This document is intended to help a company write its FX Risk Management Policy. Benefits of an established policy include senior management buy-in, clear guidelines to avoid misunderstandings, and fair evaluation of Treasury personnel performance. The main objective is to put in place an auditable framework that addresses company objectives, risk definition and tolerances, controls over processes, accountability and performance measurement. Additionally, it defines who will manage the risks and the latitude given to the risk manager, and the parameters for measuring their performance and effectiveness. It may even define Board oversight responsibilities over Treasury risk management operations. The items included in this paper are not an exhaustive list, but provide examples and best practices.
Interviews with Treasurers, reviews of industry surveys, and other sources have led us to identify 8 Key Success Factors which are common to all successful FX Hedging programs. They should be codified in every companies policy.
Centralize FX trading and risk management (enhanced netting opportunities, efficient settlement, centralized third party foreign currency receipts and disbursements)
Adopt uniform FX accounting procedures across entities
Manage forecast error (for companies that hedge forecasts, hedge errors are most likely due to forecast errors. Issues arise when local units are not charged for FX G/L)
Measure hedge performance against metrics and related benchmarks
Segregate back office functions (trading and settlement)
Measure and manage counterparty risk
Measure FX risk (using VaR, sensitivity analysis and stress testing)
BoD risk committee oversight
Company-specific policy content can be divided into 8 different categories. These categories are where a company customizes its policy to match its strategies and goals.
FX hedging objectives
Procedures & Controls
Limits (FX risk, counterparty risk, derivative types and position size)
Minimization of transaction costs
Minimizing counterparty risk
The balance of this paper offers detailed examples, guidelines and lists for each of the preceding 8 categories to guide the company in the development of its own Policy.
1. Hedging objectives
Any hedging program should be guided by objectives. Sample objectives include: eliminate FX risk, minimize hedge costs, hedge to obtain competitive advantage, minimize FX volatility over multi-year horizon, and add value through active hedging or speculative positions
If objectives include adding value through active hedging or speculation, guidance is needed to allow or disallow specific risky actions: closing out hedges prior to maturity, leaving positions open; keeping successful hedges on even if the original forecast underlying exposure disappears; increasing a net position with a derivative; and reversing a net position with a derivative (e.g., making a net long position short).
FX risk is found in many areas. The policy should specify which are important and should be hedged, and which are not. They include: third party booked transactional exposures; intercompany booked transactional exposures; third party or intercompany debt; contractual future foreign currency commitments (e.g., multi-year contracted capital expenditure payments in foreign currency); anticipated but not yet booked future foreign currency revenues and expenses; foreign unit earnings (i.e., P&L translational exposures); foreign unit booked and anticipated dividends; and foreign unit balance sheet equity.
2. Performance Metrics and Benchmarks
Establishing metrics for FX risk management is essential to ensure that risk management activities can be measured and changed if required, and to ensure the finance group does not suffer under unrealistic expectations.
A metric is a number which measures performance. A benchmark, or standard, is how we determine whether the performance we measured is acceptable. A metric is useless until it is compared to a performance standard. Performance metrics are often referred to in the corporate world as Key Performance Indicators, or KPIs. KPIs can follow the "SMART" criteria: Specific purpose, Measurable, Achievable, Relevant, and Time-phased (the value or outcomes are for a specific, relevant period). Useful KPI concepts to consider when developing your own metrics include choosing leading vs. lagging indicators (leading indicators let you fix things before they get worse), and dashboards- graphic displays which show at a glance where the trouble spots are (perhaps by currency, region, or entity). As a general rule, the fewer KPIs tracked, the better.
Useful metric categories include i) reducing operating flow volatility (e.g. income and expenses), ii) reduction of risk (from a statistical view), and iii) reduction in cost of hedging.
i) Metrics for reducing volatility include net revenue variance, and EPS attributable to FX. The latter is gaining wide acceptance, and often included in quarterly earnings reports. One common benchmark for that metric is keeping EPS (attributable to FX) to less than 0.01/share.
ii) Risk reduction metrics include scenario testing, probabilistic Earnings at Risk, and net gain/loss on contracts vs. exposures. Hedge effectiveness (in a FAS 133/IAS 39 sense) is also a strong risk reduction metric.
iii) Metrics for reduction of cost of hedging include total volume of hedge contracts, total points and premiums paid as a percentage of hedge notionals, and FX counterparty bidding performance.
3. Processes and Controls
The FX risk environment is very complex - numerous exposure currencies, entities, contracts, forecasts, accounting periods, counterparties etc. To effectively manage FX risk, processes must be designed to manage the data. There should be a process for managing balance sheet risk (remeasurement risk), utilizing best practices for forecasting the balance sheet (including forecast revenues and cash deliveries), setting accounting rates, and functional currency liquidity provision. There should be processes for managing income statement (forecast cash flow) risk, utilizing best practices such as layering hedged, variable hedge ratios, triangulation of cross-currency exposures, etc. Ideally, both balance sheet and cash flow hedging processes are integrated, repurposing cash flow hedges maturing in the current month into balance sheet hedges. The policy should proscribe specific processes to avoid unpredictable results and chaos.
In every trading environment, control procedures should be a fundamental part of the daily routine. These measures will help catch honest errors, and reduce the likelihood of any improper trading activity.
Controls need to address confirmations and record keeping, whether paper or electronic. Most companies expect same day telephone confirmations for each trade, and specify that someone other than the original trader must verbally confirm the deal. Written confirmations should be sent to a separate area from the trading function—usually a control or audit division of the company. They should obviously be sent to the attention of someone other than the initiator of the transaction. Both verbal and written confirmations must be checked carefully. Any discrepancies must be immediately resolved with the counterparty to the trade, to avoid major trading losses. Corporate control areas can monitor written confirmations to ensure adherence to foreign exchange policies and guidelines. The confirmation process not only helps avoid or reduce serious trade disputes, it also provides a valuable internal check from a policy enforcement perspective.
Some questions to address in the policy include:
Who are the account administrators?
Who approves the account administrator changes?
Who has the authority to authorize trades (outside the system)?
Who has the authority to complete the trades on the system?
How are trades confirmed and compared (manual vs. automated)?
Electronic trading issues
New bank product development poses additional issues. For example, hybrid products can pose definitional problems that must be addressed to avoid confusion. For example, is a forward participation agreement a forward or an option for control and reporting purposes? The product functions like a “flexible forward” but is actually a hybrid options product. These nuances may seem trivial, but they can produce serious problems for a treasury manager trying to explore alternative hedging strategies.
Management should present regular (quarterly or semi-annually) reports to the Board detailing the net foreign currency exposure for balance sheets hedges, cash flows hedges, and speculative trading results. A summary of the hedge trading metrics compared to benchmarks over the quarter should also be provided.
In addition, the CFO might be required to certify a number of items, including:
A statement by the CFO as to whether or not, in his or her opinion, all of the FX hedges entered during the period of the report are consistent with the Corporation’s FX Hedging Policy;
A statement by the CFO as to whether or not, in his or her opinion, all of the FX hedges entered during the period of the report are consistent with all applicable regulatory or statutory policies.
Limits should be in place regarding a number of trading parameters, as well as FX Risk metrics.
Limits should be placed on total outstanding contract notional and tenors. This limit might be described in aggregate, or per trading counterparty.
Limits should be placed on allowable instruments/products to be used in FX hedging activities. Here is a representative list: spot contracts, forward contracts, NDFs, range forwards (collars), FX swap contracts, purchased FX option contracts, sold (written) FX option contracts, purchased barrier options, exchange-traded options, exchange-traded futures.
Limits and thresholds should also be in place for FX risk, as measured by Value-at-Risk, stress testing and scenario testing, according to established metrics.
6. Minimization of transaction costs
A corporation has a duty to minimize costs, and that includes trading costs. The first place a firm should look for opportunities to reduce hedging costs is to utilize natural hedges (offsetting revenues with expenses). Natural hedges reduce the need for derivative hedges. Another tactic is for the company to enter into FX risk-sharing contracts with its suppliers and customers. After these (and other alternatives) have been exhausted, then derivative hedging must be used to manage risk.
7. Minimizing counterparty risk
For the very largest (> $1B) companies, counterparty risk is a material issue, and should be addressed in the policy. For smaller companies, it is truly a non-issue. It is anticipated that for most readers of this document, this section is irrelevant. However, for completeness sake, we include the following discussion.
An International Swaps Dealer Association (ISDA) Master Agreement is the cornerstone of any transactional relationship between two parties engaged in OTC financial transactions. It should come as no surprise that ISDAs between corporations and banks have traditionally been rather one-sided. If a company’s credit rating is downgraded beyond a certain level, its banking counterparty will notify it that it has triggered the terms of its CSA and that it needs to post additional collateral. But even if a bank actually defaults on a corporate customer, the company will likely have no opportunity to collect any collateral.
For example, a typical CSA might call for the exchange of collateral if either party’s credit rating is BBB or lower. The company may be able to operate for quite some time with a BBB rating, or even at a below-investment-grade level. If the company’s credit rating were to drop to BBB, the bank would have ample opportunity to obtain collateral under this CSA. However, if a major bank’s credit rating fell to BBB that would likely be the straw that broke the camel’s back. The bank would no longer have sufficient capital to post collateral, and its cost of funds would have already increased to a level that makes operating as a bank problematic. The bank would be much more likely to default at this same credit rating, so a CSA with these terms would provide a false sense of security to the corporate counterparty.
What should a treasurer do to level the credit-risk playing field? First, it’s imperative to monitor counterparty exposures on a timely basis and to set triggers for action. These triggers should be based on real-time indicators of a bank’s risk of default, such as its level of credit default swaps (CDS). As the bank approaches the limits you’ve set, reallocate your short-term trades and/or cash deposits as much as possible.
For longer-term exposures, such as cross-currency interest rate swaps or long-dated forwards, consider posting margin utilizing the services of a third-party collateral manager. Collateral managers accept and remit collateral based on the mark-to-market status of the outstanding trades to each financial counterparty. Companies and their banks need to spell out in their CSAs both the role of the collateral manager and the objective measures of risk that will be used to set collateral requirements for both parties.
8. Hedge accounting
Hedge accounting is a very complex subject. In addition, we are not accountants and unqualified to comment on hedge accounting choices. Many regulations apply, including FAS 52/IAS 21, FAS133/IAS 39, FAS 161 and others, and they are under constant revision. In addition, local regulations (such as UK GAAP) are being re-aligned to conform to IFRS. We recommend that you consult with your accounting firm to write this portion of your FX Risk Management Policy.
It should be obvious by now that a FX Risk Management Policy is tailored to the objectives of each individual company, and that only guidelines and suggestions can be made to assist in the writing of the policy. It is also evident that a great deal of work and thought must go into the writing and approval of the document. However obtaining senior management buy-in, establishing clear guidelines, and ensuring fair evaluation of Treasury personnel performance is well-worth the effort.
Appendix A: reporting currency, functional currency, and designated currencies to hedge
Appendix B: approved counterparties