1) There are three main types of FX risk that require management: transaction risk, translation risk, and economic risk. 2) Translation risk is often overlooked despite its potential impact on accounting metrics and lending covenants. 3) Treasurers have a variety of internal and external tools to manage FX risk, including hedging strategies, but also need to establish clear risk measurement to ensure hedging is effective.

1. a buyer’s guide to Risk ManageMent systeMs
Economic
Uncertainty Brings
FX Risk Into Focus
Managing foreign exchange (FX) risk is a key responsibility for corporate
treasurers. There are different types of FX risk that require attention, as well as
a variety of regulatory and compliance issues to address. Ben Poole examines
these challenges and the variety of tools and techniques available for treasurers
to mitigate and manage FX risk.
T
he importance of FX risk management is Translation risk receives less focus, according to but then it is correspondingly more difficult to
accentuated over periods of uncertainty, Kevin Lester, director of risk management and hedge balance sheet items in a cost-effective
which is a reason for its rise in prominence treasury services at Validus Risk Management, manner,” Murarka notes.
of the past few years. But what constitutes and gtnews contributing editor: “Translation
FX risk? For the purposes of this feature, FX risk is risk is an area that is often overlooked, at least Economic risk is also an area which deserves
made up of the following elements: in terms of the implementation of FX hedging more attention, as it represents the long-
• ransactionrisk: The risk of value changes when
T strategies, largely due to the fact that it does term risk that currency volatility poses to the
a transaction executed in foreign currency is not directly impact cash flow, and as a result value of the company, and “is arguably the
measured in the functional currency. hedging translation risk can lead to cash flow most important category of FX risk,” says
• Translationrisk: When a company has mismatches between hedging instruments and Lester. As the impact of economic risk goes
subsidiaries with assets or liabilities underlying exposures.” far beyond the reporting of FX gains and
denominated in a functional currency other losses, and can relate to more fundamental
than the reporting currency of the holding Despite its low profile, translation risk can have strategic issues such as competitiveness and
company. Most multinational companies important repercussions, particularly in terms geographic expansion, the more abstract nature
(MNCs) are heavily exposed to translation risk. of lending covenants, which are measured of economic risk can pose a challenge for
• Economicrisk: The future impact on cash using accounting metrics that are impacted corporate treasurers. However, the significance
flows and earnings of a company as a result of by currency volatility. As such, it is often the of economic risk to commercial strategy can
long-term changes in FX rates. case that the issue of translation risk deserves also mean it is an area in which the treasurers
greater focus than it currently receives in many can add considerable value to the business.
Typically, the management of transaction risk companies, particularly in situations where a
has been the main focus of corporate treasurers. high degree of leverage is employed and there is Tools for Treasurers
Transaction risk tends to be comparatively easy significant risk of breaching lending covenants. When it comes to the tools available to treasurers
to identify and manage using traditional hedging to help manage FX risk, these can be divided into
instruments, and often generates a high degree Vikram Murarka, founder of Kshitij Consultancy two main categories:
of management focus due to its visibility in terms Services, agrees, but sounds a note of caution. 1. Internal risk mitigation tools.
of creating profit and loss (PL) volatility. “Translation risk can be given more attention, 2. External hedging tools.
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2. a buyer’s guide to Risk ManageMent systeMs
Every company has a unique set of circumstances
and different market views
Internal risk mitigation tools involve minimising “Such products seem to be slowly re-emerging hedging programmes will often be judged on
the exposure or impact of FX risk on the as FX volatility has begun to decrease, and this the basis of whether or not the hedge made
company by adjusting internal business trend will likely continue as long as volatility money, thereby ignoring the original hedging
processes. These tools include intercompany remains contained,” says Lester. “This could objectives, as well as the performance of
netting programmes, risk-sharing pricing or be a dangerous trend, and treasurers should the overall portfolio (including the underlying
supply contracts, and developing natural hedging ensure that hedging products are robust exposure). Such an approach will often lead
opportunities (either through capital structure enough to manage risks effectively in highly to hedging activities that actually increase
adjustments or commercial adjustments). volatile markets.” FX risk, rather than decrease it, as the focus
According to Lester, companies are becoming becomes the hedging PL, rather than the
more focused on maximising the use of internal Looking at strategies treasurers are currently achievement of risk management objectives
risk mitigation techniques (and this trend will employing in this area, André de Klerk, which are aligned with overall corporate
likely continue over the next 12 months), as it financial risk manager at Moneycorp, suggests strategy.” In this case, it is essential to have
allows them to: corporates are using of a blend of financial quantifiable risk KPIs that are regularly
• Minimise hedging costs. products with different weightings over monitored, and used to recalibrate hedging
• Maximise credit availability (through a different periods. “Most of the companies we activity as necessary to meet the company’s
reduction in FX credit line usage). advise use a combination of spot, forwards and risk management objectives.
• Reduce the complexity of hedging FX options to achieve an appropriate result for
implementation (e.g. hedge accounting a particular requirement,” says de Klerk. “Every Kshitij’s Murarka adds: “We think that
requirements). company has a unique set of circumstances treasurers need to re-look at their preference
• Eliminate risk substitution (i.e. exchanging FX and different market views - using the right for the ‘natural hedge’. They can increase
risk for counterparty risk or liquidity risk). products at the right time is important.” the profitability of their companies - without
changing the risk profile - by asymmetrically
External hedging tools (FX forwards, options, FX Hedging Strategies hedging both payables and receivables.
structured products, etc) remain essential tools With these tools in place, treasurers need A natural hedge is a lazy hedge, producing
for managing residual FX risk (after internal tools to ensure that they have efficient hedging lazy results.”
have been fully exploited). “The popularity of strategies in place. The main areas that
structured products, particularly those involving treasurers need to pay attention to include: Mark Warms, general manager, Europe, Middle
complex derivatives or leverage, has certainly • Establishing clear hedging objectives. East and Africa (EMEA) at FXall, suggests that
waned since the onset of the financial crisis,” • Establishing quantifiable and visible risk key the main area for treasurers to pay attention
explains Lester. A key reason for this is that many performance indicators (KPIs). to in their hedging strategies is assessing
of these structured products contained ‘short • Ensuring hedging performance is regularly which trading methods they are using for a
volatility’ components, in the sense that they benchmarked against KPIs. specific situation. “Electronic trading provides
involved writing options to subsidise the cost of treasurers with a choice of execution strategies
hedging. As such, they were disproportionately “The setting of risk KPIs and hedging and it is important that choice is based on a
impacted when volatility spiked as a result of the performance measurement is an area which thoughtful process that is appropriate for the
financial crisis, and many hedging programmes could often be improved,” comments Lester. “In specific trading situation,” Warms explains.
did not perform well as a result. the absence of such benchmarking activities,
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3. a buyer’s guide to Risk ManageMent systeMs
Treasurers have often required complete end-to- analysis, making it very difficult for a third
end workflow solutions that encompass all aspects party system to meet the diverse needs of the
of trading and reporting to meet global compliance corporate treasury market,” he adds.
standards and thus manage their risks. “Execution
quality analytics tools are becoming increasingly Murarka agrees that the spreadsheet model is here
important for treasurers, providing them with to stay, but that technology providers can look at
a comprehensive trade performance overview, that as a starting point for the more complicated
as well as metrics to measure the effectiveness solutions they develop. “The most important
of their trading strategy, while at the same time technology that treasurers need is a software that
enabling regulatory compliance. End-to-end can track and collate all their FX exposures on the
integration of treasury management and hedge one side and all their hedges on the other side.
accounting systems with trading and settlement The software should look and feel like Excel, but
tools is a best practice for both risk management should work internally as a supercharged database
and operational effectiveness,” notes Warms. management system,” he says.
The Role of Technology Regulatory Environment
FX risk management technology can be divided Looking to the future of FX risk management,
into five main categories: regulation is a key ‘unknown’ that corporates will
have to pay particular attention to, according to
1. Market data. Moneycorp’s de Klerk: “The greater regulation of
2. Dealing systems. OTC [over-the-counter] derivatives is certainly a
3. Transaction/position management. concern for corporate treasurers. The biggest fear
4. Risk analytics. is that it will make hedging more expensive.”
5. Risk reporting/accounting technology.
New rules outlined under the Dodd-Frank Act in
According to Lester, there is significant overlap the US and the European Markets Infrastructure
among providers within these categories. Legislation in Europe, are placing new
“Most of the major TMS [treasury management requirements on OTC derivatives to be secured
systems] vendors do incorporate FX risk with cash collateral. Although corporate users
management functionality within their core of hedging instruments thus far secured an
systems, which facilitates everything from exemption from both regulations, they will still be
operational process management, such as required to report their hedging activities, monitor
deal capturing and basic reporting, through positions and provide detailed information to
to more analytical functionality, such as risk prove that their hedges are constructed to cover
measurement and sensitivity analysis.” commercial risk as allowed by the rules.
There are also specialised technology Over the past few years, the credit crisis
providers who focus on specific aspects of illustrated some of the limitations of current hedge
the risk management process, such as hedge accounting regulations, and accounting bodies are
accounting, deal life cycle management, working on replacement standards. Unfortunately,
exposure visibility and risk management accounting rules have been one of the things that
dashboard development. “The current trend is caused treasurers to avoid hedging. “When these
moving away from ‘all-in-one’ providers, where accounting regulations were first introduced, they
a single system is used for all aspects of FX risk became so important that they superseded the
management from operational to strategic, and business rationale for hedging. I am glad to see a
towards an integrated solution where best-of seismic shift after the financial crisis and rightly
breed providers are selected for their specific so,” says de Klerk. Economic and financial drivers
core competencies,” suggests Lester. are now far more important in determining a
hedging policy than the accounting implications.
When it comes to the more analytical or strategic
elements of FX risk management, the preferred Conclusion
tool for many corporate treasurers is still the FX presents a highly visible risk that treasurers
traditional spreadsheet (ideally populated need to manage as part of their daily
with data extracted directly from their TMS responsibilities. These challenges come in a
or accounting system to minimise data entry variety of forms, and with the OTC regulations
requirements and errors). Lester suggests that looming, it is a risk that will remain of critical
this is likely to remain the case, despite the importance in the future. There are tools and
advancements made by systems providers, due techniques available for treasurers to mitigate
to the need for flexibility when performing FX risk and manage FX risk, and it is important for
analysis. “Different corporate treasuries have every treasury department to give a thorough
very different approaches and requirements evaluation of what their needs are in this area,
when it comes to risk measurement and and to select the appropriate tools for the job.
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