Companies will often hedge foreign currency exposures against harmful exchange rate fluctuations. Having decided to enter financial instruments, such as forward exchange contracts and options/collars, it is necessary to evaluate the performance of the hedging programme. There are a number of reasons companies will transact hedging not all of which are about “beating the market”. Stabilising selling prices or input costs, reducing volatility of profits, gaining a competitive advantage or displaying strong controls and risk management to key stakeholders are all good reasons to hedge FX.
Regardless of the reason for hedging, an evaluation helps with understanding whether the company has achieved its FX hedging goals. It confirms whether the hedging strategy has been successful, determines whether the choice of hedging instrument was appropriate, challenges whether anything could be done differently e.g. perhaps paying some premium for options might have delivered an enhanced result.
There are a number of metrics for assessing the success of an FX hedging strategy:
- Was the prevailing market rate at the maturity of the contract better or worse than the rate the contract was entered at?
- What is the P&L impact at the maturity of the contract?
- What is the weighted average rate of all FX contracts that matured in the last month/period i.e. the average conversion rate?
- Did the conversion rate beat expectations/budget?
- Would the company have been better off doing nothing?
It is important to address these questions otherwise the success of the hedging is too subjective. So how can a company easily understand the impact of its hedging decisions? Systems such as HedgebookFX can provide most of the answers. For example HedgebookFX’s Matured Deals Report includes the prevailing market spot rate at the maturity of the contract, the P&L impact and the conversion rate for the month.
Comparing against a benchmark
Having a benchmark rate to compare against is also helpful. The company’s monthly conversion rate can be compared to alternative hedging approaches such as no hedging (spot rate), passive hedging (mid-points of policy risk control limits, if the company has one) or some other mix of hedging instruments and/or duration of hedging.
The chart below is automatically generated for Hedgebook users. In this example the actual NZD/USD conversion rates are plotted against two alternative measures:
- No Hedging (spot)
- A mix of spot, six month and 12 month FX Forward contracts
The chart allows an objective consideration of the impact of hedging decisions.
Using a passive benchmark allows the business to understand the value added by the decision makers i.e. hedging decisions are captured within the actual conversion rate. The conversion rate is the outcome from active FX risk management. Critically evaluating the outcomes from hedging allows the business to gauge the success of its hedging programme.
Want to know more about managing your FX? Download our free guide “Dollars & Sense”, which covers how to better manage FX Risk. Understand what constitutes FX risk, whether you should be hedging against it, the common financial instruments involved and the technology tools available to make the process easier. https://www.hedgebookpro.com/hedgebook-fx/