Getting the House in Order

by Karlien Porré, Director and James Adams, Senior Manager, Treasury Advisory, Deloitte LLP

With companies facing volatile currency markets and increased risk aversion, many corporate treasurers are going back to basics and revisiting their risk management policies, particularly for foreign exchange risk. In this article, we explore some of the latest thought areas.

A heightened risk environment

Many corporate treasurers used the relatively calm conditions at the start of 2011 as an opportunity to catch up with their housekeeping and complete long awaited tasks. Those that chose to revisit their risk management policies are fortunate enough to be in a more resilient position to weather the volatility that returned in the second half of the year. Escalating European debt concerns, slowdowns in the global recovery and ongoing regulatory changes in the banking sector are just a few of the factors that are contributing to current market uncertainty.

Increasingly, companies that did not have the opportunity to review their policies are approaching us to discuss the lessons learnt from the crisis and latest thoughts in this area. Foreign exchange risk management has always been a topical issue. Although treasury policy in itself is nothing new, the tools and approaches have developed markedly in response to this increased focus.

Before revisiting their policies, companies first need to be clear about what they would like to achieve from a risk management perspective. This requires taking a step back to understand the nature of their risks. Treasurers can then evaluate them in light of the organization’s risk appetite and develop a revised policy. At this point, companies can then effectively consider their use of derivatives and other hedging techniques.

Start with a risk management framework

A common framework for approaching the problem is outlined in figure 1. If we take this approach and apply it to foreign exchange risk management, a series of questions needs to be addressed.

What is my risk?

The three main types of foreign exchange risk that companies typically monitor are transactional risk, translational risk and economic risk.[[[PAGE]]]

Transactional risk involves actual flows of cash in the future, for example those resulting from exports or imports.

Translational risk involves the foreign exchange difference experienced when re-converting a foreign exchange value into the functional or reporting currency of the company or Group concerned. The translation may be in respect of earnings, costs, assets or liabilities. Frequently translation risks turn into transaction risks at a later date as earnings are repatriated or assets and liabilities are realized.

A further consideration for many companies is the economic risk of foreign exchange movements. These arise due to long-term changes in currency values and often have a material impact on the relative competitive position of a company.

The hedging decision

When treasurers have identified and evaluated their risks, they can then consider whether to accept the risk internally or transfer it externally. The first step in any hedging strategy is to be very clear on two questions:

1. The size of the risk – is it big enough to cause an issue?

If the answer is ‘yes’, then the next question is :

2. What are your hedging objectives?

Determine your FX hedging objectives – not as easy as it may appear at first

When faced with multiple currency exposures, it may at first appear simple and straightforward to decide on the hedging objectives. Most companies want to replace uncertainty and the risk of surprises with certainty and the ability to forecast with a strong degree of confidence. The question is: Which financial indicator should be hedged? The starting point may be that cash is the key driver of value, and hence this should be the focus. In practice, however, hedging cash may result in un-hedged income statements and volatility in reported profits and taxes. A trade-off often needs to be made.

For example, let us take a UK listed company which has subsidiaries in various locations, such as Euro and USD denominated countries. Each entity has cross-border sales or purchases and hence faces local currency transaction exposures. The question is simple: What should the FX hedging policy aim to protect? Broadly speaking, there are two main approaches:

• A common strategy is to hedge local transaction exposures into the local reporting currency of each entity. Thus, non-Euro sales or costs in a Euro entity would be hedged into Euro, protecting local Euro profitability and cash flows. Consolidation of foreign earnings into Group currency, here Sterling, is not usually hedged for a variety of reasons until they are distributed in cash, e.g. in the form of upstream dividends. The latter may not happen until, or after, year-end. As a result, consolidated surplus cash is exposed to exchange rate movements and not protected. Returns to shareholders in the form of dividends therefore remain largely exposed to the currencies of the underlying operations. In contrast, as local taxation of transactions would generally be calculated on the basis of the reporting currency of a legal entity, this approach creates the least local tax volatility. A further point to consider would be an effective post-tax hedging strategy for dividends received by Group Treasury in the local currency of the remitting entity to the extent such dividend flows are tax exempt for the UK parent.
• Another strategy is to effectively ignore the reporting currency of the individual foreign entities and hedge all exposures directly into the Group’s primary currency, in this case, Sterling. For example, Sterling denominated sales by a Euro entity would not be hedged into Euros; instead its Euro costs would be hedged into Sterling. Whilst this approach may achieve the holy grail of protecting cash flows in the primary currency, it gives rise to many practical obstacles and disadvantages, which must either be overcome or accepted. The main disadvantage is that reported earnings in local currencies are not hedged and will potentially display material FX gains and losses. Whilst these would be ‘unrealized’ – as the ‘realized’ cash position is protected in Sterling – they could have an indirect cash impact as there may be local tax payable on any FX gains reported in the local entity’s accounts. Other challenges include the need to explain the inevitable FX gains and losses that would end up in the consolidated earnings to investors, and to ensure that financial covenants treat these FX gains and losses appropriately to avoid breaches being triggered.

Strategies can combine an element of both extremes and effectively deliver a ‘half way’ result. For example, individual entities hedge their local exposures through internal deals with Group Treasury, thus protecting their local P&L. Group Treasury then calculates the consolidated net cash flow exposure to its main currency and hedges those in the external market. This would achieve a hedged cash position and local income statements (thus avoiding potential local tax volatility) but all visible FX impacts in the income statement would continue to exist within the Treasury entity.[[[PAGE]]]

In practice, most companies opt for a version of the first approach. The second approach is more common in certain industries, mainly commodity businesses such as oil companies, where the business is largely driven by one currency (typically the US Dollar) and hence local currency results are relatively less important.

How much risk can you take?

The most appropriate approach will depend on a number of factors; however, a key factor is whether the strategy is consistent with the risk appetite of the Board. As with many risks such as insurable risk, companies choose to accept some risk and lay off other risks with third parties; the same holds true with foreign exchange risk management. The strategy must be consistent with the Board’s expectations and understanding of those risks that are worth accepting, and those which are unacceptable and therefore should be hedged in the market after any natural offsets have been eliminated. In some cases, companies might decide to accept additional risk to support other business objectives. For example, choosing to procure in local currencies to concentrate FX management in-house rather than with local suppliers.

Whichever FX hedging strategy you adopt, the key is to be absolutely clear on its objectives and understand its shortcomings. One thing is certain: No FX policy can achieve everything.

Trading approved derivatives

There are now a variety of derivatives being actively marketed. At a time when the exchange rate might already appear to be against you, a forward foreign exchange deal can seem to be merely locking in the bad situation, while buying an option can look very expensive.

Some companies are therefore attracted to more complex derivatives. These structures often contain embedded options such that there is no net premium when entered into, and they may appear to ‘outperform’ the current market rate. Whilst these often look appealing at first sight, there are a number of issues to consider from a policy and accounting perspective, including their effectiveness in stressed market conditions.

Treasury policies must state very clearly which derivatives are allowed to be used. These polices should be consistent with the risk appetite, objectives and internal resources of the organization. There have been examples of companies entering into more complex derivatives and being caught out by movements in rates that have resulted in material unexpected losses. In one case, this caused financial covenants to be breached and loans had to be renegotiated.

Derivatives are valuable risk management tools, but as these lessons show, they should be used by companies with the appropriate policies, resources and technology in place to fully understand their implications.

A consistent approach

Companies have benefitted recently from showing an increased desire to adopt a formal approach to their risk management strategies. While each business is unique and there is no single strategy that can achieve everything, there is a consistent approach that can be applied across companies.

This begins with quantifying the risk, identifying possible risk mitigation techniques, illustrating the financial effects of the alternative strategic options and evaluating this in a format that is consistent with the Board’s risk appetite. The output from this process is a hedging policy, which is justifiable to internal and external parties, providing a framework to navigate the current market uncertainty.[[[PAGE]]]