So you've decided to hedge, but how much?

By Ritwik Sarkar
Mar 07, 2023

Corporates continue to face new and difficult management choices when it comes to effectively reducing FX risk because currency volatility is anticipated to be a constant in the short- and medium-term market structures. After a firm confirms that they must hedge their exposures, it can be overwhelming, for those that are new to FX hedging, to know where to begin. Having an FX program is advantageous for companies, but management may be surprised to see FX impacting earnings or liquidity despite having an FX program that hedges business units' cash flows. It frequently comes down to assessing the existing hedge policy %age and determining whether it no longer serves the intended purpose of hedging and instead functions as an arbitrary hedge rather than a back-tested strategic plan.

Corporates New to FX Hedging

Corporate interest has increased because of efforts to reduce unplanned fx p/l volatility as it has become more frequent in recent years. To preserve the flexibility of the fx program, it is now crucial for finance teams to be able to communicate the impact of their decisions on earnings and cash flows to management in a clear and timely manner. Senior management has a different relative fx emphasis. Despite the fact that corporate treasury teams who are new to fx hedging or corporates with a finance team that wears several hats, may be better groomed to focus on liquidity objectives. Finding the right balance between finance and senior management goals is important when creating a new foreign exchange program. Other factors to examine include whether the program makes sense to non-operational stakeholders and what counterparty measures should be considered. For companies who are new to currency hedging, here are some starting questions to consider.

Which operational cash flows need to be hedged? i.e. hedge the largest exposure and leave smaller exposures alone due to hedging costs
What timeline should the FXRM follow? i.e. 6mth FXRM program to mirror business cycle, shorten the length of program for increased decision flexibility
What percentage of the exposure should be hedged? Should the percentage focus on liquidity, earnings, or product price control? A simple recommendation is to layer the hedges over the time horizon to allow for forecast error, business developments. A 50% hedge may over simplify the solution but its better than having no hedge in place.
How should the exposure be hedged, what is an optimal product weighting of the policy mix for cash flow deliveries? i.e. spot, forward, option product structures

Corporates Testing their Existing FXRM Program

Firms who already hedge often fall into not or loosely reviewing their existing programs relative to their hedging policy percentage performance and what its achieving for the group. Treasury and or corporate finance staff may feel having a hedge program implemented is enough to adequately manage fx volatility. While our team agrees, having an fx risk management policy and program is better than doing nothing, but falling into the habit of not reviewing and back testing its results can be just as impactful as staying idle. Evolution of the firm can be the reason for the change in the FX program.

When developing a new fx program, it is important to strike a balance between finance and senior management objectives; how much weight should be assigned to protecting earnings versus cash flows, does the program make sense to all stakeholders, and what are the counterparty implications.

An organization which pivots from being focused on liquidity risk and having the most effective cash flow deliveries could grow into being more focused on earnings results. In an inflationary climate, management's relative fx focus may shift to what percentage of earnings are at risk or simple underlying product price control. Corporate personnel who are experiencing new fx issues because of the initial reason they began hedging may inquire as follows.

Is the current fx hedge achieving senior management’s objectives? managing the balance between earnings at risk vs cash flows at risk, underlying business product pricing, credit rating implications
When was the last time our team reviewed our current fx risk management program?
What was the original reason the firm implemented the fx risk management program?
Is the current hedging policy percentage acting as an arbitrary hedge or is it a strategic approach that can be clearly explained to management and easily adjusted if needed? i.e. is the treasury team still focusing on liquidity implications when earnings and product pricing need more attention?

Why Focus on Accurate Hedging Policy Percentages

Cash flows might change depending on currency rate fluctuations at the business unit level. If a US company expects to pay CAD to a Canadian supplier in six months, it may be tempting to hedge the whole exposure when the invoice is produced, but this would overweight earnings at risk over cash flows at risk. It creates a hurdle by introducing additional fx risk and needing to disclose to stakeholders on potential impact during internal or external group reporting profits in USD. Financial teams that develop or maintain their forex programs must identify an acceptable hedging strategy % to achieve an effective balance that reduces P/L volatility while maintaining optimal liquidity levels.

Modelling and monitoring this policy percentage and how it’s delivered is what multinational corporates should consider engaging in as a routine risk management process, whether if new to having an fx program or when looking at reviewing an existing program in place.

Disclaimer: The views expressed in the article are Klarity FX's own, they should not be taken as investment advisory. Klarity FX bears no responsibility from any unforeseen outcomes that come as a result of the information in this article.