As part of their foreign exchange management, some treasury departments use very complex strategies to minimise the risk of future cash flows in foreign currency on earnings.
As part of their foreign exchange management, some treasury departments use very complex strategies to minimise the risk of future cash flows in foreign currency on earnings. An essential component of the process chain, in addition to determining and implementing a risk strategy, is the analysis of its effectiveness and subsequent determination of potential strategy adjustments, and so achieve feedback control. Performance measurement provides information about the effectiveness and therefore success of the risk management strategy.
But how can the effectiveness and success of an implemented strategy be measured? The hedge effectiveness to be determined as part of hedge accounting and its documentation is frequently cited as an established performance measurement method. The purpose of determining hedge effectiveness is to establish the extent to which changes in fair value of the hedged exposure are offset by changes in fair value of the hedging instrument. However, at closer inspection it becomes apparent that this method is only of limited use for performance measurement.
If, for example, the dollar offset method is applied using the hypothetical derivative approach, it is assumed for reasons of simplicity that the hedged exposure is equivalent to the hedging instrument arranged. This results in degrees of inaccuracy that should be avoided in performance measurement. These inaccuracies also arise with other methods used for determining hedge effectiveness, so that these are of only limited use for measuring the performance of FX management. Moreover, not all companies use hedge accounting.
If we approach the issue from the perspective of the objective of the hedging strategy, there are two fundamental models:
Let us now have a specific look at three approaches in detail:
There are also various other methods used in practice. Not every approach leads to meaningful information; in fact, the specific risk profile and risk strategy need to be taken into account in the selection of methods (especially with a view to the above-mentioned opportunities-based vs risk-minimising strategies). Apart from an extensive database (historical and future exposure data, hedging transactions, market data, etc.), the use of performance measurement methods for the purpose of foreign exchange management, above all, requires powerful treasury IT, so that performance measurement can be conducted swiftly and efficiently in the course of feedback control.
Source: KPMG Corporate Treasury News, Edition 65, March 2017
Author: Stephan Plein, Senior Manager, Finance Advisory
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