5 Things to Consider When Planning an FX Policy
By Klarity FX Desk
November 21, 2019
Companies operating in international markets should establish a robust FX risk management policy. We view the policy as a company’s documented set of laws regarding identification of risk profiles and tolerances, its objectives and its strategies for dealing with currency risk. Too often a company will say that it adheres to a policy, but when challenged, it’s just an outline to the approach they have adopted or inherited. A policy should be tailored to match the risk profile of the company with appropriate strategies and goals. This guideline is intended to help outline some key considerations and bring structure to policy formulation.
Identify the Risks
Some risks are easy to identify like foreign currency receivables. However, others may not create a direct exchange of funds, but are important for accounting purposes or strategic positioning. As a simple guide, list all the transactional, translational and economic risks. Once this has been done, exhaust opportunities for netting and look for important relationships. For instance, does the company need to manage the commodity exposure and the associated currency risk if they are strongly correlated? Do not forget to detail when the exposure is created. Is it when the invoice is sent, or when the sale was agreed? Ranking of exposures can be helpful. For most companies, the management of transactional and consolidated corporate earnings exposures takes precedence over exposures arising from accounting translation methods.
Measure the Risks
Its sounds obvious, but is too often overlooked. You can’t manage what you don’t measure. Quantifying the risk is probably the best way to exemplify to the executive management team that the FX risk needs to be managed. This can be done by completing some scenario stress testing, or providing a sensitivity analysis - such as the impact of a one cent move on margins. More comprehensive volatility at risk (VaR) studies provide probability based measures and allow for diversification benefits within the different exposures a company may face.
Define the FX Objectives
Objectives established should reflect management’s tolerance and attitude toward FX risk, and should be clearly stated. An objective may be structured financially; for instance, reduce the amount of risk resulting from market volatility, or perhaps to hedge a price on a specific contractual obligation. Objectives should also outline when it is acceptable not to manage the exposure; for instance, when the cost of hedging a position is prohibitive. Management should be responsible for ensuring that any action taken to decrease exposure is economically justifiable. Protection objectives typically state when not to hedge, and can be expressed in qualitative or quantitative terms. The main point is to avoid hedging decisions being made without regard to cost and efficiency. Failure to adhere to the objectives is usually when a company finds itself drifting towards a speculative approach. Establishing risk thresholds provides a meaningful metric that the treasury can act upon.
Select and Develop an FX Program
A variety of hedging techniques are available for managing currency risk. These techniques may be internally aimed at reducing or preventing an exposed position from arising. More likely an external technique will be applied; typically contractual measures aimed at minimizing exchange losses that may result from an existing exposure. Program designs are required to be fit for purpose and actionable. Hedging everything over a fiscal year is easier said than done. The company may not have enough facility with the bank, or it may fail the conditions when applying for hedge accounting. Some programs are designed to defer outcomes for a period, while others may provide cost averaging to reduce exposure volatility.
Establish Controls & Guidelines
In every trading environment, control procedures should be fundamental. Common sense measures can help catch errors, and will also reduce the likelihood of any improper activity. At a minimum, the foreign exchange policy should address:
- Responsibilities for maintenance of exposure tracking and regular benchmarking to risk threshold metrics, as well as accurate reporting of hedges.
- Names of authorized traders with associated trading limits and instrument availability and approval.
- List of approved FX counterparties with available facilities.
- Trade confirmation procedures, with hierarchal or cross departmental sign off where necessary.
The policy formulation process is not difficult on the surface. It is the thorny issues and debates that emerge that tend to hinder development and implementation. In the proper context, a foreign exchange management policy serves several important functions. In addition to the critical control function of managing or mitigating currency risk, an effective policy also helps in assessing treasury performance; providing a framework for analysis, and involving the foreign exchange function in broader corporate decision-making. These benefits can be just as important as the control issues addressed by a formalized policy.