Mid-sized companies meeting currency risk management challenge.

Treasury Strategies recently completed a benchmarking review of how mid-sized, growth-oriented companies are facing the challenge of currency risk. Interviews with treasury executives were in-depth and encompassed the entire risk management cycle. It was expected that these companies might be struggling to develop a logical currency risk framework or be concerned about trading and accounting for derivatives. It turned out, however, that what caused nearly all of the companies the greatest concern was the challenge of obtaining accurate and timely exposure data.

A Five-Step Approach is recommended for companies reviewing their approach to currency risk management. Begin by defining the type of currency risk to be managed. If treasury, executive management and the business units don't agree on which risks are important, you don't have a strong foundation. Second, determine how to measure defined risk. In essence, this is what treasury reports on the weekly executive dashboard. Third, establish an efficient process for gathering exposures. Fourth, determine what strategy the company will employ to manage this risk. It's important to note that staying exposed can be just as wise as hedging. Finally, if a company is going to hedge, it must have an efficient and compliant process for trading, tracking and accounting for derivatives.

Prioritizing Currency Risk. In the interviews, four categories of currency risk were defined: economic, transaction, forecasted and translation. When asked where they placed the highest priority, the majority of the study participants named transaction risk. Transaction risk is clearly measurable, and its effects are reported directly as gains or losses in operating income. The second priority was forecasted risk. Nearly all companies were concerned with forecasted exposures; however, only a few were comfortable that they could accurately forecast those. Translation risk, reflected in other comprehensive income, was a low priority, as was economic risk.

Monitoring Exposure: A Practical Challenge. The companies in the study were using the traditional methods of gathering exposures. Most common was a monthly exposure spreadsheet that each business unit emailed to the corporate treasury. A few companies accessed the general ledger directly to gather exposure data for the business units. Others relied on informal investigations of major sources of currency risk.

Treasurers struggled with the objective of getting timely exposures monthly when the close cycle may take as long as two weeks. When asked what they considered the greatest challenges of managing currency risk, it was the practical challenge of obtaining accurate exposures in a timely and efficient manner that caused the greatest frustration. One company followed a process each month of close, review, reforecast of month-end exposure position and hedge; by the time the company actually placed the hedge, month-end was only two weeks away.

Setting the Strategy. Once a company has measured its exposure, the next step is to determine how to manage it. The study participants that hedged relied heavily on "plain vanilla" forwards. A typical company would establish coverage levels for varying timeframes, for example, hedging 100 percent of booked exposures, 50 percent of forecasted exposures over the next rolling 12 months, and 25 percent of forecasted exposures between 12 and 24 months out. Some companies made limited use of vanilla options. Options are a popular technique when the company does not want to commit to a hedge position or is concerned about lack of an off-setting accounting gain/loss. Notably, the flexibility provided by forward/option hybrids such as range options and participating forwards was not as critical as correctly measuring exposure and calibrating the right hedge ratios.

A number of firms recognized that non-derivative hedging techniques can also be highly effective. One company required treasury to approve any sales contracts not denominated in U.S. dollars. Treasury might then require a currency clause to protect both the company and the customer from exchange swings outside of an agreed-upon band.

Successful Execution. When it came to the final steps of executing hedge trades, most companies worked with their bank, either trading online or by telephone. Few regularly bid the trades or utilized an auction portal. Surprisingly, only one company identified FAS 133 as a significant challenge. Several respondents had not chosen hedge accounting for their program, citing the short nature of their positions.

For companies hedging forecasted exposures and electing hedge accounting, the principal challenge was to ensure that derivatives could be matched to a pool of exposures with similar time horizons. By hedging only a portion of forecasted exposures (with a smaller portion for more distant and less accurate exposure forecasts), the company could ensure a reliable level of underlying exposure with which to demonstrate effectiveness.

Stephen Baird (stephen_baird@treasury strategies.com) is a Principal with Chicago-based Treasury Strategies.