Published: April 01, 2010
Some weeks ago, I came to the realisation that if I had to start another article with the words ‘the financial crisis’ then I would probably go mad, but on this occasion, I think it is justified and will therefore try to hold on to my sanity for just a little while longer. The theme of this article does indeed start with ‘the financial crisis’ but for once, it is focused on neither liquidity nor credit risk. One of the other implications, but which has received far less attention, has been the impact on the way that corporate treasurers have approached their foreign exchange (FX) risk.
One of the major implications of the crisis has been the increased focus on FX risk and what it means to the business.
The whole concept of risk management has changed unrecognisably over the past two years. The volcanic ash that closed airspace in the UK and much of Europe is an example in point. As treasurer of one of the major airlines told me earlier that week, you model the cash flow (as well as logistical) impact of planes being grounded for 24 or 48 hours, but certainly not for a week. The same applies to FX risk. With unprecedented market volatility, combined with uncertainty of revenues, the way that companies approach FX risk has changed considerably.
With unprecedented volatility in USD rates in particular, one of the major implications of the crisis has been the increased focus on FX risk and what it means to the business. As Anders Aslund, Corporate Risk Advisory, Commerzbank, explains,
“The importance of FX risk management was accentuated strongly during the crisis. Even if exposures are small, the potential financial impact of market movements can be significant if volatility is high.”
This volatility is not simply created by the impact of market movements. As Chris Leuschke, Global Head of FX Sales, RBS, emphasises,
“Treasurers have been forced to deal with volatility in terms of the impact of market movements, but also uncertainty in revenues, which in turn creates more FX risk.”
The combination of FX volatility and business flows that differ substantially from forecasts has resulted in many companies being over- or under-hedged. However, as Anders Aslund, Commerzbank, highlights, the implications of FX movements also extend beyond cash flow:
“The implications of FX movements do not only apply to costs and revenues. During a period of extreme volatility, many companies risked covenant breaches on their loan book triggered purely by FX moves, so we have worked closely with our clients to avoid any negative impact. We are also proactive in helping clients to draft loan documentation by analysing potential covenant sensitivities to FX rates and determine the right choice of currency in which to denominate their debt, to match operational cash flows and/or currency composition of net assets.”
The first step to making effective hedging decisions is to forecast cash flow effectively. Over the past two years, the inadequacies of many companies’ hedging policy, such as to hedge 50% of budgeted cash flow, have been revealed; consequently, while an accurate and proactive approach to forecasting has become more important for liquidity management purposes, it is an equally significant element of FX risk management as Aslund outlines,
Treasurers have been forced to map their risks more closely than they have in the past. In this respect, the crisis was helpful, as it has been easier to secure resources for this as FX risks have become much more visible and prominent. This has involved looking at cash flow and liquidity forecasts more deeply; by better understanding exposures and risk, it can be managed more effectively.”
Chris Leuschke, RBS, continues,
“Cash flow forecasting has become more volatile than under normal business circumstances. In the past, earnings and sales could be forecast reasonably easily. Since the crisis first struck, cash flow forecasting has been under more scrutiny, and many companies have found themselves either over-hedged as a result of over-estimated revenues, or under-hedged due to large currency movements. Consequently, treasurers have had to adopt a more rigorous approach to FX risk management.”
Cash flow forecasting can no longer be simply a rolling monthly process, perhaps just using budget information from the ERP, but a highly responsive activity using up-to-date information from business units, and reviewed on a continual basis. [[[PAGE]]]
In addition to forecasting more accurately in order to identify exposures, treasurers’ approach to hedging has changed. In the past, many would hedge an exposure and leave the hedge transaction until maturity. Today, the approach to hedging has had to become more proactive in line with more detailed and timely forecasting, as Leuschke explains,
“Treasurers have looked at their hedging portfolio and taken a more proactive, analytical approach; rather than just one-off hedging of flows, and leaving the hedge transaction until maturity, they have been more active in reviewing and adjusting the tenor, amount and level of the hedge. The crisis illustrated the importance of putting in place the right tenor of hedge transaction, which is closely related to cash flow forecasting accuracy. Some have extended the tenor of hedges, but overall, we are seeing treasurers becoming more conservative in the ratio of exposures that they hedge.”
The first step to making effective hedging decisions is to forecast cash flow effectively.
Not only has corporate hedging become more proactive, but the type of transactions has also changed. Use of FX forwards and swaps has been core to most treasurers’ hedging strategies in recent years. However, this is now changing as treasurers become more inclined towards the use of options. Terms such as ‘options’ and ‘derivatives’ still fill many people with dread, for a variety of reasons.
Firstly, treasurers are loath to pay a premium, and in the past, may have found it difficult to justify this internally. However, just as senior management now recognise the importance of liquidity management, they also realise that unprecedented market events mean that a new approach to financial management, including FX hedging, may be justified.
Secondly, the hedge accounting demands of FAS 133 and IAS 39 have discouraged many corporates from pursuing option-based strategies in the past. This approach has in many cases proved detrimental, again leading to a change of strategy.
Thirdly, options often seem to be shrouded in mystery and fear, and many treasurers feel that they do not have the internal human or technical resources to manage more complex instruments appropriately. Chris Leuschke emphasises,
“There is proven value in including optionality in a hedging portfolio. Most companies use FX forwards; however, during the crisis, a major difference between the financial fortunes of peer companies was the effectiveness of their hedging programme. While some corporates have been reluctant to purchase optionality by paying a premium, the value to this approach is now recognised. We are able to show them that the premium should not be a concern as it can often be built into the hedge outcome or lent against the hedge proceeds.””
Anders Aslund continues,
“Since the crisis, more companies are seeing the value of option-based hedging, such as barrier-based option structures, which can be a very useful tool when used appropriately, especially for hedging ‘worst case scenario’ risks.”[[[PAGE]]]
Speak to your banks about potential hedging strategies and ensure you understand your alternatives fully.
But under FAS 133 and IAS 39, the use of options became an anathema. While these regulations are changing, does the crisis mean that hedge accounting treatment is no longer a priority? Anders Aslund responds,
“While FAS 133 and IAS 39 introduced some worthwhile thinking into companies’ hedging decisions, such as understanding their reasons and rationale for hedging, the requirements went too far. When these regulations were first introduced, accounting requirements became so important that they superseded the business rationale for hedging. Now treasurers are taking a more balanced view: if cash flows need to be hedged for economic reasons, lack of hedge accounting treatment is not reason enough to avoid hedging.”
Chris Leuschke concurs,
“While five years ago, reluctance [to use options] was often due to concerns about how to achieve hedge accounting treatment under IAS 39 or FAS 133, this is less the case today, and the crisis has highlighted that economic drivers for hedging should outweigh the accounting implications.”
But if treasurers are starting to throw off the accounting shackles, are all departments in a position to manage the more complex instruments that have often been central to front page stories of financial losses in the financial press? To do so effectively needs a treasury mandate, together with sufficient resource and expertise, systems and reporting. Anders Aslund, Commerzbank provides reassurance,
“We are helping clients to identify and align their risks. Treasurers are always under-resourced, and during a period when they have been under pressure, they have become more open to advice and solutions from their banks and this openness helps us provide better matched hedging solutions.”
He goes on to say, however,
“Treasurers often feel that they are under-equipped to do the risk analysis they need, and are constantly striving to improve. In many cases, particularly in companies that operate internationally, treasurers need to upgrade their toolkit, including both technical and human resources to get better visibility and understanding of both the scope and complexity of the risks they are charged with managing.”
So what actions should treasurers who may need to consider more proactive and specific hedging solutions be taking?
i) Speak to your banks about potential hedging strategies and ensure you understand your alternatives fully.
ii) Involve individuals engaged in front office, risk management, back office and accounting (which may often be the same people) to check that the implications of conducting new hedging strategies are recognised, from deal capture through to ongoing reporting and accounting.
iii) Conduct a cost benefit analysis to determine the relative economic benefits of a hedging strategy if hedge accounting treatment cannot be applied.
iv) Engage system vendors early on to identify any system modifications or additional set-up that may be required to manage more complex instruments. The cost of these modifications, additional system modules or new report definition should be built into your cost benefit analysis.
v) If you have used a spreadsheet-based solution for managing treasury operations, it is unlikely that option-based products can be supported easily. In these situations, consider implementing a specialist solution, or finding out from your banking partners what tools they may be able to provide. For example, as Chris Leuschke, RBS explains,
“Only the largest corporates have dedicated treasury or risk management systems and resources, so we work closely with clients to help address this. For example, we provide online risk management tools that analyse their exposures and hedges across portfolios, including transactions both with RBS and with other banks. These tools illustrate any gaps between forecasts and hedges, and allow ‘what if’ analysis on currency movements.”[[[PAGE]]]
The golden rule remains: don’t deal what you don’t understand. This is not a negative indictment on treasurers, merely a recognition that not all departments have the people and technology to be able to manage more complex instruments effectively. However, there is undoubtedly a shift in attitudes taking place, with the accounting tail no longer wagging the treasury dog (blame Pepper for the pun, he doesn’t have the patience to do his accountancy exams, much like his owner. Also I apologise to accountants who may have been flattered at being described as a dragon, and now in a slew of similes, are being presented as more canine than draconian). Banks are providing more proactive support both in terms of advice and the tools to manage more complex hedging structures; furthermore, most treasury management systems will provide capabilities in this area.
Another challenge that is looming for treasurers is the greater regulation of OTC derivatives.
One of the major ways that risk management has changed is the realisation that assessing probabilities and preparing for events that could easily be envisaged is not the point of the exercise. The purpose of risk management is to prepare for the unexpected, rather than the simply undesirable. As Anders Aslund, Commerzbank outlines,
“During the crisis, every treasurer had to rethink their risk. The price of risk was too low in the past, and therefore companies became complacent. What was previously considered as a ‘worst case scenario’ has been shown to be a relatively moderate view, so treasurers now need to and increasingly do think the unthinkable when stress testing their hedging portfolio. For example, in the past, treasurers may have modelled USD appreciation by 10, 20 or 30% but now they are looking at a potential appreciation of 60%, or perhaps even 80%, and looking at how they could manage this type of extreme scenario, and the cost of hedging, or not hedging this risk.”
Another challenge that is looming for treasurers is the greater regulation of OTC derivatives. In Europe, it appears that corporate users will be exempt from the new regulations, so treasurers’ hedging behaviour should be unaffected. This assumes that these exemptions will not be reversed by the Basel III proposals that will be finalised late in 2010. In the United States, however the situation is far from clear, potentially severely impacting on treasurers’ ability to hedge their genuine economic risks. Treasurers are advised to continue talking regularly to their banks and treasury associations to keep up to date with the latest developments and as a channel for making their views known. The EACT continues, for example, to be very active in representing the needs of corporate treasurers both in Europe and further afield.
Furthermore, the crisis illustrated some of the limitations of current hedge accounting regulations, and both FASB and IASB are working on replacement standards. What is clear is that the next two years are likely to see major shifts in the way that hedging decisions are made, the transactions that are undertaken will potentially change depending on the outcome of regulatory decision-making in the United States, and the accounting treatment of these transactions will change. Many treasurers found that they were over- or under-hedged during the crisis, leading to major financial uncertainty and a loss of competitive advantage compared with peer companies, so throughout these changes, it will be vital to keep the economic needs of the business at the forefront of hedging strategies.
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