When it comes to business risks for manufacturers and exporters, time and again FX volatility comes out as the number one concern. FX risk management is seen as a murky world but it doesn’t have to be if you are disciplined about following these six steps.
Step 1 – Identify the FX exposure
It is an important first step to identify and measure the foreign exchange exposures that need to be managed. You will need to think about the timing of the receipt or payment. What date do you need to hedge to? As an exporter, how confident are you funds will be received on a certain day, week or month? For an importer, often it will be an invoice that will need to be paid on a certain day, based on the agreed payment terms with the supplier.
You may have some offsetting risks. From a risk management point of view it reduces your risk if you can offset any incoming amounts against any outgoings that are in the same foreign currency, so that you only hedge the net amount. Again this will depend on the timing of the receipt and the payment.
Step 2 – Develop your FX risk management policy
Once you have identified your FX exposure it is then important to formulate a Risk Management Policy that is followed in a disciplined way. This policy can be developed by yourself or you can use your bank or an independent treasury adviser/consultant to help you.
The policy will include the amount of hedging that can be transacted (likely a minimum and maximum percentage of the exposure) and the instruments that can be used.
Depending on the size of your organisation, often the Board of Directors will approve the policy and give senior management the authority to act within it. The only time senior management would go back to the Board would be if they wanted to do something that was outside of the agreed Risk Management Policy.
Step 3 – Ascertain and measure your budget and/or costing rates
For most companies it is important to protect the budget rates that have been agreed prior to the start of the financial year. For manufacturers it may be a costing rate for a particular job or event that is important.
The protection of such rates may well be the underlying reasons to hedge. It is important that these rates are identified and measured.
Step 4 – Formulate your hedging strategy
Formulating a hedging strategy that works within your policy and bests position you to achieve the outcomes you desire is an important step.
It is important that you have access to accurate information when looking at your strategy. You need to have good visibility over your expected cashflows, the hedging you may already have in place and where exchange rates currently are.
You may require some outside help to formulate your strategy. Your bank or an independent treasury adviser/consultant can assist with this in terms of the instruments you should use, the exposures you are hedging and the amount of risk you are prepared to take.
Step 5 – Execute your hedging strategy
Once the hedging strategy has been formulated the next step is to execute. It is important that you understand the impact of the hedging you are putting in place. For those using FX forwards this is simpler than if you are also using options as a hedging instrument.
If you can’t explain to your board the instruments you are entering into and the impact on your FX position then you shouldn’t be entering into them.
Step 6 – Evaluate the results and adjust if necessary
The final step in the hedging process is to evaluate and measure the results, and, if necessary, adjust the strategy.
The basis of the evaluation will depend on the overriding reason to hedge. Was it to protect a budget rate, a costing rate or merely to give some certainty of cashflow?
To measure these results you need to be able to accurately track the hedges you have put in place and compare to the budget rate or the spot rate on the day. This will require the ability to measure the weighted average exchange rate achieved and to compare against the yardstick you have chosen. This is possible within a spreadsheet but easier with a treasury system.