Cash & Liquidity ManagementFXThe challenges in FX exposure management

The challenges in FX exposure management

The importance of FX risk management has grown significantly over recent years on the back of international expansion, high levels of market volatility, and regulatory and accounting changes. Alankar Karol of GTreasury draws upon the challenges for treasurers and how to tackle these.

Foreign exchange (FX) risk management has always been fundamental to treasury’s responsibilities. However, its importance has grown even more significantly over recent years, driven by international expansion, high levels of market volatility, and regulatory and accounting changes.

Consequently, treasurers are becoming more active in monitoring and managing their FX exposures, and reviewing and refining their policies more regularly. For small and resource-strapped departments, however, the challenge is how to manage the increased scale of risk, and therefore potential impact on corporate earnings without creating additional operational overheads.

The FX imperative

Companies of all sizes and industries are expanding internationally, pursuing new sales opportunities and extending supply chains. As a result, treasurers are managing exposures of increasing scale in a greater number of currencies. This adds operational and financial complexity, particularly given that each currency cycle can differ considerably.

High levels of volatility have become a market norm, driven not only by economic indicators but global geopolitics and increasingly frequent ‘black swan’ events. For treasurers globally, the ability to achieve timely, accurate and complete visibility over FX risks and to pursue more flexible hedging solutions to manage them has become a priority.

It is not only the market environment that is prompting a greater focus on FX risk management strategies: regulatory change is also influencing treasurers’ approach to hedging. The global financial crisis in 2008-9 exposed the limitations of existing hedge accounting regulations, most notably IAS 39.

In many corporations, risk management policy had been influenced more by the need to achieve hedge accounting treatment than the earnings risk itself. This often led to sub-optimal and inflexible approaches to hedging, frequently described by the more cynical as “the accounting tail wagging the treasury dog”.

With IAS 39’s replacement, IFRS9 coming into effect, however, treasurers are now able to tailor their hedging approach more precisely to their business risks, and therefore be more proactive in reducing the impact of FX volatility on corporate earnings. Many are starting to look at a broader spectrum of hedging strategies, including building optionality into their hedging portfolios, and are therefore looking to their treasury and risk management systems (TRMS) to support a wider range of instruments, including valuation and accounting treatment.

“With IAS 39’s replacement, IFRS9 coming into effect, however, treasurers are now able to tailor their hedging approach more precisely to their business risks, and therefore be more proactive in reducing the impact of FX volatility on corporate earnings.”

Limitations in FX approaches

While the combined impact of internationalization, volatility and regulatory change may have pushed FX risk management up treasurers’ list of priorities, however, there remain a variety of challenges.

Many treasurers find it difficult to identify their FX exposures in the first place. These are typically generated across different parts of the business, so the information on which treasurers make their hedging decisions may be fragmented, inconsistent or incomplete. Inevitably, treasury is better placed to manage FX exposures if it is of high quality, complete and provided as early as possible.

In many cases, treasury only receives this information once invoices have been raised, so the risk has already been crystallized. In other cases, treasurers develop their hedging strategies based on budget positions that ultimately bear little resemblance to actual flows, leading to significant mismatches and ultimately a greater risk to earnings.

Secondly, even where exposure information is available and where FX policy permits a precise approach to hedging in line with the company’s specific risks, many treasurers lack the tools to achieve this. Treasurers need the ability to visualize their exposures and the impact of actual or proposed hedging strategies to make effective decisions, as well as the ability to manage the revaluation and accounting treatment of hedging transactions.

Without these capabilities, many treasurers are forced to adopt a less proactive or precise approach than they would wish to do so given their business risks. In other cases, treasurers are managing their exposures in only a handful of currencies, leaving substantial risk to earnings because of volatility in smaller currencies.

From operational to strategic exposure management

While in the past, access to flexible, comprehensive risk management solutions may have been limited to the largest multinational corporations with the most sophisticated treasury management functions, this is no longer the case. Today, treasuries of all sizes and levels of complexity are embracing the opportunity to visualize, model and manage their risk management exposures more effectively, and therefore add significant value to their organizations.

The first step is to identify global exposures, which is more difficult if treasury activities are decentralized. Consequently, many companies are choosing to centralize some or all aspects of financial risk management and channeling exposure information from across the business into a single regional or global treasury center with a central TRMS.

Some choose to build interfaces directly between the organization’s enterprise resourcing planning (ERP) tools and the TRMS to capture this forecast or actual exposure information. In other cases, business units may update the TRMS directly with FX exposures, and maintain this data periodically.

In both cases, data can be updated regularly to reflecting changing forecasts, and as forecasts are replaced with actual purchase orders or invoices. By integrating and streamlining processes for collecting and consolidating exposure information, treasury achieves accurate, complete visibility over global exposures, and can redirect its resources from collecting to analyzing and managing these exposures.

With exposure information in a single location, treasury is then in a position to visualize these exposures together with existing hedges. Some choose to overlay these results with a benchmark hedge portfolio. Treasurers can then report on, revalue and monitor the effectiveness of an existing or proposed hedge portfolio, stress test against different market scenarios according to varying degrees of severity and/or probability, and model the impact of alternative hedging strategies.

Eliminating friction: an end-to-end approach

Most treasurers stop here in their FX exposure digitization strategy, and then add or adjust hedges manually based on the information provided by their TRMS. This creates a point of friction and the risk of error in operations or judgment. However, the potential for further automation and straight-through processing through a combination of sophisticated data analytics, machine learning and systems integration is now becoming a reality.

Traditionally, a treasurer may decide what hedging transactions to perform based on the reporting provided by the TRMS, call his or her banks for competitive quotes, check counterparty credit limits, execute the transactions and record these transactions in the system for settlement, reporting and accounting. This takes time, resource and introduces the risk of error.

However, treasurers should now be looking for their TRMS to recommend the required hedge transactions based on a user-defined logic that reflects the company’s FX and credit risk management policy. If the treasurer accepts these transactions, they can be transmitted directly to an online dealing platform, checked against credit limits, executed according to the company’s counterparty policy and recorded in the system automatically, all in a single step. Settlement and confirmation then take place according to the appropriate segregation of duties.

“However, treasurers should now be looking for their TRMS to recommend the required hedge transactions based on user-defined logic that reflects the company’s FX and credit risk management policy.”

The benefits of an automated FX hedging approach in combination with a comprehensive risk reporting and modeling approach are considerable. Hedging decisions are made objectively and in line with both FX and credit policies. Transaction processing and integration are seamless. This end-to-end approach to FX exposure capture, analysis and hedging allows treasurers to spend time on analyzing and refining the effectiveness of their hedging policy and exploring potential hedging strategies.

By doing so, they can develop more precise ways of optimizing hedge effectiveness, minimizing costs and therefore managing the impact of FX volatility on the business. This positions treasury to support further international growth without creating additional complexity or capacity constraints, adding tangible value to the business and facilitating success.

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