to access the general ledger to directly gather exposure data for the business units. Other companies had not established a clear program for tracking exposure. They relied on informal communications and investigations of major sources of currency risk.
More interesting were the common challenges the companies shared with us. Treasurers struggled with gathering timely exposures monthly when the close cycle may take as long as two weeks. For companies attempting to forecast exposure, the challenge could be even greater. One company followed a process each month of close, review, reforecast of month-end exposure position, and hedge. By the time the company actually placed the hedge based on this forecast, month-end was only two weeks away. When asked what they considered the greatest challenge to managing currency risk, respondents identified the practical challenge of obtaining accurate exposures in a timely and efficient manner their greatest frustration. These frustrations far surpassed the more commonly cited challenges of trading derivatives and qualifying for hedge accounting:
| No. of Companies | Top Challenges |
|---|---|
| 7 | Getting timely and accurate reporting of exposures from business units |
| 4 | Obtaining accurate forecast of non-booked exposures |
| 3 | Resources and information to perform economic assessment of currency risk |
| 2 | Designing optimal balance sheet structure that minimize non-functional currency balances |
| 2 | Monthly exposures stale by the time balance sheet is closed |
| 2 | Lack of policy and procedures: no program in place |
| 2 | Lack of automation in consolidating exposures (reliance on Excel) |
| 1 | Forward points on long-dated forwards |
| 1 | Concern, unfamiliarity, lack of resources to handle derivatives |
| 1 | Complying with FAS 133 |
Once a company has measured its exposure, the next step is to determine how best to manage the exposure. There are several options available, such as:
Those study participants who hedge rely heavily on plain vanilla forwards for coverage. Forwards permit companies to lock in an exchange rate and, assuming the exposure estimate is accurate, eliminate the risk entirely or up to a target coverage level. A typical company would establish coverage levels for varying timeframes. For example, they would hedge 100% of booked exposures, 50% of forecasted exposures over the next rolling 12 months, and 25% of forecasted exposures over the next 12 to 24 months.
A few companies occasionally utilized vanilla options. Options are a popular technique when the company does not want to commit to a hedge position or is concerned about lack of an off-setting accounting gain/loss. For example, one company used options to hedge anticipated acquisitions. The company was concerned about the risk of taking a forward position on a commitment that is off balance sheet and could create a derivative loss with no offsetting gain. It was interesting to note that mid-size companies exhibited little interest in the myriad special features that may be attached to derivatives. For these companies, the flexibility and sophistication provided by forward/option hybrids such as range options and participating forwards was not as critical as correctly measuring exposure and calibrating the right hedge ratios.
Finally, it is critical to bear in mind that non-derivative hedging techniques can also be highly effective. Partnering with business units and procurement functions, treasury can influence business decisions such as currency of invoicing in order to reduce exposure. One company we talked with required treasury to approve any sales contracts not denominated in US dollars. Treasury would then recommend whether a currency clause should be included in the contract that would protect both the company and the customer from exchange swings outside of an agreed-upon band.
When it came to the final steps of executing hedge trades and properly accounting for outstanding derivatives, the mid-size companies we spoke with were generally comfortable with their practices. These mid-size companies were maintaining a relatively small book of derivatives. A typical program consisted of covering around five currencies among five to 10 divisions. Each month, treasury would re-measure the exposures, aggregate them across the business units (sometimes netting exposures between business units) and then trade one forward for each currency and month. Most of the companies worked with their bank, either trading on-line or by telephone. Only a few participants regularly bid their trades or utilized an auction portal.
Surprisingly, only one company identified FAS 133 as a significant challenge in managing currency risk. In fact, a number of respondents had not chosen to elect hedge accounting for their program, citing the short tenor of their positions. For the companies hedging booked exposures, there was simply no need to defer derivative losses since the underlying exposure was a recorded item. For companies hedging forecasted exposures and electing hedge accounting, the principal challenge was to ensure that the derivatives could be matched successfully to a pool of exposures with the same time horizon. By hedging only a portion of forecasted exposures (with a smaller portion for more distant, less accurate exposure forecasts), the company was able to ensure a reliable level of underlying exposure with which to demonstrate effectiveness.
Several of the companies we spoke to had simply not been able to establish a currency risk program. In the larger universe of mid-size companies, we suspect the proportion of companies needing advice and help in this area is even larger than suggested by our interview participants. Additionally, it is clear that the operational challenges of managing exposures far exceeds other concerns such as developing more sophisticated trading activities. We expect these companies will devote scarce resources to operational improvements that improve efficiency and control such as through the utilization of treasury technology.