What are the benefits of cash flow at risk (CFaR) and earnings at risk (EaR) and why should more treasury teams be embracing it?
For the corporate treasury department, there usually needs to be some pain first before doing something about it. There could be some volatility in earnings that can’t be explained by the best practice hedging strategy and the percentage bandwidth that exists within it. Only then do they realise that the best practice model doesn’t work, and the reality is they’re just performing a liquidity play for the business.
If you think about how percentage hedging works, your business unit sends you a forecast of your currency exposures, and then you either hedge them 100% and you take all the risk centrally, or you hedge the percentages of that business unit’s exposures and leave some of the risk there.
If you’re a UK company and you have a European entity that has some forecasts in foreign currencies, you’re only reporting the foreign currency elements. What you’re not thinking about is the impact of those forecast and hedging on the group in Sterling terms on reported earnings.
Public companies usually have best practice policies around percentage hedging of currency exposures, however, they still make announcements of falls in earnings or falls in revenue due to exchange rate movements. So, how can it be best practice?
Treasurers need to think about what the impact is on their group, and how FX rate movements are impacting earnings. You start looking at earnings at risk and say, ‘Okay, now I can see these two working together’. Unfortunately, until now, this is usually a reactive rather than a proactive movement.
What can be done to encourage treasury to get on board with this before they take a hit or experience too much pain?
It needs a mindset shift and that starts with education. The good news is that there is a lot of interest. Bloomberg held a webinar in July 2019 with several clients and nearly 700 subscribers. We are starting to see people questioning best practice.
When I started in treasury in the 1980s, the consulting houses started saying this is best practice. So, for nearly 40 years they’ve been following this approach of best practice, and no one’s really challenged it until now.
Why do you think that is?
Complacency – They accepted that this is best practice, they inherit the process, no major disasters have happened, or if they do, they’ve gotten away with it.
No one’s challenging themselves by asking what they’re doing and looking into the underlying risks of the business. You learn the process that’s been done before you come into your new job, and then you start doing exactly what the previous person did. And the process repeats itself.
People should focus on the underlying risk and whether they are really reporting the right numbers. Are they really doing the right things?
How can technology improve the picture?
CFaR and EaR are tools that have been around for a long time. But there has been an adoption problem because people don’t understand how they can leverage them.
It has changed by optimising the link between the two and thinking about the impact of hedging based on the cash flow forecasting being done today on earnings. Having an optimisation tool enables treasurers to make some very specific and targeted hedging strategies and have a different conversation with the board.
A company board makes risk decisions all the time. They make acquisitions and decide based on the risk for the company of that acquisition being successful.
You mentioned your webinar earlier. During that discussion, there was a comment that it took too long to implement a new policy. Is this somewhere where the latest solutions can really help?
The latest solutions make the process much simpler to adopt more complex policies. For example, trying to explain percentage hedging when it is not equated to KPIs is much more complex than saying, ‘I can now manage the amount of FX risk I have on my earnings, and I can measure my performance against my KPIs and on my earnings per share’. These are important discussions to have with your board.
At board level, it is much simpler than it is for the treasury department because treasury needs to understand the models, the underlying risk of the business and how they are managing it, rather than just following best practice. It is tough because they will be going against the grain of 80% of companies who are supposedly using best practice hedging strategies. It requires a lot of effort to go into the granular detail of their own business, how it would work and then back test it. Putting in effort in the front end and leveraging the technology to do it can really help.
Are we going to see a real rush from treasury to embrace new CFaR solutions, or is it something that continues to develop or evolve slowly?
I think the adoption model will be standard where early adopters will recognise this and realise there was a problem to start with. Then, you will see a bigger flow as this grows and there will be acceptance that there is a need for change. That comes from more conversations, more education and more debate.