Upheavels on the foreign exchange market (such as devaluation of the Rouble, appreciation of the Swiss franc) and the smoldering 'Grexit' discussion have greatly lifted the attentiveness of management to currency management. Even when currency management is a long-established function for many Corporate Treasury departments, with accompanying sets of rules, procedures and methods, the issue arises time and again: why do significant currency effects occur in some cases despite currency management?
These days the focus of Treasurers' actions is mostly on the management of transaction risk. The examination of translation risk is not defined as 'the subject of Treasury controlling activities' and is thus evidently excluded from probably many risk management guidelines. Even macroeconomic risk is often viewed as being a topic for the overarching corporate strategy and is not considered by Treasury. These 'artificial' restrictions on Treasury activities lead to essential elements of currency management not being monitored and managed – including the effects resulting from this.
Treasury thus has to aim for an integrated end-to-end view of currency management in the group.
Using a example of a decision being set, the following aims to show the features of an integrated approach to currency management: in this case we use the acquisition of a division which is to appear on the market independently and is fully consolidated in the group of companies.
Treasury initially uses a strategic analysis to resolve the following issues:
Based on the results of the analysis, an application of the general currency management strategy of the group can, for instance, be validated for the new division too (i.e. risk mitigation predominantly through 'natural hedging'). At the same time, managing currency risk aims to occur without being unintentionally counterproductive in respect of macroeconomic risk over the short term. As for instance in the case where hedging occurs at an unfavorable fixed margin compared to the competition (i.e. the hedging of transaction risks creates additional macroeconomic risks).
Furthermore, translation risk needs to be considered in the course of setting the functional currency for the division. The impact of translation effects occurring in the course of balance sheet and financial ratio consolidation (particularly also rating and financial debt covenants) can then be clearly derived. On this basis, Treasury can then analyze when active hedging of translation risk for specific balance sheet periods appears beneficial (i.e. through the use of average rate forward contracts). The result is made transparent to the management and corresponding courses of action and risks are shown.
In the course of managing transaction risk, transaction risks arising from the division's continuing business operations need to be integrated in the already existing currency strategy of the group. An exact and regular collection and validation of the transaction risks of the division is the basis for this. In addition, it is necessary to address whether the business environment of the division is appropriate to apply the group management strategy for transaction risks to the risk positions of the division (functional currency, relevant currency relations, risk horizon, scope to pass on prices). Many Treasurers are misguided by a false sense of security; a currency strategy guided by incomplete information may lead to unpleasant surprises.
It is evident from the example that further significant issues in respect of currency risk management arise in the course of making a decision in some cases; Treasury needs to address these as the issues are interrelated. For instance hedging activities for translation risks generally lead to additional risk positions in the area of transaction risks. By contrast, managing transaction risks influences the indicators that are to be managed in the area of translation risks (i.e. hedging of planned transactions). In addressing the corresponding aspects arising from the aforementioned issues, integrated risk reporting brings together the risk areas in currency management, creating transparency in the process.
In sum, currency management offers Treasury the opportunity (indeed it compels Treasury to seize this) to integrate itself into strategic decisions through its competent analyses and thus to prove the importance and value added of Treasury.
You can learn more on this issue in our webinar: 'Currency Management – the Success Factors for Efficient Risk Management' on April 30.
Author: Stephan Plein, Senior Manager, firstname.lastname@example.org
Source: KPMG Corporate Treasury News, Edition 41, March 2015
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