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Let facts guide management of foreign exchange risk

Given all the uncertainty and risk in the business environment, you would think most companies would do everything they could to reduce the uncertainty in their own business.

Given all the uncertainty and risk in the business environment, you would think most companies would do everything they could to reduce the uncertainty in their own business.

But when it comes to uncertainty due to volatile exchange rates, most companies are not doing all they can, according to a Wells Fargo bank study.

The study found that 75% of public companies and 90% of private firms surveyed in North America don’t even track overall exposure to exchange rate (FX) volatility.

That means they can’t say with any level of certainty whether the company’s overall position is “long” (need to sell) or “short” (need to buy) with respect to the other currencies they deal in as part of their business.

These companies may well do some hedging. They might hedge payables or receivables or long-term contracts that have predictable cash flows. However, without a good grasp of the company’s overall FX exposures there is no way to say whether the hedging is effective.

Companies that limit hedging to single transactions or balance sheet accounts do so because these are the only exposures that accountants can see clearly.

When a gain or loss on a forward contract matches and offsets the loss or gain in a receivable or payable balance, to an accountant that’s proof the hedge was successful.

And if the hedge can be fine-tuned to match the cash flows of a transaction, it can offset those flows so there will no gain or loss to report, which makes accountants even happier.

FX exposures are more than what accountants see

The exposures to FX volatility that are important to shareholders of a company are larger, longer and more nuanced than what’s visible in the narrow perspective of the accounting department.

Every commitment to purchase or sell in other currencies creates FX exposure and risk. The transactions can vary by amount, duration and degree to which they are avoidable. They can be for a defined period or be open-ended. When embedded in long-term contracts, they are a tangible risk long before any invoice is issued or received to put them on the balance sheet.

The big picture

Hedging to protect business value rather than to keep accounting practices tidy is about reducing volatility and risk throughout a company’s cash cycle, which is long for a capital-intensive business and short for trading companies.

Looking at the overall position might reveal other exposures that should be considered or that a different approach, like borrowing in the currency of the asset to be hedged, is cheaper and more effective.

Benefits of bulk buying apply. Fewer and larger hedges can be cheaper and easier to administer.

FX exposure management starts inside the company

“Know thyself” applies in spades to companies that want to effectively manage FX risk. The first step has to be identifying and consolidating exposures from across the organization.

Purchasing and sales managers plan and execute commitments that create FX exposures. Their performance may even be assessed based on business unit results that include the effects of volatile FX rates, which seems unfair when they can’t do anything about it.

A fairer approach would be to have purchasing and sales managers fix the rates for future cash flows by entering into an internal forward contract with the company’s treasury department.

They would do this by notifying the treasury department and using the same rates that would apply to a hedge being arranged with a bank. The rate would be used to calculate gains and losses when cash changes hands.

The use of internal forward contracts transfers all FX exposures from across the company to the treasury department. Treasury consolidates the information with all the other exposures and takes whatever measures are consistent with the strategy and policies of the company.

While not hedging is a strategy that may be right for some companies, if it can’t be measured and compared with the alternatives, it’s really just unsupported bias. With a detailed picture of the company’s exposures, strategies can be measured and compared.

The company will know, with some degree of accuracy, whether it’s long or short on other currencies that it deals in, by how much and over what period of time. It will know its overall position and be able to assess the effect of decisions that change it.

Management can now have a strategy that has measurable results. The board can approve policies to deal with risks that it understands. 

Guy Heywood is a Vancouver-based finance and treasury consultant.