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Why did we bother hedging the US dollar a year ago, given that the exchange is still as high as before?

Performance measurement in currency management

Treasurers are only too familiar with the phenomenon of questioning risk management decisions after the fact.


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Or: The importance of performance measurement in currency management

A year ago, the above question probably was: "Why did we hedge at an exchange rate of 1.30 and now have to accept a loss of 20%?" Treasurers are only too familiar with the phenomenon of questioning risk management decisions after the fact. Therefore, to assess performance fairly, there are two important issues that need to be considered: first, defining a clear hedging strategy, and second, consistently measuring the successful use of discretion.

The hedging strategy will of course have to be derived from the key parameters 'risk profile', 'objectives', 'risk horizon' and 'risk appetite'. If, for example, the objective is to hedge a margin, and as a consequence it is necessary to also hedge revenue or purchase prices when the other margin component is fixed, it makes little sense to lament the loss of opportunity to make more profit after the fact. I

f forward exchange contracts are agreed for a longer period of time in clearly defined stages in order to equal out currency gains and losses through hedging of the average exchange rate, then the only answer a treasurer can give to the question of the exchange rate achieved is: "because this is how we fixed it".

However, unsatisfactory target achievements may provide grounds for questioning a chosen strategy and assessing, for example on the basis of historical data or scenarios, whether another strategy could have produced better results. This should be done by considering a sufficient number of possible trends in exchange rate. The fact that for a steadily rising exchange rate put options rather than forwards would have been the better choice to hedge foreign currency revenues is probably a trivial conclusion in most cases.

However, if there is room for discretion with regard to the hedging strategy in terms of the amount or date of contract or the type of derivatives used, the treasurer will of course have to justify his decisions. Hindsight bias (also known as the knew-it-all-along effect) is always a popular feature in making such judgments, especially when taking a behavioral finance approach, however never appropriate. Logically, a decision can always only be compared with the alternative that was available at the time of making the decision. This alternative can never presume knowledge of actual future trends in exchange rate.

The purpose of performance measures in currency management therefore is two-fold. On the one hand, they are to reflect to what extent the treasurer has adhered to the specified strategy (e.g. hedge ratios). On the other, it must be demonstrated that the autonomy of decision granted to the treasurer, on account of the alleged or assumed market knowledge, is justified. In particular, the benefits of making the decision must outweigh the costs, otherwise the proverbial monkey (or an algorithm for the animal lovers among us), known from asset management, could make the decision.

Performance indicators for the first task, which should really be referred to as 'compliance indicators', are for example the degree of compliance with a specified hedge ratio or the deviation from a (sensibly) defined target (budget) rate.

The actual performance indicators, on the other hand, compare the outcome of the hedging decision taken with an alternative available at the time of making the decision. This could also be a deterministic hedging strategy (for example, a so-called 'monkey' that hedges a set ratio each day or performs hedges defined on the basis of specific market signals). On the other hand, a hedge can be compared with a non-hedge that takes into account the cost of hedging (for example, many treasurers have justified the loss from unhedged depreciation of the ruble with hedging cost savings in prior years – however, why the major rise in volatility was not taken as a warning signal is another matter).

Another practical example is justification of an option strategy – or not having one – by comparing opportunity losses from forward transactions with gains from unhedged positive trends in exchange rate plus option premiums.

The definition of a deterministic strategy is particularly effective as a basis for comparison with a discretionary strategy when the alternatives are already taken into consideration at the time of making the decision and not only in retrospect. Modern IT systems provide this opportunity, as with 'Treasury 4.0' for example, by calculating the type, amount and maturity of a foreign currency hedge based on accurately determined exposures.

If, on that basis, a different decision is taken by the treasurer or a risk committee with regard to the ratio or date, the reasons have to be made transparent (such as a particular market expectation). The more data are available for the algorithm (e.g. inflation rates, volatilities, purchasing power parity, interest rates, etc.), the better must be the quality of decisions taken by the treasurer or committee that cannot be automated. It is this quality that performance indicators should measure. However, the threshold should not be set too low for this comparison, and therefore all available parameters be made available to the 'monkey', if possible, for automatically deriving the hedges to be concluded.

And last but not least, the possibility of attributing a foreign currency hedge either to a clearly defined strategy or a decision influenced by market expectations will then answer the question posed at the beginning as to why the exchange rate was hedged the way it was and not otherwise.

Source: KPMG Corporate Treasury News, Edition 59, September 2016
Author: Stephan Plein, Senior Manager, Finance Advisory,

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