Cash-flow-at-risk leads to more effective currency hedging

Cash-flow-at-risk - more effective currency hedging

Currency risk continues to be a focus of CFOs and treasurers due to the persistently high volatility and unexpected movements of exchange rates.

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Currency risk continues to be a focus of CFOs and treasurers due to the persistently high volatility and unexpected movements of exchange rates. Companies should therefore no longer rely on conventional, static strategies for currency hedging purposes. A recent empirical analysis conducted by KPMG has shown that dynamic hedging strategies provide significant advantages in currency management, especially in more volatile markets.

Fluctuations in exchange rates have increased in recent years for many currencies – well known examples are the Russian rouble, the Brazilian real, and also the US dollar and Turkish lira. However, these signals are not taken into account in many currency strategies – foreign exchange hedging is frequently static, i.e. occurs at pre-determined rates and dates. Other companies refrain from currency hedging altogether due to the high forward premiums for some currencies or their own exchange rate forecasts. Not infrequently, unexpected foreign exchange losses and undesirable fluctuations in interim/annual profits due to insufficient hedging or open positions are then interpreted as 'black swans'.

Evidence of increased rate volatilities well in advance

However, these events were not always unforeseeable, as there was already evidence of increased rate volatilities well in advance in many cases. The right response to such volatile markets are early warning indicators close to the market as well as flexible hedging strategies. Cash-flow-at-risk (CFaR) is a particularly suitable risk indicator for that purpose.

This risk measure represents the maximum loss on expected cash flows that is not exceeded at a certain level of probability. A hedging decision is then made in accordance with a defined risk limit, for example the ratio of CFaR to EBIT. If the defined limit is exceeded, the causes for the increase in risk as well as alternative risk-reducing hedging activities are analysed.

Within the framework of an empirical study it became evident that for 2014 and 2015 risk management via CFaR would always have been a superior strategy to static ones for a currency portfolio consisting of the above-mentioned currencies. The usual risk objectives, namely a reduction in 'worst-case foreign exchange losses' and reduction in the fluctuation of interim/annual profits or other common KPIs, were most effectively achieved with risk management based on CFaR.

An exclusively static hedging strategy, on the other hand, resulted in a less effective hedging outcome, as hedging decisions were not made at the optimum time or set too low. A speculative position used for comparison purposes, with an open currency exposure – e.g. due to an exchange rate forecast – also led to less than optimum outcomes with regard to achieving the risk objectives.

Two central components: level of risk and probability of occurrence

While currency-differentiated cash flow planning is indispensable for assessing group-wide currency risk, CFaR provides a single, aggregated indicator for the entire portfolio and entire – including long-term – risk horizon. Correlations and opposing trends in exchange rates within the portfolio are considered in measurement. Thus, the two central components of exposure management are taken into account – level of risk and probability of occurrence. Such an integrated view is not possible with an exclusively static observation of absolute exposures and supplementary indicators such as the volatility of individual currencies. However, it should be noted that, in addition to the necessity of reliable data input and the right model assumptions, only very few treasury management systems are capable of calculating a complete CFaR on a standard basis.

Volatile markets require flexible hedging strategies. Using CFaR as an indicator results in more effective risk reduction on an empirical basis, because the company operates more timely and thus closer to the market. However, increased uncertainty should also be mitigated by Treasury with stress tests, scenario analyses or benchmarks. As a supplement to CFaR analysis, these measures can offset model deficiencies and increase risk transparency.

A combination of CFaR with a fixed minimum hedging rate is one way to achieve a more dynamic hedging strategy. While real 'black swans' still cannot be provided for in this manner, the effects on the company will at least be limited in the best case scenario. And, whether better currency management is worth the investment, can be assessed quickly with a glance at the currency losses that had to be recognised in one's own company over the past years.

Source: KPMG Corporate Treasury News, Edition 53, March 2016
Author: Christian Pfeiffer, Manager, christianpfeiffer@kpmg.com

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