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.

Assessing success

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.

HB Demo NZD - FX Matured Deals Report

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

FX Benchmark

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.

As clearly highlighted by the Brexit induced currency volatility, UK based importers and exporters have their own challenges when managing foreign currency cashflows. However, the approach to FX management is the same as how we approach it in New Zealand and Australia. Foreign currency cashflows (known or forecast) are identified and quantified, then hedging contracts such as forwards and options are entered to mitigate the impact of current fluctuations on P&L.

The UK, therefore, is a natural market for the Hedgebook software and as such we have opened a UK office in London. Wicked, innit?

London CityAs Hedgebook’s UK Client Relationship Director, Graham Dockrill, says, “The UK operates under the same IFRS accounting regime as New Zealand and Australia, plus the importers and exporters based here have an equally volatile foreign exchange landscape to navigate as those companies based in Australasia. Hedgebook is fit for purpose here in the UK and there are literally tens of thousands of companies in the SME space that can benefit from Hedgebook’s easy-to-use software. My goal is to introduce Hedgebook to these companies so they can manage this significant risk to their businesses and make better hedging decisions.”

Click here to view Graham’s contact details

The dairy industry remains the back-bone of the NZ economy with annual exports in excess of $11 billion. Waikato Milking Systems is an award winning (2016 ExportNZ Exporter of the Year) manufacturer of dairy technology used to increase the efficiency and productivity of the milking process. Based in Hamilton, Waikato Milking Systems exports to more than 20 countries globally so naturally foreign exchange is a significant risk requiring close management.

Waikato Milking Systems

According to Richard Aubrey, Waikato Milking System’s CFO, “With currency exposures in USD, EUR, GBP and AUD the time had come to move away from relying on spreadsheets to manage the company’s foreign exchange risks. Hedgebook provides an easy-to-use system for the finance team, strengthens our internal controls and provides clear visibility over our hedging position. Using information from Hedgebook we can easily provide the sales teams with FX assumptions when pricing new business opportunities.”

Hedgebook looks forward to working with Richard and the team.

New compliance rulesThe global financial crisis was the catalyst for a myriad of changes in the regulatory environment of derivatives. From Hedgebook’s perspective it is the changes that relate to the fair value of financial instruments that is particularly of interest. Although banks have been reporting CVA and DVA for a number of years, it is only over the last couple of years that we have seen greater numbers of end users/companies doing so.

Alongside CVA and DVA within the family of derivative valuation adjustments sits FVA (Funding Valuation Adjustments). FVA is an adjustment to the risk-free valuation of financial instruments and reflects the bank’s funding and liquidity cost of a trade. Until recently, the reporting of FVA was only for the bank side and not included in mark-to-markets sent to the customer. However, as of March 2016 Westpac has been including FVA within the valuations of interest rate swaps sent to the customer.

Hedgebook’s understanding of the accounting standard (IFRS 13) is that end users are not required to report FVA in the accounts, therefore, for those companies relying on Westpac’s valuations they may be reporting incorrect valuations. It is a question for the auditors, although it is fair to say that there is even less audit consensus (understanding?) on FVA than there is on CVA/DVA. It will be interesting to see if any of the other trading banks follow Westpac’s lead and include FVA into derivative valuations and what it means for companies relying on these valuations for financial reporting purposes.

Kapiti Coast District Council (KCDC) has been a Hedgebook client for almost two years. Originally Council’s requirement for Hedgebook was to perform the independent valuations of its interest rate swap portfolio at 30 June financial year-end, including the sensitivity analysis for +/- 100bps. Independent valuations are required by KCDC’s auditor hence reliance on bank valuations is not acceptable. Beyond valuations the finance team has taken advantage of some of Hedgebook’s other functionality such as interest accrual and cashflow reports to assist in the day-to-day management of derivatives and debt. Says Mark de Haast (Financial Controller), “I am super impressed with Hedgebook and cannot wait to see the new developments.”

At Hedgebook we listen to the feedback of our users to ensure future development is practical, useful and simple to use.

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