Managing FX Risk

ManagingFX Risk

An Eight-Step Plan to Establish a Corporate Foreign Exchange Policy

The following is an interesting article from the Wells Fargo Treasury & Risk Magazine. It was written by Dave Napalo, Senior Vice President, Foreign Exchange Division, Wells Fargo.


Following the corporate failures of recent years, the Sarbanes-Oxley Act (SOX) has set in motion a grounds well of changes in corporate governance and risk compliance. Corporations have been challenged to respond to the proliferation of new standards that establish measurements for good risk management practices. The requirement for impeccable financial controls has touched virtually every area of a company’s business. The reach of SOX has clearly extended to the practice of foreign exchange (FX) risk management, an area already thrust into the spotlight due to the market volatility  that has prevailed for some time. As a consequence, many corporations have undertaken an assessment of whether their FX risk management practices are appropriate for their underlying exposures, as well as whether their financial controls pass muster in a SOX environment. As part of that process, a sound formal policy for FX risk management is a major  step towards satisfying the new standards for financial controls. The policy must lay out clear mandates for action and governance with clearly defined responsibilities. To craft a policy, we recommend an eight-step approach:

STEP ONE: DEFINE CORPORATE PHILOSOPHY AND OBJECTIVES

The first step is to establish a framework for the policy. It outlines the principal business lines and overall corporate objectives and stipulates those areas where the company is prepared to take risk. For example, a company in the laser technology field might recognize that risks necessary to remain at the cutting edge of research cannot be hedged away. Conversely, most companies will identify risks that can be hedged away – for example, foreign exchange, interest rate and commodity risks that may affect financial performance. In most cases, companies state their intention to offset their FX risk since it is not an area in which the company has a competitive advantage.

STEP TWO: IDENTIFY EXPOSURES  

The next step involves identification of major exposures – generally, these exposures are grouped under the headings of transactional, translational and economic exposures. Transactional exposures wouldrelate to buying or selling in any foreign currency. Translational exposures would relate to protecting the value of overseas investments and reported income. Economic exposures might be the most difficult to capture because they relate to issues that usually arise from foreign competition. It is also useful to include as an addendum to the policy a glossary of terms, including acronyms that are unique to a company’s practices and operations.

STEP THREE: QUANTIFY EXPOSURES  

This step measures the degree of importance of the exposure. The specific measurement technique can vary. Some companies may use sophisticated modeling techniques such as value-at-risk to measure exposures. Equally valid approaches are simpler and rely upon measuring recent historical changes of currency relationships and their impact on exposures. Whatever the approach, the objective is to define which exposures are significant. Any hedging activity should be proportional to the exposure.

STEP FOUR: DEFINE RISK MANAGEMENT POLICIES AND PROCEDURES  

In this step, specific actions and responsibilities are identified. Those exposures that present significant risks to the company are identified and designated for hedging. The chain of responsibility for making decisions and executing them is formally established. Ranges of acceptable hedging activity should also be established. For example, a company might elect to hedge no less than 50% but no more than 80% of forecasted foreign sales over a specified time period. Each exposure must be systematically addressed. This step will necessarily be complex as it represents the heart of any hedging policy. Most companies include in this section an explicit statement that speculative activities should not be undertaken under any circumstances. Speculative activities would include any action that would add to, rather than reduce, the financial risks of the company.

STEP FIVE: IDENTIFY STRATEGIES TO MANAGE RISK  

In this step, derivative strategies to managerisk are explicitly identified. Approved derivatives will reflect the procedures established in Step Four. In order to provide additional flexibility, most companies will specify a range of approved derivatives, including forward contracts, purchased options, and forward-equivalent option-combination strategies. The specific hedging technique selected will depend on the circumstances of each exposure. For example, if certainty of an outcome is the main objective, forwards are likely to be the required derivative. Alternatively, for competitive reasons, a company may need upside potential from currency movements. In this case, authorizing purchased options and option-combination strategies will provide the desired trade-off of protection against adverse market moves while preserving upside potential from the underlying exposure. It is advisable to provide a broad choice of hedging instruments at the outset since amending the policy later to include more choices is usually administratively burdensome.

STEP SIX: EXECUTE STRATEGIES  

This step governs the actual execution of a derivative instrument for a hedge. The individuals approved to enter into transactions would be identified. Levels of approval based upon size or nature of transaction would be specified. A counterparty or counterparties, together with credit limits for outstanding positions, would be established. This step also includes implementing appropriate internal controls, including independent confirmation of trades.

STEP SEVEN: MONITOR EXPOSURES AND HEDGES  

Once risk management actions have been taken, the process does not end. Monitoring must become a standard practice:  

• The hedge actions need to be monitored for performance, as FAS 133 requires a company to reflect the mark-to-market results of the derivatives in financial statements.
• The underlying exposures must be monitored on an on-going basis to insure that the position does not become over or under hedged.
• Responsibility for the appropriate measurements needs to be defined.  
• The chain of responsibility to whom the results are communicated and in what format should be established.  
• An escalation procedure should be in place if there is ever any evidence of an erroneous outcome or impropriety.  
• Finally, there should be a secure set of controls for measuring the hedging outcome. Any spreadsheet used for measuring purposes should have a secure backupin an audit function. To the extent possible, hard-coded formulas should be used to avoid corruption of internal equations.

STEP EIGHT: REVIEW AND MEASURE PERFORMANCE  

Risk management should be a process of continuous improvement. The policy itself should be viewed as a living document. Within the policy, there should be an explicit commitment to review the policy on an annual basis to confirm that it is meeting its compliance objectives of risk reduction and enabling the company to reach its financial goals. This process should be documented, reviewed, approved and signed so that the mandated officers can attest to the integrity of the provisions on an on-going basis.

CONCLUSION

The benefits of comprehensive FX risk management should be realized in a more predictable and stable financial performance. A well-crafted risk management policy is an essential component of this process. Once goals and responsibilities have been made clear, every person in treasury will benefit from the well-defined mandate. The policy will provide a sound foundation for SOX compliance. And ultimately, the shareholders will benefit the most from improved financial controls and performance.