This article follows on from “Currency gain or loss – the great unknown for many companies” in October 2015.
For many decision-makers in the business world – and hence for corporate treasury departments too – the topic of currency management remains a focal issue in ongoing activities and projects. In many cases, it is a topic whose importance has in fact grown and to which a new dimension has been added since autumn 2015. Discussions surrounding the possible consequences of the UK's exit from the European Union, for example, are only one of several factors that have focused attention on what might happen as a result of different exchange rate scenarios and hedging strategies.
On top of the need to provide ex-post explanations of currency gains or losses, closer attention is thus also being paid to analysing possible alternative prevailing conditions in the context of 360-degree currency management. By simulating various alternative courses of action for the company in advance, scenario analysis enables a suitable risk management strategy to be identified.
In particular, this kind of analysis is based on different exchange rate scenarios. The standard approach begins by presenting a baseline scenario in light of historic volatility. The next step is then to calculate alternative scenarios – such as best-case and worst-case scenarios – in line with the individual company's assessment of the market. Comparing different sets of prevailing conditions in this way can reveal potential future currency gains or losses. Scenario analysis can then be rounded off by outlining different hedging strategies for the different risks, and by factoring them into hedge accounting. This approach gives companies a wide range of options to compare the effectiveness of different hedging strategies with regard to planned data, and to reconcile the effectiveness with the expected hedging costs and the firm's risk-bearing capacity.
Before such scenario analysis can be successfully applied to currency gains or losses, however, a number of conditions must first be met.
Database: Meaningful analysis begins with the information that is available within the company regarding the planning of foreign currency cash flows and the underlying expected and posted foreign currency transactions. This in turn necessitates appropriate exposure planning throughout the corporate group in order to fully cover all risks. Where different types of exposure are recorded in different systems – such as foreign currency liquidity and planned transactions, for example – a consolidated database with neither gaps nor redundancies is needed as the basis.
Assumptions: Since scenario analysis always has to work with assumptions and simplifications, the company must define the underlying assumptions in advance. For example, average expected payment terms should be defined for receivables and liabilities denominated in foreign currencies in order to determine the period in which there may be foreign exchange effects on the balance sheet. Other assumptions can, for instance, include the definition of posting dates and the intervals at which exchange rates are updated.
Hedging strategy: In line with the company's general hedging strategy, details of the scope and horizon of current hedges must be specified along with possible alternative strategies in order to identify different hedging outcomes. In particular, the distinction between central and decentralised hedging and between gross and net calculations can lead to significant changes in currency gains or losses.
Management reporting: To improve acceptance of the effects identified by scenario analysis within the company, and also to make them as useful as possible, it makes sense to present the alternative currency gains or losses in a format based on the familiar foreign currency reporting format. At the same time, the form of presentation used for external financial reporting – in particular regarding the use of hedge accounting – should also be factored into the presentation of results.
If due account is taken of these requirements when applying scenario analysis to currency gains or losses, and if the quality of the corresponding planning data is adequate, the resultant analyses can be an effective tool for the ongoing monitoring and optimisation of currency management within the company. That is why existing plan/actual comparisons of currency gains or losses may also be complemented by an additional, more in-depth investigation of the causes and effects. Given that examining different scenarios can play a key part in explaining historical currency gains or losses, there is no need to restrict the functional scope solely to forward-looking analysis.
In conclusion, we note that relevant scenario analyses – which can be tailored precisely with the aid of suitable reporting solutions – can be a useful addition to the standard corporate practice of identifying, explaining and controlling a company's foreign currency risks. Applying this technique enables treasurers to supplement accurate planning and appropriate ex-post reporting with further planning aspects and even the definition of a suitable hedging strategy.
Source: KPMG Corporate Treasury News, Edition 56, June 2016
Author: Robert Abendroth, Senior Manager, firstname.lastname@example.org
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