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DesigningForeignCurrencyRiskManagementPolicy
forMultinationalCompanies
ExecutiveMasterinInternationalFinanceMasterThesis
Student:A.SirvanCANITEZSupervisor:Dr.JeroenE.Ligterink
Date:August2016
2
TABLEOFCONTENTS
1.INTRODUCTION 3
2.UNDERSTANDINGFXCURRENCYRISK 5
a)WhyisitinevitableforMNCstoexposeFXcurrencyrisk? 5b)WhatdoestheliteraturesayontheimportanceofmanagingFXcurrencyrisks? 6c)HowtoManageItEffectively:FinancialPolicies,OperationalHedgingandHedgingviaDerivatives 7
3.DESIGNINGANEFFECTIVEFXRISKMANAGEMENTPOLICY 9
a)Purpose 11b)Scope 12c)Objectives 14d)IdentificationandQuantificationofExposures 15e)ModelsfortheMeasurementoftheFXRateRisk 25f)IdentificationofHedgingStrategy 27
4.HEDGINGGUIDELINES 30
5.DEVELOPINGOPERATIONALSTRUCTUREFOREFFECTIVERISKMANAGEMENT 31
6.MONITORING,REPORTINGANDEVALUATION 32
7.CONCLUSION 33
BIBLIOGRAPHYANDWORKSCITED 37
3
1.Introduction
Given the growing scale of cross-border trade of commodities, products and services,
internationalcapitalflowsandrapidspreadofscienceandtechnologywhichenabledreduction
of transportation and communication costs all around the world, it is fair to say that the
existenceofeconomicglobalizationisgettingstrongerandstronger.Asaresult,itisbeneficial
to keep inmindof economic determinants fromother economies as globalizationhasmade
economiesintheworldmoreintegratedthaneverbefore.(Han,LiangandWu,2015)
Thisisparticularlyimportantformultinationalcompanies(MNCs),whichstandbeforeamuch
widermarketandhighervarietyofrisksthandomesticcompaniesduetotheglobalpotential.
Thus theyaremoreexposed the risksofdifferenteconomies inwhich theyhaveoperations.
Although it is debated which risks correspond to which specific business aspect, one can
generally argue that the categories of international business risks can be divided into four
sectorsbeing;productrisks,commercialrisks,politicalrisksandfinancialrisksincludingforeign
exchange (FX) currency risks. This paper particularly focuses on the FX currency risk, which
affectscompany’sfinancialsfromassetsandliabilities,tocashflowandearnings.Thereforeif
notmanaged properly, itmay risk all the performance indicators, competitiveness and even
existenceofthecompany.
Although there have been many research papers and articles written by academics and
focusedoncertainpartsofriskmanagement,corporatetreasurers,aspractitioners,seemto
sufferfromlackofacomprehensiveroadmaptobuildaneffectiveFXRiskManagementPolicy
(will be referred as “Policy” for now on). This research paper aims to fulfill this gap by
buildingblocks,structuringaframeworkbytouchingalltherelevantpracticalmattersaswellas
providinginformationfromrelatedliterature.Thispaperdoesnotaddresstoaspecificindustry
ororganization,thereforeitprovidesgeneralrecommendations,wherepossible.
Anotheraimofthispaperistoquestionwhetheritisnecessarytobringafreshlooktocertain
concepts and rules related to FX risk management, which have already been known and
discussed formanyyearsandnotchangeda lot. For instance, it ispossible to finddifferent
classifications of FX currency risk in the literature. Some academicians prefer to consider 2
main categories; being “transactional” and “translational”while some researchers prefer to
add “economic” exposure among the other two as amain category. This paper defends an
alternative classification and divides transactional risk into three; being “committed”,
4
“anticipated(economic)”and“exceptional”cashflowssimplybecausetheyareallpartofthe
company’scashflowwithdifferentcertaintyandfrequency.Ontheotherhand,translational
exposure is divided into two as “consolidation on balance sheet and income statement” as
generally accepted. Additionally, despite the fact that the definitions of different types of
exposurearequiteclearonpaper,isitreallyblackandwhiteinrealityoraretheregrayareas
whenitcomestoaholdingcompany,whichhasoperationsinmanycountriesviasubsidiaries
and jointventureswithdifferent functional currencies? In thataspect, the seemingly simple
examplesprovidedinthepapertargettocreateacleardistinctionbetweendifferenttypesof
exposuresaswellascomparingtheoperatingincomeresultsincaseofdifferentportions(i.e.
partlyorfully)ofhedging.Theseexamplesalsoshowwhetherprioritizationofdifferenttype
ofexposuresmakesasenseintermsoffinancialresults.
Inorder todesign aneffective FX riskmanagementpolicy, it is highly significant to start by
understanding the concept of FX currency risk, how and why it is created along with
questioning if it ispossible toavoid itornot.Naturally, if it ispossible toavoid it totallyor
eliminate partly, theremight be noor less necessity for all the cost and effort for hedging.
Given the real-world imperfections in the financialmarkets and the desire and necessity to
haveoperationsindifferentcountriesforcertainreasonsrelatedtobusiness(i.e.tocreatea
competitiveadvantagebybecomingcost-effectiveorproducingbetter-qualityproductsetc.),
itcouldbeunavoidabletoexposethiskindofrisks.Consideringthatwecannotavoidittotally,
nextlogicalquestionarisesabouthowtomanageiteffectively.Atthispoint,itisquestioned
whether it ispossible tomitigateexposureviasomeotherways,consideredas“operational
hedging”.
Havingclarifiedtheexposuretobehedgedviafinancialinstruments,thepapercontinueswith
designing the framework of an effective policy by stating the pillars; the purpose, scope,
objectives of the policy as well as identification and quantification of exposures. Following
that,thepaperbrieflytouchesdifferentmodelsforthemeasurementofFXrateriskandgives
alternative hedging strategies for various risk appetites. Subsequently, hedging guidelines,
developinganidealoperationalstructureaswellasmonitoring,reportingandevaluatingtools
concludesthepolicy.
5
2.UnderstandingFXCurrencyRisk
a)WhyisitinevitableforMNCstoexposeFXcurrencyrisk?
Companies canbeexposed to FX currency risks due todifferent reasons such asbuying and
sellinggoods,servicesandproductsfrom/toforeigncountriesoreveniftheybuyandsellthem
from/todomesticsuppliers/clients,thepricescanbeindexedtoaforeigncurrency.Sincethis
paper addressesMNCs,which typically conduct their international activities through foreign-
affiliated companies often operating in different currency environments, understanding the
relationshipbetweentheparentanditsaffiliateswillbehighlightedinordertocapturehowFX
currencyriskcreated.
A parent must use procedures to transform foreign currency financial statements. The
proceduredependsonthecurrencyinwhichtheforeignaffiliateprimarilymakesitsoperating,
investing, and financing decisions—termed its functional currency. To identify an affiliate’s
functionalcurrency,theparentisrequiredtodistinguishbetweenaffiliateswhoseactivitiesare
integratedwiththeparent’sdomesticactivities(e.g.,theaffiliateservesasasalesoutletforthe
parentcompany)andthosewhoseactivitiesareself-containedwithintheforeignenvironment
(e.g.,theaffiliateproducesandsellslocally).Thus,asRobinsonandStocken(2013)suggest,the
affiliate’sfunctionalcurrencyservesasanindicatorofthe“real”locationofdecisionmakingfor
eachaffiliateandthusleadstheexposureofthedifferentdynamicsofeachcurrency.Onthe
otherhand, theparent company’s choiceof functional currency leads translational exposure
fromaffiliate/subsidiaryperspectiveaswellastransactionalexposurefromtheperspectiveof
parent,itself.
Inan idealizedworld,without informationandtransactionscosts,explicitor implicitcontract
periods (i.e. strictly written or implied agreements which maintain mutual relationship,
therefore affects pricing) andother obstacles to instantaneous price adjustments, deviations
fromvariousequilibriumconditionssuchaspurchasingpowerparity,thelawofoneprice,and
both the domestic and international Fisher effect would not occur; neither would firms be
exposedtoexchangerisk.Especially,ModiglianiandMiller(1958)showedthatfirmvalueand
financial policy decisions are unrelated in the absence of market imperfections. However,
because real-world imperfections inmarkets for real goods and services as well as financial
assetsdoexist,firms(andtheirvalues)canbesubjecttoexchangerisk.(Dufey,GunterandS.L.
Srinivasulu,1983)
6
b)WhatdoestheliteraturesayontheimportanceofmanagingFXcurrencyrisks?
Now thatwe acknowledge the existence of FX currency risk for certain businesses, the next
questionarousesonhowtomanageitorevenshouldweevenbothertomanageit?Smithand
Stulz (1985) showed that hedging could increase the value of the firm by reducing the
probability,andthustheexpectedcosts,of financialdistress.Nanceetal. (1993)arguedthat
firmscanreducetheprobabilityofencounteringfinancialdistressnotonlybyhedging,butalso
bymaintainingmore liquid assets or lower dividend yields. They predicted that increases in
liquidityordecreasesinthedividendyieldreducetheprobabilityofhedging.Froot,Scharfstein
and Stein (1994) highlighted the importance of risk management by arguing that it lets
companiestransferfundsfromsituationsinwhichtheyhaveanexcesssupplytosituationsin
which theyhavea shortage; inotherwordsborrowing from themselves.On theotherhand,
Copeland and Joshi (1996) argued that anticipating the consequences of hedging is difficult
since so many other economic factors change when FX rates change. As a consequence,
hedging activity risks being wasteful to the firm’s shareholders, and may actually increase
exposure if management fails to reduce total risk by hedging, shareholder value may be
eroded.
In theory, most of the exposures of a company related to interest rate, currency, and
commodity price will not increase the risk of a well-diversified portfolio. Investors or
shareholders can eliminate it by holding diversified portfolios (Stulz, 1996). Given that
shareholders can easily diversify, they will be indifferent to companies, which reduce their
earningsvolatilitybymanagingtheirfinancialrisks,aslongastherearenoadditionalcosts.
However, in practice, the companies are concerned about total risk. High volatility in
earningshasthepotentialtocauserealfinancialcostssuchasbankruptcy,underinvestment
andexcessive taxation. Therefore, although there is abunchof controversial arguments in
literature,recentstudiesarguethatasuccessfulhedgingprogrammayincreaseshareholder
value by reducing costs related to differentmarket imperfections. (Hagelin and Pramborg,
2004)Withthehelpofaproper riskmanagement, thecompaniescan (i) reducedirectand
indirect costsof financial stress (suchas legal costsor reputational costs), (ii) avoidunder-
investments (due to conflict of interest between equity and bondholders of the company
during financial distress), (iii)manage tax liabilities efficiently, (iv) increase corporate debt
capacity.
7
Although existing theories predict that firms hedge to mitigate financial constraints,
informationasymmetry,andagencyproblems,Giambonaetal(2014)claimedthatlackofdata
limitedtheabilitytotestthemsotheysurveyedpublicandprivatefirms’CFOsfromallaround
the world in early 2010 and found inconsistencies with existing theories. According to their
findings,fundamental-corporateobjectivessuchascashflowvolatilityorshareholders’interest
seemed behind reasons why firms hedge, but not as suggested by current theories. They
argued that personal risk aversion was important for corporate hedging as well as other
personalcharacteristicssuchasage,experience,education,andcompensation.
c)HowtoManageItEffectively:FinancialPolicies,OperationalHedgingandHedgingviaDerivatives
Iffinancialrisksarepotentiallycostlybutthespecificreasonsarehardtoisolateinsimpletests,
then a next logical step is to examine the interactions between derivative use and other
financial and operational policies (Aretz and Bartram, 2007). Some theoretical research has
tackled derivatives usage in this way. For instance, Leland (1998) illustrates how a dynamic
derivatives strategy affects capital structure and investment in the presence of financial
distressand(endogenous)agencycosts.Hedgingprimarilyincreasesfirmvaluethroughhigher
optimal debt levels (i.e., a greater tax shield) as opposed to lower expected taxes or lower
expected distress costs. The most important implication of Leland’s model is simply that
hedging decisionsmust be considered simultaneously with other financial decisions such as
determiningthepreferred levelandmaturityofdebt.Titman(1992)alsodisplays thatuseof
derivatives (specifically, interest rate swaps) should affect the amount andmaturity of debt.
Extending these lines of reasoning suggests that firms alsomust consider the interactions
betweenhedgingpolicyandfinancialdecisionssuchascashholdingsandpayoutpolicy.
Some studies also inspect the role of “operational hedging” and its relation to financial
hedging.Forexample,Mello,Parsons,andTriantis(1995)investigatetheinteractionbetween
production decisions and FX hedging when it is costly to change the country in which
productionoccurs.Additionally,GuayandKothari(2003)suggestthatthevalueofderivatives
positions is not significant enough to have important direct valuation effects and that prior
findingsmight be “driven by other risk-management activities (i.e., operational hedges) that
arecorrelatedwithderivativesuse” (p.426).This isalsoargued inanotherpaperbyBodnar,
Jong andMacrae (2002), inwhich they examine the influence of institutional differences on
corporateriskmanagementpracticesintheUSandtheNetherlands.Theyfindthat6%ofthe
8
USfirmsand4%oftheDutchfirms indicatethatexposuresaremoreeffectivelymanagedby
othermeans, someof the foreign exchange exposuremay be shed bymeans other than by
usingderivatives.Operationalhedging, for instance,bymovingfactoriestocountrieswhere
foreign currency revenues are incurred, or financing in the foreign currency, may be
alternativestrategiestousingderivatives.Also,partofoperatingrevenuesandcostsmaybe
in the same foreign currency, thereby reducing the total foreign currency exposure to a
tolerable levelwithout using derivatives.Alternatively, leading and laggingmethod (which
refer mitigating possible losses by altering the timing of FX cash flows) can be used to
managetransactionalexposure.Forinstance,ifacurrencyisdeprecating,onewillpreferto
receive its receivablesasquickaspossiblewhilepreferring toholdon forpayments in the
samecurrency.
WhenitcomeshowtomanageFXcurrencyrisks,onemayalsoarguethatempiricalresearch
has yet to consider the potentially broad role of financial risk management in general and
derivativesusage inparticular.As anexception,GrahamandRogers (2002)directly estimate
theeffectofderivativesuseonleverageusingasimultaneousequationsmodel.Theyfindthat
derivativesusehasapositiveeffectonleverageandisolatethechangeinvalueofthedebttax
shield attributable to hedging and estimate that hedging indirectly increases firm value by
about1%.TheGrahamandRogersanalysisrevealsthattheresultofinterestisnottheeffectof
leverageonderivativeusebutinstead,theeffectofderivativesuseonleverage.
In one of their studies, Bartram, Brown and Fehle (2009) examine the use of derivatives by
7,319 firms in 50 countries that together comprise about 80% of the global market
capitalizationofnonfinancialcompanies,which is the firstcomprehensiveglobalexamination
of hedging practices and the use of foreign exchange, interest rate, and commodity price
derivatives.Thisanalysisshowsthatderivativesuseissignificantlyrelatedtootherimportant
financial characteristics such as leverage, debtmaturity, holdings of liquid assets, dividend
policy, and operational hedges. This finding suggests a need for further theoretical and
empirical analysis that incorporates the use of derivatives into broader models of financial
management.
They also highlight that firmswith less liquid derivativesmarkets, typically inmiddle-income
countries,arelesslikelytohedge.Thisfindingisconsistentwiththeassertionsofsomepolicy
makersthatderivativescouldbe important in limitingtheseverityofeconomicdownturns in
developingeconomies. The impactof this finding is reinforcedbyother results showing that
9
these firms,which are typically located in countrieswith higher economic and financial risk,
prefer to hedge more often, ceteris paribus. Consequently, it is likely that financial policy
makers could facilitate corporations’ financial risk-management activities by pursuing
strategiesthatencouragethedevelopmentoflocal-currencyderivativesmarkets.
Considering the conclusions of the research papers in this subject, pursuing a series of
questionsasinExhibit1couldprovideaclearguideabouthowtoassessdifferentmethods
of hedging. The key, while answering to these questions, is to look from a cost-effective
perspective, naturally. For instance, moving the production facility to the country where
revenues are incurredmay be costlier than hedging via derivatives but putting an option
related to “leadingand lagging” in supplierand client contracts isprobablynot, given the
negotiation power of an MNC. Having investigated each and every possibility related to
operationalhedgingmethodsinconjunctionwithcriticalfinancialdecisions,acompanywill
concludewithasubstantialbasisthattherestoftheexposurewillbesubjecttohedgingvia
derivatives.
Exhibit1:AssessmentofAlternativeHedgingMethodsbeforeDerivatives
3.DesigninganEffectiveFXRiskManagementPolicy
Given the international environment variables such as political risk, international market
imperfections, complexity of operations, FX currency risk and local factors of countries on
one hand and opportunities for international diversification on the other, the MNCs are
Havehedgingdecisionsbeenconsideredsimultaneouslywithother6inancialdecisionssuchasthepreferredlevelofleverageandmaturityofdebt,cashholdingsandpayoutpolicy?
Isitpossibletomovefactoriestocountrieswhereforeigncurrencyrevenuesareincurred?
HaveyouinvestigatedtheinteractionbetweenproductiondecisionsandFXhedgingwhenitiscostlytochangethecountryinwhichproductionoccurs?
Haveyouinvestigatedthepossibilitytomatchthecurrencyforsomepartofoperatingrevenuesandcosts?
Isthecompanypolicy6lexibleenoughtoleadandlagreceivablesandpayableswhenitisofinterest?
10
expectedtocontinuedoingbusinessonthesharpedgeofsword,inotherwordsinaworld
fullofrisksandopportunities,whichrequireshighlyeffectiveriskmanagementpolicies.
Furthermore, as Guillén and García-Canal suggest, in recent decades, due to a number of
reasons including slowdown in developed countries, MNCs shift their focus to emerging
markets (EM), which have higher potential for growth and higher profitmargins although
they bring along new risks such as exposure to FX currencies with higher interest rates,
volatility and fragility. To visualize the volatility comparison of stable currency pairs with
emergingmarketones,theGraph1couldbereferred.
Graph1:HistoricalVolatilityof3MATMOptionContractsforEURUSD,USDTRY,USDBRL(Bloomberg)
The historical volatility of 3-month at-the-money (ATM) option contracts (compiled via
Bloomberg and dates back to 2009) for EURUSD has been lower compared to USDTRY and
USDBRL;whichconcludesthatbeingexposedtoemergingcountryFXrisk isriskierandthus
requiressensitiveattentionandmanagement.
InordertomanagefinancialrisksarousingfromFXcurrencies inaneffectiveway, it ishighly
significant todesignapolicy,which is comprehensiveenough toaddresspurpose, scopeand
objectives as well as identification and quantification of exposures, hedging strategies,
allocationofresponsibilitiesandmonitoringtheeffectivenesssothatitembracesanyonewho
isinvolvedinriskmanagementprocessinthecompany.Benchmarkingstudiesamongpeersis
11
anotherdimensionforaproperriskmanagementpolicyintermsofadoptionofbestpractices
acrosstheindustry.
a)Purpose
Ingeneraldocumentationterms,thepurposestatementisusedtooutlinewhythecompanyis
issuing the policy and what its desired effect or outcome should be. Adopting the same
approach,thispartoftheFXRiskManagementPolicyshouldaimtoserveastheintroduction,
whichclarifieswhatisintendedwiththispolicydocumentalongwiththeexpectedoutcome.
Two different examples are given below as assertions, which could serve as purpose
statements:
1.“Themainpurposeof thePolicy is toestablishan in-depthguidelinetomanageFX
currency risks across the company; including joint ventures 1 , subsidiaries 2 , and
affiliates3.
The Policy aims to give a common sense of FX currency risk by definition, how to
measure and mitigate the exposure along with assignment of responsibilities for
managingit.”
2.“ThePolicyprovidestheframeworkforacomprehensiveforeignexchangeexposure
management strategy in the context of the company’s financial objectives, existing
businessactivities,andoperatingenvironment.
Volatility in foreign exchange ratesmay affect the competitiveness, profitability, and
valuationofacompany’sinternationaloperations,inotherwords,mayleadincreased
costs and cause reduced market share and profit. This Policy is developed and
1An association of two or more individuals or companies engaged in a solitary business enterprise for profit without actualpartnershiporincorporation;alsocalledajointadventure(West'sEncyclopediaofAmericanLaw,edition2.(2008).RetrievedJune122016fromhttp://legal-dictionary.thefreedictionary.com/joint+venture)2In the law of corporations, a corporation or company owned by another corporation that controls at least amajority of theshares. (West's Encyclopedia of American Law, edition 2. (2008). Retrieved June 12 2016 from http://legal-dictionary.thefreedictionary.com/subsidiary)
3TheBlack's LawDictionary (1999) defines affiliate as a corporation that is related to another corporation by shareholdings orothermeansofcontrol;asubsidiary,parent,orsiblingcorporation.Otheronlinedictionariesdefineasubsidiaryasacompanyforwhichamajorityofthevotingstockisownedbyaholdingcompany,whileanaffiliateisacompanyinwhichanothercompanyhasaminorityinterest.
12
documentedtodescribethecompany’sattitude,objectives,andappropriateresponses
whenmanagingforeignexchangerisk.”
b)Scope
Inordertobecosteffective,mostofthecompaniesprefernottohedgealltheexposureand
trytolimitpossiblecoverageandoptimizecosts.Inthatrespect,thispartofthePolicyshould
address which countries, currencies and/or subsidiaries are within the scope of the
documentation, hence actively managed. Additionally, MNCs have presence in more than
certainnumberofcountriesandevencontinentsbutduetoacoupleofreasons,applicationof
the same Policy for every country may not be enough to get the results intended.As an
example,insomecountries,hedgingtheexposuremighttobesoexpensivethatitwritesoff
theprofitexpected fromthesales itself.Thus,onemaychoosenot tohedge theexposure
deliberatelyormaymakeuseoflocalsolutionsforlessliquidcurrenciesinsteadofexecuting
therequirementsofageneralpolicy.
Toillustratewhatsortoflocalsolutionsareoutthere,itispossibletorefertherecentmoveby
the National Bank of Egypt. According to a Bloomberg article dated March 14, 2016
(http://www.bloomberg.com/news/articles/2016-03-14/egypt-s-biggest-lender-offers-hedge-
against-local-bond-risk),TheNationalBankofEgyptwouldofferdollarcalloptionsforuptoa
yeartoinvestorsbuyingTreasurybillsdenominatedinEgyptianpounds,whichguaranteesthe
foreignexchangeexit, includingthevalueofprincipalplusthecoupon.Thisproducthasbeen
introducedafterthecentralbank’sdecisiontoallowEgyptianPoundtoweakenbyalmost13%
in theofficialmarket,andaimed to restore foreign interest inEgypt’sdebtmarket.From an
MNCperspective,whichhasoperationsinEgypt,thusincomeinlocalcurrency,thismightbe
an alternativeway of hedging local currency risk. Instead of keeping the earnings in local
currency and taking the risk of weakening it by more than 10%, the company can buy
Treasury bills denominated in Egyptian pounds with dollar call option facility in order to
guaranteetherepatriationofearningsindollarvalueatmaturity.Naturally,thepriceofthe
Treasurybillswill includeoptionpremiumtherefore thecost-effectivenessof the transaction
shouldbecomparedtotheriskofunhedgedpositionandactaccordingly.
Consequently, the determination of scope is quite important in terms of getting efficient
results.Asasuggestion,onemayconsiderlimitingthescopewithapercentageofcoverage
according to the risk appetite of the company. For instance, some companies may find it
adequate if the Policy covers 70% of the income generated in the currencies, which were
13
addressedbythePolicyinsteadofbeingfullyhedged.Asasecondexample,onemayconsider
limitingthescopewithEMcurrencies,whichhavehighervolatilitiescomparedtodeveloped
market(DM)currenciesasshownabove.Thirdly,athresholdcanbedeterminedintermsof
“materiality”andeverythingcanbehedgedexcessingthatamount.
Additionally,itmightbeusefultostudyonthecorrelationsofthecurrenciesexposedbefore
makingadecisiononthescope.Forinstance,thetablebelowshowsthecorrelationmatrixfor
variouscurrenciescalculatedwithdailybidpricesfortheperiod01/01/2012and30/06/2016.
Asonemayexpect,weseeaconsiderablepositivecorrelationbetweenAustralianDollar(AUD)
andNewZealandDollar(NZD).ThispairisfollowedbyMexicanPeso(MXN)andSouthAfrican
Rand (ZAR).On theotherhandAUDandCanadianDollar (CAD)hada correlationof -0.63. If
AUDandCADhavemovedinoppositedirections63%ofthetimestudied,havinganexposure
oflongAUDandlongCADmeanshavinglesspositionthanthesumofthemduetothefactthat
whenAUDhasrallied,CADhaspartlysold-off.Thus,inthisspecificcase,ifonehedges2units
of long AUD and long CAD (1 unit each), the positions might be over-hedged due to the
correlationof-0.63.
Exhibit2:AnExampleofCorrelationMatrix
Subsequently,ifthetwoexposurescanceleachotherincaseofaperfectcorrelationorif
relativelyhighcorrelationdecreases theexposure, itmaybewise toavoidentering into
twotransactionsordecreasetheamounttohedge.
Onecriticalpointhere istokeepinmindthatcorrelationsdochangeduetodivergence in
monetary policies, currency’s sensitivity to commodity prices, as well as economic and
political factors. Therefore, the Policy should address this fact by being as dynamic as
requiredifthescopehasbeendecidedaccordingtocorrelations.
14
Intermsofscoping,allthechoiceswillbringdifferentadvantagesanddisadvantages.Butit
isadvisabletolookforanswerstothesequestions:
1. DoyouhaveexposuretorelativelyvolatileEMcurrencies?
(As Graph 1 shows, developed market (DM) currencies tend to be less volatile
comparedtoEMcurrencies,whichimplieslessFXriskfromacorporateview.)
2. Doyouconsiderthatexposureasmaterial?(i.e.15-20%ofincomegeneration)
3. Wouldyouconsiderthepredictabilityofcashflowashigh?
4. Isitpossibletohedgethatexposurewithfinancialinstruments?
5. Isthemarketliquidenoughtoprovidereasonablequotation?
(If the answers are “yes” for the first 5 questions, it is reasonable to keep these
currencieswithinthescopeduetothereasonsexplainedabove.)
6. Doesthecostofhedgingsweepawaytheprofitmadefromthatbusiness?
7. Are there less costly or alternative local solutions? (Just like Egypt example given
above)
8. Have you checked correlation matrix and found out near perfect or perfect
correlations?
9. Haveyoucheckedwhetherthecurrencyofexposureispeggedtoanothercurrency?
(Becauseifit’spegged,itisexpectedtobelessvolatileandnear-perfectlycorrelated
toanothercurrency.)
(If theanswersare “yes” for the last 4questions, it couldbewise to keep these
currenciesoutofthescopeinordertooptimizecosts.)
c)Objectives
Regardless of methods or scope to be adopted, one of the foremost objectives of the
Policy is the reduction of the volatility in financials to ensure sustainable growth and
return for stakeholders as well as general risk management gains mentioned in the
Introduction part. Depending on the company’s key performance indicators (KPI)
reductionof thevolatilitycanbeconsideredforbalancesheetand/or incomestatement
(i.e. earnings, EBITDA or EBITA). For instance, Philips prefers to use EBITA as a KPI4so
reductionofvolatility inEBITA is likely tobe theirmain targetwhileAkzoNobel5refers to
growthinEBIT.
4http://www.philips.com/corporate/resources/annualresults/2015/PhilipsFullAnnualReport2015_English.pdf5https://www.akzonobel.com/sites/live.corp.prod.an-platform.com/files/q2-report-2016.pdf
15
The sub-objectives of the policy can be classified into two groups, being financial and
organizationalobjectives.Amongfinancialones,followingobjectivesarecanbeconsidered
asawholeorpartlyinaccordancewiththescope.
1. Toeliminatetheprobabilityofcostlylower-tailoutcomesinkeyfinancials
2. Tominimizethevolatilityofnon-functionalcurrencyfluctuationsonaconsolidated
basis
3. To assess and mitigate the potential exchange rate risk on receivables, payables,
asset&liability
4. To manage the potential impact of marking to market non-functional currency
exposuresandderivativesthroughtheincomestatement
As a part of comprehensive risk management document, the intended outcomes of the
policy from organizational perspective should also be clarified. In that respect, the
organizational objectives can be some of the following depending on the nature of the
company:
1. Todefinerolesandresponsibilitiesofpersonnelinchargeofriskmanagement
2. Toimproveefficiencyandsafetyofriskmanagementfunction
3. Toimparttransparencytotheriskmanagementfunction
4. Toadopt“bestpractices”
5. TosetbenchmarksforTreasurytooperatewithinrisklimitsandprudentialcontrols
d)IdentificationandQuantificationofExposures
The risk management literature identifies two classes of FX risk; being translational and
transactional. Brownlee, Wilson, Grayson and Conroy (2008) pinpoint that transaction
exposure exists during the normal course of international business transactionswhenever
twoormore currencies are involved and there is a lag between the date of a contract is
signed or goods delivered and the date of payment while translational exposures occur
because of the need to translate the financial statements of foreign subsidiaries and
affiliates into the currency of the parent company in order for consolidated financial
statementstobeprepared.
HagelinandPramborg(2002)refertoeconomicexposureaswellanddivideitinthree:the
exposureof committed transactions, theexposureof identifiable anticipated transactions,
16
andcompetitiveexposure(unidentifiableanticipatedtransactions).Bytransactionexposure
they refer to the two former. They also think that competitive exposure is notwithin the
scopeofhedgingviauseofderivatives(typicallymanagedbyoperationalhedges)referring
that fewfirmstendtohedgethis typeofexposurewithcurrencyderivatives (Bodnaretal
1998). Additionally, Butler (1999) provides a discussion on the problems associated with
usingfinancialhedgestomanagelonger-termedcompetitiveexposure.
They also argue that transaction exposure and translation exposure tend to affect firms
differently.Transactionexposuretocurrencyriskreferstopotentialchangesinthevalueof
future cash flows as a result of unexpected changes in exchange rates. If competently
executed, transaction exposure hedges should reduce the variability of cash flows and
consequentlythevariabilityoffirmvalue.Translationexposure,ontheotherhand,arisesas
the financialaccountingstatementsof foreignaffiliatesare translated into thecurrencyof
theparentfirm.Thegeneralrecommendationofthefinanceliteratureisnottoworryabout
thistypeofexposureandthusnottohedgeit(seee.g.Butler,1999).Thereasonsforthisare
thattranslationgains(losses)tendtobe(i)unrealizedandhavelittledirectimpactonfirms’
cashflows,and(ii)poorestimatorsofrealchangesinfirmvalue.Thustheyconcludethatif
this is true, translation exposure management should be inefficient in reducing firms’ FX
exposure.
Consideringtheliterature,FXcurrencyriskscanbecategorizedasbelow:
Exhibit3:CategorizationofFXCurrencyRisk
Thetranslationalriskscanbeobservedupontheconsolidationofincomestatementand/or
balancesheet.WithinInternationalFinancialReportingStandards(IFRS),itisfairtosaythat
hedgingthetranslationriskonthebalancesheetiseasiercomparedtohedgingonearnings
FXCurrencyRisk
TranslationRisk
ConsolidationonBalanceSheet
ConsolidationonIncomeStatement
TransactionalRisk
CommittedExposures
AnticipatedExposures(EconomicExposures)
ExceptionalCashFlows
17
level due to restrictionsonhedge accounting treatment. For instance, let’s assume that a
EUR company is expected to generate GBP 50 million earnings in each quarter for the
comingone-yearperiodonconsolidatedbasis.Soattheendoftheyear,theGBPearnings
willbetranslatedattheaverageratefortheyear.Tohedgethecurrencyrisk,thecompany
canenterinto4forwardcontractstosellGBP50millioneachandbuyequivalentamountof
EURatthebeginningoftheyearwith3,6,9and12-monthmaturity.Attheendoftheyear,
any loss/profit on the average rate will be cancelled out by profit/loss on the forward
contractsprotectingthecompanyfromadversemovementsofthecurrencypair.However,
thiswillcausesomekindofvolatilityinquarterlyreportssinceforexample,therewillbe4
forwardcontractswithGBP200millionnotionalwhilethereisonlyGBP50millionofearning
at the end of Q1. Therefore at the end of each quarter, the consolidated P&L will be
showing changes in the mark-to-market (MtM) of the four forward contracts with less
underlyingexposuretomatch.Hence,itisimportanttokeepinmindthathedgingearnings
may cause temporary volatility in quarterly reports but it will be gone at the year-end
financials.
Transactional risk can be divided into three groups as committed exposures, anticipated
exposures(economic)andexceptionalcashflows.“Exceptional” isusedtorefercashflows
arousing fromone-time events likemergers or acquisitions,which need special attention.
ThereforetheyshouldnotbeincludedinthePolicytoenableflexibilityfromthem.
To understand transactional and translational risks on committed exposure basis, the
following illustrationsandhedgescenariosmightbehelpful. Let’sconsider thatwehavea
parentcompanywhosefunctionalcurrencyisEUR.ItgeneratesincomeinEUR,USDandSEK
whilethecostspaidtosuppliersareinEUR,SEKandGBP.Thiscompanyalsohasasubsidiary
intheUKwithafunctionalcurrencyofGBP.IthasGBPincomebutEURcosts.
18
Exhibit4:Cost&IncomePatternoftheParent&Subsidiary
Accordingtotheexamplefigures,GroupgeneratesoperatingincomeofEUR668.56withthe
exchangeratesbelow.
6
Exhibit5:OperatingProfitBreakdowninParent,SubsidiaryandGroupBase
SCENARIO1:
1) EURstrengthens15%againstallcurrencies
2) TheGrouphasnothedgedanyofthecurrencyrisk
6Scenarioratesshow15%strengtheningofEURagainstallcurrenciesandtransactioncostsareignoredforsimplicity.
19
Considering that the Group has not hedged any of the currency risk, in case of 15% of
strengtheninginEURwillcause13%ofdecreaseinGroup’soperatingprofit.
Exhibit6:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario1
SCENARIO2:
1) EURstrengthens15%againstallcurrencies
2) TheGrouphashedgedexternaltransactionstolocalcurrencyofeachentitybefore
EURstrengthening
In this scenario, parent company and subsidiary hedge the external transactions (i.e.
excludingintercompanysales)beforeEURstrengthens15%againstallcurrencies.Sincethe
hedgesaredonetolocalcurrenciesofeachcompany,translatingUKsubsidiary’scostofEUR
60intoGBPcausestheincreaseofGBPexposurefromGroupperspective. Inasituationof
strengtheningEUR, thismakesour caseworse.Additionally,byparent company’shedging
thetransactionalexposureofGBP40,theoffsettingopportunitybetweenparentcompany’s
GBPexposureandthetranslationalexposurearousedbyUKsubsidiaryhasbeencancelled.
Consequently, this strategy brings more operating profit of EUR 18.07 compared to the
Scenario1.
20
Exhibit7:Cost&IncomePatternoftheParent&SubsidiaryunderScenario2
Exhibit8:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario2
SCENARIO3:
1) EURstrengthens15%againstallcurrencies
2) TheGrouphashedgedonly internal transactions to local currencyofeachentity
beforeEURstrengthening
Under this scenario, although it is an internal transaction (i.e. intercompany sales), the
Group benefits by hedging a big chunk of its EUR costs in subsidiary basis and therefore
reducingtheGBPtranslationalexposure.
21
ThisisalsoanaccountingfriendlywaysinceInternationalAccountingStandards39(IAS39)
Paragraph80statesthat inconsolidatedfinancialstatementstheforeigncurrencyriskofa
highlyprobableforecastintragrouptransactionmayqualifyasahedgediteminacashflow
hedge, provided the transaction is denominated in a currency other than the functional
currencyoftheentityenteringintothattransactionandtheforeigncurrencyriskwillaffect
consolidatedprofitorloss.Forthispurposeanentitycanbeaparent,subsidiary,associate,
jointventureorbranch.
Exhibit9:Cost&IncomePatternoftheParent&SubsidiaryunderScenario3
Exhibit10:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario3
22
SCENARIO4:
1) TheGrouphashedgedbothinternalandexternaltransactionstolocalcurrencyof
eachentitybeforeEURstrengthening
This scenario eliminates transactional risk completely; therefore the bottom line is better
thanabovescenariosexceptbasecase.However,translationalriskstillexistsandthenatural
offset opportunities, which arouse by parent company’s GBP costs and subsidiary’s EUR
costs,arevanished.
Exhibit11:Cost&IncomePatternoftheParent&SubsidiaryunderScenario4
Exhibit12:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario4
23
SCENARIO5:
1) The Group has hedged both internal and external transactions to parent
company’scurrencybeforeEURstrengthening
Inthisscenario,translatinginternalandexternaltransactionsintoEUR,whichistheparent
company’s functional currency,eliminates transactionaland translational risks.Although it
bringsadesirablebottomlinecomparedtootherscenarios,thisapproachisnotaccounting
friendlybecausethetranslationriskofUKsubsidiarydoesnotrepresentaneligibleexposure
forhedgeaccounting. It ishighly likely that therewillbe timegapbetweentheprofitand
lossofhedgetransactionsandrecognitionofGBPearnings,whichwillcausevolatilityinP&L.
Additionally,notalltransactionalexposurescanberealizedascashflowsintheanticipated
future.
Exhibit13:Cost&IncomePatternoftheParent&SubsidiaryunderScenario5
24
Exhibit14:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario5
Exhibit 15 summarizes the outcome of different scenariosmentioned above. The case of
15%strengtheningofparentcompany’scurrencyagainstallcurrenciescauses13%decrease
inGroup’soperatingprofit.Itisalsotheworst-casescenarioforbothparentandsubsidiary
perspective.
However, in somecases,hedgingdecisions canbetter-offonlyoneparty;eitherparentor
subsidiary. For instance, just like in Scenario 3, hedging only internal transactions (i.e.
intercompany sales) will help protecting subsidiary’s operating profit but parent will still
suffer because of unhedged external deals. Therefore, it is important to pay attention
internalandexternaltransactionsdistributionbeforemakingadecisionaboutthescope.
Additionally,hedginginsubsidiarylevel(tolocalcurrency)andnotconsideringtheexposure
fromGroupperspectivecancauseadditionalexposureasseeninScenario2.EURexposure
foraGBPcompanyisconsideredtobeatransactionalexposurealthoughfromEURparent
companyperspective, itdoesnot representa translationalexposure since the currencyof
theexposurematcheswithfunctionalcurrencyoftheparentcompany.
Insomecases,asinScenario4,eliminatingtransactionalriskscompletelymayleadvanishing
ofsomenaturaloffsettingopportunities(i.e.GBPliabilitiesforEURparentcompanyorEUR
liabilities for GBP subsidiary). Thus, ideally, Scenario 5, which requires hedging of both
transactionalandtranslationalexposures,givesthebestfinancialresults.Yet,inreality,itis
notviablebecauseof(i)beingnothedgeaccountingfriendlyasexplainedaboveand(ii)time
gap for transactional exposures between anticipation and realization. Considering the
imperfectionsinrealworld,prioritizingthetransactionalexposuresincludingintercompany
transactionshavehigherpotentialtogivebetterresults,ifnotperfect.
25
Strategy Op.Profit
(Parent)
Op.Profit
(Subsidiary)
Op.Profit
(Group)
BaseCase
EUR348.56 EUR320.00 EUR668.56
Scenario1 Nohedge
EUR338.31 EUR254.78 EUR593.09
Scenario2 Hedgeonlyexternal
transactionstolocal
currencyofeachentity
EUR348.56 EUR262.61 EUR611.17
Scenario3 Hedgeonlyinternal
transactionstolocal
currencyofeachentity
EUR338.31 EUR270.43 EUR608.75
Scenario4 Hedgebothinternaland
externaltransactionstolocal
currencyofeachentity
EUR348.56 EUR278.26 EUR626.82
Scenario5 Hedgebothinternaland
externaltransactionsto
parentcompany’scurrency
EUR348.56 EUR320.00 EUR668.56
Exhibit15:SummaryTableofFinancialOutcomesofVariousScenarios
e)ModelsfortheMeasurementoftheFXRateRisk7
Havingdefinedthetypesofexposure,logicalnextstepisthemeasurementoftheserisks.As
VanDeventer,Imai,andMesler(2004)andHolton(2003)explainintheirbooks,measuring
currencyriskmaybehighlycomplex,atleastwithregardstotranslationandeconomicrisk.
Oneofthewidelyusedmethodisthevalue-at-risk(VaR)model,whichcanbedefinedasthe
maximumlossforagivenexposureoveragiventimehorizonwithX%confidence.TheVaR
measure of exchange rate risk is used by firms to estimate the riskiness of a foreign
exchange position resulting from a firm’s activities, including the foreign exchange
positionofitsTreasury,overacertaintimeperiodundernormalconditions.Accordingto
Holton(2003),theVaRcalculationdependson3parameters:
7ThispartisgivenforinformativepurposeswiththeaimofbrieflymentioningdifferentwaysofmeasurementoftheFXraterisksandtheirfeatures.Sincethispaperaimstoprovidepracticalguidance,thecalculationmethodsforthesemodelsarekeptbeyondthescope.
26
1. Theholdingperiod,i.e.,thelengthoftimeoverwhichtheforeignexchangeposition
isplannedtobeheld.Thetypicalholdingperiodis1day.
2. The confidence level at which the estimate is planned to be made. The usual
confidencelevelsare99percentand95percent.
3. TheunitofcurrencytobeusedforthedenominationoftheVaR.
However, as Papaioannou (2006) suggests the VaR does not define what happens to the
exposureforthe(100–X)%pointofconfidence,i.e.,theworst-casescenario.
Forexample, if theFXpositionhasa1-dayVaRofEUR10mnat95%confidence level, the
companyshouldexpectthatunderusualconditions,thevalueofthatpositionwilldecrease
nomorethatEUR10mnwith95%probabilityduring1dayperiod.Onecanalsorephraseit
bysayingthat thecompanyshouldexpect thevalueof thisexposuretodecreasebymore
than EUR 10mn on 5 out of 100 trading days. Since the VaRmodel does not define the
maximum loss with 100% confidence, firms often set operational limits, such as nominal
amountsorstoplossorders,inadditiontoVaRlimits,toreachthehighestpossiblecoverage
(PapaioannouandGatzonas,2002).
Thereare3significantmodelstocalculateVaR:
1. Historical simulation, which assumes that currency returns will have the same
distributionastheyhadinthepast
2. The variance-covariance model, which assumes that currency returns on a firm’s
totalforeignexchangepositionarealways(jointly)normallydistributedandthatthe
change in the value of the foreign exchange position is linearly dependent on all
currencyreturns
3. Monte Carlo simulation, which assumes that future currency returns will be
randomlydistributed
The historical simulation, whose main benefit is that it does not assume a normal
distributionofcurrencyreturns,isthesimplestoneamongthethreealthoughitrequiresa
largedatabaseandintensivecalculation.Theshortcomingsofvariance-covariancemodelare
its assumptions of normal distribution and linear dependency, although it allows for a
quickercalculation.MonteCarlomakesuseofvariance-covariancemodel’scomponentsby
simulating them randomly and handling the underlying distribution even if non-linear
factorsareinvolved.Sinceitrequiresintensivecalculations,mostcompaniesprefertodo
itwiththehelpofsoftware.
27
f)IdentificationofHedgingStrategy
Consideringthefactthathedgingwillcostmoney,itishighlyimportanttofindandapplya
cost-effectivestrategy,whichwillsuitcompany’spolicyaswellasitsbudget.
Forward rates are a function of interest rate differentials and therefore they have little
predictivepowerforfuturespotratesinshortandmediumterm.(Sanchez,2013andPolito,
2000)Thus,positivereturncanbegeneratedbytakinglongpositioninhighyieldcurrencies
againstlowyieldcurrencies;whichiscalled“carry”.(However,thisstrategyhasthepotential
to suffer fromviolent short-termdrawdownsespecially foremergingcurrenciesandoften
used by hedge fund.) Applying this to hedging, favorable carry can be considered as
incentivetohedgesinceforwardpointsaregainedandnegativecarrycanbeconsideredas
thenetcostofhedgingsinceforwardpointsarepaid.
Given the current literatureandpractice, thereareanumberofhedging strategies,being
static, rules-based, opportunistic, limited, proxy, “buy at-the-money forward (ATMF)
options”,“sellotheroptions”andasacombinationofsomeorallashybrid.
Statichedge referstotheposition,whichisputinplaceandkeptuntilthematurityofthe
contract. The usual instruments under this strategy are forward, futures and European
options.Incaseofchangingexposures,thisstrategymayleadlossescomparedtounhedged
positions.
Dependingontwoconditions,highyieldcurrenciesdon’ttendtodepreciatebymorethan
forwardpointsonaveragesostatichedgewith forwardcontracts tendtogenerate losses.
Forinstance,ifimpliedvolatilityistradingaboveitshistoricalaverage,itmaymeanthatthe
currency depreciation has already occurred. Also, if forward points are trading above its
historicalaverage,thecurrencyneedstodepreciatefurtherinordertocompensateforthe
elevated forward points being paid. Hence hedging with forward contracts are likely to
generate losses as the currencymay not depreciate asmuch as elevated forward points.
Thus, rules-basedhedgemaybedesignedforthesecurrenciesbydeterminingathreshold
for1YATMFimpliedvolatilityand1Yforwardpointsasa%ofspotthresholdandhedging
accordingly.
28
Opportunistichedgerequiresforecastingpossibilityofcurrencydepreciationquantitatively
and/orqualitativelyandhedgingonlywhennecessary.Therisk inthisstrategy is itsstrong
dependencyonbeingabletodetecttheupcomingcrises.
Limited hedge refers to hedge only for extreme scenarios via out-of-money option
contracts. For this strategycall spreads (inwhichequalnumberof calloptionsarebought
andsoldtogeneratelimitedprofitwithreasonableprices)canbeused.
Proxyhedgerequireshedgingexposurebyusingcorrelatedcurrencieswithlowercosts.The
riskappearsoncethecorrelationbreaksdown.
Asamitigationofhedgingcost, selling lowerstrikeputs inorder to fundcalls (i.e. collars)
can also be considered. By this way, upfront costs can be decreased or evenmade zero
althoughanimplicitopportunitycoststillexists.
The table below lists the most important advantage and disadvantage of each strategy
mentioned.
HedgeStrategy Pros Cons
Static Easytoexecute Notflexibleincaseofchanging
exposures
Rules-based Easytounderstand
Difficulttomanipulate
Relativelydifficulttoset-upin
termsofdecidingonrules
Opportunistic Cost-effectiveandflexible Requiresstrongforecastingof
currencytrends,whichisvery
difficultconsideringefficient
markets
Limited Cost-effective Providesprotectiononlyfor
extremescenarios
Proxy Cost-effective Dependsonhistoricalcorrelation
data
Exhibit16:ProsandConsofVariousHedgeStrategies
Theyallcanbehighlyeffectivedependingonthecurrencypair,duration,andriskappetite
of the company because they are addressing different needs of the organization. It has
29
alreadybeendiscussedthatundercertaincircumstances,managingtheFXcurrencyriskvia
financial instrumentsmaynotalwayscreatethe intendedvalue.For instance, itmightnot
bereasonabletohedgewhenthevolatilityandpredictability is lowwhilepartlyhedging
via option contracts might be a solution for the cases with low predictability and high
volatility.Optioncontractswillgivemoreflexibilitywhilepartlyhedgingwillpreventextra
costs in case of unwinding over-hedged positions caused by low predictability. If
predictabilityandvolatilityarebothhigh,hedgingsignificantportionviaforwardcontracts
could be economically efficient. As such, creating a “hybrid” approach, which means
making use of some of the strategies together, could be the best solution in order to
ensureflexibilityandeffectiveness.
Furthermore,duetothenatureofpredictabilityofbusiness(i.e.shorttermvisibilityforcash
flows is better than longer time horizons) “layered hedging” via options and forward
contractscanalsobeadoptedasa“hybrid”approach.
Maturity(Months)
3 6 9 12 15
ProportionforOptions 10% 15% 25% 30% 30%
ProportionforForwards 90% 75% 55% 40% 20%
TotalCoverage 100% 90% 80% 70% 50%
Exhibit17:AnExampleofLayeredHedgingModel
The illustrative table above shows this strategy for a 15-month period. Each quarter
requires a reviewof forecasted versus realized cash flows in order to keepupwith this
dynamichedgingstrategy.Forinstance, ifhedgedcashflowismorethanrealizedfigures
attheendofQ1,proportionofoptionsandforwardsforQ2shouldberearrangedsothat
totalcoveragedoesn’texceedtheauthorizedpercentage. Inthataspect,thisexampleof
layered approach incorporates static, rules-based and opportunistic hedging strategies
withinitself.
IAS39 limits the typesof derivatives tobeusedduringhedgeaccounting treatment8with
plainvanillaproducts likeforwardsandoptionswhileIFRS9allowstousebroaderrangeof
8Theimportanceofhedgeaccountingtreatmentisbrieflyexplainedwithanexamplein“d.IdentificationandQuantificationofExposures”part.
30
hedging instruments, i.e. non-derivative financial asset or liability measured at fair value
throughprofitorlossalthoughitstilldoesn’tallow(net)writtenoptions.
4.HedgingGuidelinesOncetheexposureisdeterminedthefollowingstepsshouldbefollowedtomanagetherisk
effectively:
Purpose& Benchmarking:Althoughmany corporates adopt “no speculation, only hedge”
approachforFXRiskManagementPolicy,therearealsoanumberofcorporatesthatdecide
to adopt amore aggressive approach, within which one of themain aims is to generate
financialincomeincludingFXgains.
Forecasting: It’s significant to develop a 6-month and/or 1-year forecast on the market
trendsforhighlyexposedcurrenciesandmakehedgingdecisionsaccordingly.Maindirection
ortrendwillalsoleadthechoiceofmosteffectivehedgingstrategy.
RiskEstimation&ThresholdDetermination:Basedontheforecasts,measuringthevalueat
riskisthenextlogicalstepforaneffectiveriskmanagement.Accordingtotheriskappetite
and tolerance of the company, some thresholds should be set for each currency pair
regardingtoVaR,stop-losslimitspertransactionand/orperday,hedgeratios.
HedgeInstruments:Dependingonthehedgestrategy,scopeandobjectivesofthecompany,
Treasury should be able to use various financial instruments including forwards, futures,
swaps,optionsandotherderivativeproducts.Theriskappetiteofthecompanyalsoplaysan
importantroleforthedeterminationoftheinstrumentstobeused.Forinstance,duetothe
nature of unlimited loss potential, most companies do not allow net written-option
positions. Therefore the company should have clear policies and procedures that define
roles and responsibilities and describe internal controls on the process of exercising and
expiringforeigncurrencyoptions.
Allocation of Responsibilities: There should be a clear guidance in the delegation of
responsibilities among Chief Financial Officer (CFO), Group Treasurer and Front Office,
BusinessUnits/BusinessTreasury,OperationsandAccounting&Controlling.CFOandGroup
Treasurerpositions areexpected tobeactive indetermining themain framework suchas
31
signing-off hedging strategies, clarifying the threshold and allowed instruments. As the
executionorgan,FrontOffice,isexpectedtohavethefollowingresponsibilities:
1. Monitoringthecompany’sconsolidatedexposure
2. Decidingwhichexposurethecompanymustmanagepriortotheothers
3. Determining currency exposure and hedge proposals for currencies in accordance
withPolicy
4. Forecastingexchangeratemovementsandtrends
5. Choosingthehedginginstrumentaswellasthetimingofexecution
6. Adjusting the company’s exposed position through measures consistent with the
Policy’sstatedobjectives
Business Units/Treasury have the support function by being the bridge between local
entitiesandheadquarters.Theyalsohaveasignificantroleforthedeterminationandeven
decreasingofexposurebyinvestigatingoperationalhedgingpossibilities.
5.DevelopingOperationalStructureforEffectiveRiskManagementAccordingtoBankforInternationalSettlements(BIS),operationalriskistheriskofdirector
indirectlossresultingfrominadequateorfailedinternalprocedures,people,andsystems,or
fromexternalevents.Operationalrisk for foreignexchange inparticular involvesproblems
withprocessing the transactions,productpricing,andvaluation.Operational riskmayalso
stem from poor planning and insufficient procedures, inadequate systems, failure to
properly supervise staff, defective controls, fraud, and human error. On the contrary of
financialorcreditrisk,itmaybedifficulttoquantifythecostsofoperationalrisks.Therecan
be direct and financial results of poormanagement of operational risk, just as when the
companysettles lateor settles inawrongcurrency.Therecanalsobe indirect results like
reputationalcostsinsomeothercases.
Operations, Accounting & Controlling and Compliance units are responsible formanaging
theoperationalriskasdescribedabove.Accounting&ControllingDepartmentisresponsible
for ensuring all transactions are properly recorded to the balance sheet and income
statement. Following the initial entry of transaction into general ledger, the position is
recurrentlymarkedtomarketuntil it isclosedundertheirsupervision.Inthatrespect, it is
32
important to conduct daily valuations for the outstanding positions and inform senior
management in case of any excess. Another critical responsibility of this group is the
compliance with hedge accounting principles in accordance with the latest regulation.
Especially with IFRS9, it is planned to bring some flexibilities for corporates as briefly
mentionedabove;thusitisanimportantdecisiontobemadewithallstakeholderswhento
and not to apply hedge accounting under the supervision of Accounting & Controlling
Department.
Another decision point under this subtitle is the level of centralization in terms of
operationalstructure.TherearedifferentapproachesthatcanbeseenamongMNCs.First
example is decentralized model, which gives the responsibility for determining risk
managementstrategytotheindividualsubsidiarycompaniesorbusinessdivisionswiththe
centralization of the principal riskmanagement functions, such as front office,mid-office
and back-office operations. Another example could be centralized approach,where all FX
risk management activities, from operational to strategic, are consolidated within the
corporatetreasury function.Asabalancedmodel,authorityandresponsibility forhedging
decisions and strategy can be split between the corporate treasury and the various
subsidiaries, resulting in amore collaborative approach to riskmanagement.According to
thestructureandsizeofcorporate,theremightbeprosandconsofeachmodelcompared
toothers.Itisalsorelatedtocorporatecultureandtheseniormanagement’swillingnessof
delegation of the power to subsidiaries; thus it is not possible to mention about one
approachtobe“better”thanothers.
Under Compliance Department’s supervision, all the staff including Operations, Business
TreasuryandFrontOfficeshouldfullyunderstandallFXriskmanagementstrategiesandthe
roleofeachparticipantwithin theFXprocess flow (i.e. counterparties, credit, compliance,
andinternalaudit).Policiesandproceduresshouldbedocumentedandupdatedperiodically
since business strategies, responsibilities and roles tend to change and evolve constantly.
Alongwithstrategiesandprocess flows,all staffshouldbe fullyawareofoperational risks
andwillingtomitigatethembyimplementingadequatecontrolpoints.
6.Monitoring,ReportingandEvaluation
Inordertoevaluatetheeffectivenessofthehedgestrategies,itisveryimportanttobeable
tomonitormark-to-market (MtM) valuations of the contracts, which have been used for
33
hedging. However, there might be some conditions which prevent MtM of an derivative
contract, suchaswhen themarket is inactive (whichmeansquotedprices arenot readily
and regularly available on real-time data providers like Thomson Reuters or Bloomberg
and/orthosepricesdonotrepresentactualandregularlyoccurringmarkettransactions)or
whentherangeofreasonablefairvaluesestimatesissignificantandtheprobabilitiesofthe
differentestimatescannotsensiblybeassessed.Especiallyafternewregulationsintroduced
followingthe2008financialcrisis,mostofthereal-timedataprovidersstartedofferingsome
valuation tools. As an example, Bloomberg’s valuation tool, BVAL provides rigorous,
transparent, and defensible pricing available at that day to help better identify,measure,
monitor and manage valuation uncertainties. They also provide “BVAL Score” which is a
numerical rating that shows the relative strength of the quantity and quality of market
inputsusedincalculatingtheBVALprice.Itmightbehandyusingthiskindofvaluationtools
eitherviatheterminal itselfortransferringthepricesprovidedbyobjectivesourcestothe
programusedbythecompany.
Mostvaluationtechniquesarebasedupondiscountedcashflowanalyses;inwhichexpected
futurecashflowsarecalculatedanddiscountedtopresentvalueusingadiscountingcurve.
Prior to considering credit risk, the expected future cash flowsmay be known ormay be
uncertainandrequireprojection.In‘Projection’case,marketforwardcurvesareutilized.In
optionmodels,theprobabilityofdifferentpotentialfutureoutcomesmustbeconsidered.In
addition, thevalueofsomeproductsmaybedependentonmorethanonemarket factor,
andinthesecasesitwilltypicallybenecessarytoconsiderhowmovements inonemarket
factormayaffecttheothermarketfactors.
At thispoint,Accounting&ControllingandComplianceDepartments takeresponsibility to
establishaccountingpoliciesforfairvalueandproceduresgoverningvaluationandtoensure
compliancewithallrelevantaccountingstandards.
7.Conclusion
Giventheinternationalenvironmentvariablessuchaspoliticalrisk,socialrisk,international
market imperfections,complexityofoperations,FXcurrencyriskandother local factorsof
countries,multinationalcompaniesarestrugglingtocontinuetheirbusinesses.Furthermore,
inrecentdecades,duetoanumberofreasonsincludingslowdownindevelopedcountries,
MNCs shift their focus to emergingmarkets, which have higher potential for growth and
34
higherprofitmarginsalthoughtheybringalongnewriskssuchasexposuretoFXcurrencies
with higher interest rates, volatility and fragility. Even though you consider that they
combine these risks with the opportunities of international diversification, they will still
requirehighlyeffectiveriskmanagementpolicies.
In that respect, due to the very nature of being involved in international operations and
investments,multinationalcompaniescanbequitevulnerableagainstdramaticchanges in
FXratesdependingontheirnetexposures.Although,intheory,mostoftheexposuresofa
company can be eliminated by investors via diversified portfolios, the companies are still
concernedabouttotalrisk.Highvolatilityinearningshasthepotentialtocauserealfinancial
costssuchasbankruptcy,underinvestmentandexcessivetaxation.Therefore,recentstudies
arguethatasuccessfulhedgingprogrammayincreaseshareholdervaluebyreducingcosts
relatedtodifferentmarketimperfections.
ThispaperparticularlyfocusesontheFXcurrencyrisksincethefluctuationsinFXrateshave
the potential to affect company’s KPIs, financials, profit margins, value of assets and
liabilities as well as equity. Therefore, if not managed properly, it may risk all the
performanceindicators,competitivenessandevenexistenceofthecompany.
WhenitcomestomanagingFXcurrencyriskseffectively,financialinstrumentsshouldnotbe
considered as the only option tomitigate risks. There can be different alternatives under
“operationalhedging”witharangeofvariouscosts.Thispaperprovidesclearguidanceon
how to assess these alternatives from a cost-effective perspective. Only after having
investigated each and every possibility related to operational hedging methods in
conjunctionwithcriticalfinancialdecisions,acompanycanconcludewithasubstantialbasis
that the restof theexposurewillbe subject tohedgingvia financial instruments,which is
themainfocusofthispaper.
Subsequently,thispaperpresentsallkeystepstobetakeninordertodesignaneffectiveFX
riskmanagementpolicyincludingthedefinitionofFXrisk,purpose,scopeandobjectivesas
wellasquantificationofexposureandvarioushedgestrategiesbasedonthenatureofthe
risk.
In termsof scoping, it is concluded that it isnotpossible tohedgeeverythingdue to cost
restraints. For instance, in some countries, hedging costs can write-off the profit of the
35
business;thus,itmightbewisetochoosenottohedgethe(whole)exposuredeliberatelyor
to make use of local solutions for less liquid currencies instead of executing the
requirements of a general policy. Thus, the determination of scope is quite important in
termsofgettingefficient results.Thispaperpresentsa fewsuggestionsaswellasasetof
questions,whichwillprovideaclearguidanceonscoping.
Inobjectivespart,itisarguedthatregardlessofmethodsorscopetobeadopted,oneofthe
foremost objectives of the Policy is the reduction of the volatility in financials to ensure
sustainable growthand return for stakeholders aswell as general riskmanagement gains.
However,eachcompanyhasdifferentfinancialKPIs,thusitisconcludedthatthereduction
of the volatility can be considered for different items of financial reports, like earnings,
EBITDAorEBITAandincludedinthePolicyinthatway.
Ultimately,thepaperprovidesanoverviewoftheissuesassociatedwithunderstandingand
managing FX risks by maintaining basic but realistic examples from corporates. In that
respect, these examples show 5 different scenarios, in which the parent and subsidiary
hedge different types of exposures partially or fully. The outcomes are represented in
operating profit. At the end, although Scenario 5, which requires hedging of both
transactionalandtranslationalexposures,givesthebestfinancialresults,itisconcludedthat
itisnotviablebecauseof(i)beingnothedgeaccountingfriendlyasexplainedaboveand(ii)
timegapfortransactionalexposuresbetweenanticipationandrealization.Consideringthe
imperfectionsinrealworld,prioritizingthetransactionalexposuresincludingintercompany
transactionshavehigherpotentialtogivebetterresults,ifnotperfect.
FX currency risk management is not a recent concept; thus, it is possible to find many
researchpapers,booksandarticles focusingondifferentpartsof it.However, this paper
provides a comprehensive step-by-step, practical guide to design an effective risk
management policy by combining the academic and the practitioner’s perspective. It also
questionswhetheritisnecessarytobringafreshlooktocertainconceptsandrulesrelated
toFXriskmanagement,whichhavealreadybeenknownanddiscussedformanyyearsand
not changed a lot. Finally it aims to structure a framework by touching all the relevant
practical matters as well as providing academic proof for recommendations given. In that
respect,itisimportanttoperceivethatitisnotpossibletorecommendoneverykeystepsince
eachcompanyhasdifferentdynamicsandthispaperisnotwrittenforaspecificcompany.In
order to address majority of MNCs, the aim of this paper is to provide all the relevant
36
informationinapracticalway,createawarenessofdifferentapproacheswhilechallengingthe
generally-acceptedrulesandyet,torefrainfromgivingstrongrecommendations.Ultimately,
thepolicyofeachcompanywillbetailor-made.
37
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