Most companies with foreign exchange exposures have in place hedging policies which guide their risk management actions. This article introduces some of the key areas that should be considered when formulating a policy.
Measures to reduce or eliminate an exposure to risk are referred to as hedging. The terms hedging an exposure and hedging a risk are used interchangeably.
Should exposures be hedged?
When designing a treasury policy, the first question that should be answered is should exposures be hedged? Deciding on whether to hedge currency exposures will depend on:
How significant the potential risk is considered to be; and
The company’s attitude to currency risk.
Those who favour hedging all exposures argue that a failure to hedge is a decision to take a position in the market and so incur risk. In contrast, those that favour selective hedging argue that the costs and effort of hedging are justified only when an adverse movement in exchange rates can be foreseen, making such an action profitable.
Establishing a Risk Management Framework
Once a decision has been made to manage foreign exchange risk, it is necessary to establish a corporate framework in which that risk can be evaluated and managed. Without adopting a framework, the effectiveness of risk management is potentially compromised.
The company might establish a corporate philosophy whereby the primary goal of foreign exchange risk management is to protect the economic value of the company from the negative impact of exchange rate fluctuations, at the lowest possible cost. Because foreign exchange volatility also provides opportunity for gains, a secondary goal might be to strike a balance between risk and return.
The board could develop a written policy for every major aspect of the treasury function to ensure that the cash flow and risk management process is controlled within known risk/return parameters.
This policy should outline the role of the treasury function, and should:
Consider the treasury policy and its objectives:
Active management style (focus on strategic hedging, based on market view); or
Passive (set and forget) approach.
Set a benchmark to evaluate the performance of the hedge. Some benchmarks commonly used include:
Spot rate on day USD is received
Forward rate at time exposure is recognised
Budget rate (worst case rate)
Call option (premium cost + strike rate = benchmark)
The action of choosing a benchmark is an important step, as it is a measure of the hedging effectiveness.
Include a systematic means of tracking all exposures:
Measurement of financial risk from extreme movements in markets to which the company is exposed.
Outline acceptable methods of risk assessment and risk management:
Understand fully the company risks and exposures – transactional, translation or economic. In other words, the financial risks faced by the company in its normal course of business.
Use the benchmark to determine an acceptable worst-case scenario, and desired best-case scenario.
Outline dealing procedures and requirements:
Methodical approach to dealing transactions
Delegations for transactions and the authorisation of transactions
Outline information requirements to be established prior to entering all types of financial transactions:
Market view
Understanding of the “deal specific” risk
Include a list of acceptable financial instruments and techniques.
Limit overall exposures to prudent levels. For example, establishing guidelines to time linked limits:
Year 1: 50/80 rule (minimum 50% hedged, maximum 80% hedged)
Year 2: 30/50 rule (minimum 30% hedged, maximum 50% hedged)
Year 3: 10/30 rule (minimum 10% hedged, maximum 30% hedged)
Have clear lines of responsibility:
Specific individual responsibility for dealing transactions
Separate responsibility for back-office functions such as confirmations and settlement of transactions
There are also a number of accounting and taxation requirements that should be given consideration.
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