Identifying anomalies and formulating responses
For companies with international operations and significant foreign exchange risks, detailed analysis of these risks is tremendously important. As well as examining the possible effects of FX on earnings, such analysis should in particular focus on foreign exchange exposure – the point of departure for all efforts to control FX activities. Appropriate risk control measures – from risk reduction to exposure management to hedging strategies – can then be identified.
In everyday practice, exposure analysis is often limited to merely adding foreign exchange positions together. Rarely is more in-depth analysis conducted in order to pinpoint specific measures and reveal potential for optimisation. Sadly, the consequences are blatantly obvious: All too often, unexpected FX effects give treasurers a nasty surprise. Common causes include a lack of accurate planning for the maturity profiles of payments in foreign currencies, with the result that specific hedging does not take place. Alternatively, risk horizons are often assumed to be too short or too long. This leads to economic underhedging or overhedging, with all the effects this entails for foreign exchange.
What, then, should be done? What is needed is a 360-degree analysis of the risk position to create transparency about the nature and structure of foreign currency cash flows! Comprehensive analysis lays a solid foundation on which to identify the risk profile. It should cover four distinct dimensions:
The precise number and definition of dimensions must be tailored to each specific company depending on the business model and both external and internal conditions (e.g. data availability and any regulatory changes).
What is known as a "cash flow map" provides a very vivid complement to FX risk position analysis. At a given point in time, a cash flow map visualises internal and external cash flows, breaking them down by currency within the structure of the company being analysed. A variety of structured information can thus be seen at a glance. For example, the nature of the cash flow – internal or external, the specific currency and/or the sender or recipient – can be seen immediately. In addition, by juxtaposing a current cash flow map with maps from previous reporting periods, it is possible to produce tangible historical comparisons.
The figure below shows an example of a cash flow map based on a fictitious company headquartered in Germany:
Click here to enlarge image.
What can we learn from this cash flow map? If we look at the payments in foreign currencies made by the Finnish subsidiary and the same subsidiary's intercompany transactions with the German parent company, we first see external cash flows in Norwegian kroner (NOK), Russian roubles (RUB) and Polish zloty (PLN). If these positions are netted, the Finnish subsidiary is left with inflows totalling KNOK 12,100, KRUB 4,300 and KPLN 1,600. Transactions with the German parent company give rise to payables and receivables denominated in EUR, NOK and PLN. In this example, the netting of all external and internal NOK cash flows gives the Finnish company a NOK exposure of KNOK 100.
This detailed insight into the risk position of the Finnish subsidiary allows potential for optimisation and alternative courses of action in the context of foreign exchange management to be identified in order to control or mitigate risks within the company. Based on this new overall perspective, it would, for example, be possible to validate the extent to which intercompany transactions could in future be invoiced in euros rather than in a foreign currency. The map also shows that some Norwegian customers pay the Finnish company in euros. One way to optimise the constellation would be to further increase the proportion of external EUR inflows from Norwegian customers, as this would reduce the company's NOK risk position. Both measures would reduce foreign exchange exposure – without the need for expensive hedging instruments.
In this context, it would also be feasible to examine what foreign exchange effects occur in the value chain of a specific product group. All transactions in a product group's value chain that cross the borders of the single currency area could be visualised transparently, thereby highlighting the associated foreign currency effects.
Analysing a company's FX risk position opens up all kinds of possibilities! If highly granular data is used, the information about cash flows can be broken down to a wide variety of levels (to analyse individual divisions or regions, for example). Compared to purely tabular solutions derived from databases, the visualisation of cash flows creates a user-friendly overview which allows anomalies and peculiarities in the structures to be spotted quickly. Based on these insights, solution strategies can be formulated to reduce a company's FX risks. One special benefit is that visualising cash flows makes it easier for the treasurer to communicate with the CFO and other parts of the organisation (purchasing, sales and controlling, for example), and thus to illustrate the advantages of taking action on foreign exchange management.
Alongside operational risk management, regular and detailed analysis of the foreign exchange position is vital if anomalies in the risk profile are to be identified. Such analysis allows specific control and containment actions to be taken, for example. These in turn can lower foreign exchange risks – and significantly reduce the risk of nasty surprises for the treasurer.
Source: KPMG Corporate Treasury News, Edition 67, May 2017
Author: Stephan Plein, Senior Manager, Finance Advisory, firstname.lastname@example.org
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