The risk position, the risk strategy and the risk controlling
Current developments on the foreign exchange market, in particular the appreciation in value of the EUR against the USD, are once again clearly showing that economic theories – such as the interest rate parity theory – are only useful to a limited extent when it comes to predicting exchange rate developments. In particular in an environment of political uncertainty or impending trade wars, it is now almost impossible to forecast exchange rate fluctuations and decision makers in companies face difficult situations. In this case Treasury is faced with the challenge of implementing appropriate and effective strategies on the basis of suitable instruments and demonstrating the added value of these strategies to management, as well as functions such as purchasing, sales and controlling – and thus supporting their decision making process.
In order to attain the goal of having an effective foreign exchange management system, transparency has to be created regarding the risk position and foreign exchange effects and there also has to be a certain level of flexibility regarding the course of action to be implemented. But what components are required for this and how should they be designed? We will answer these questions in the following segments and outline the three pillars of risk management: the risk position, the risk strategy and the risk controlling.
The basis for any decision and course of action in the field of foreign exchange management is transparency on the risk position and knowledge of the drivers that influence the risk position and foreign exchange gains or losses. Detailed knowledge of the risk horizon of the exposure in various business divisions and regions provides a key basis in this regard in order to effectively manage potential effects using different instruments. Unfortunately, we see all too often in our advisory practice that the risk horizon for the entire exposure is set to a flat period of 12 months and no specific detailed analyses of the market conditions and price elasticity are carried out. And in this regard it is clear: In many business divisions the risk profile in foreign exchange management is increasingly being influenced by differentiation and only specifically taking these factors into account can lead to effective foreign exchange management.
The generation of exposure data is also an important aspect in this regard. On the one hand, the areas of future, planned transactions, the quality and reliability of planning assumptions and the data used are of decisive importance (such as revenue and sales planning, knowledge of the payment behaviour of customers). On the other hand, when it comes to risk positions that have already been recognized and contracted the focus is on other aspects: in these areas the focus is on extracting data that is as extensive as possible from the various systems, validating and aggregating them against each other (for example accounts payable/receivables subledgers, general ledger, business warehouse). However, as the Treasurer should not spend their time downloading, manually reconciling the content of and consolidating data, instruments to automate the data extraction and validation process play a key role in this regard. There are now established and standardised tools available for this task. Our experience has shown that the automation of this process directly leads to an improvement in the accuracy of the depiction of the exposure meaning that a corresponding investment can be quickly calculated.
In times fraught with uncertainty, the issue of flexibility in respect of the analyses and courses of action is right at the top of Treasurers' lists of priorities. Observing scenarios represents an important instrument in this regard, both for the development of the exposure as well as for gauging the effectiveness of alternative hedging strategies. In this regard the hedging strategy itself is the centrepiece. What is clear is that static strategies according to which a certain flat-rate percentage of the exposure is hedged, possibly also staggered over the time, are outdated and should be consigned to the past. In times where it is almost no longer possible to explain exchange rate fluctuations using standard models, there is the significant risk that exchange rate fluctuations will be identified too late or even not identified at all. The use of early warning indicators has been proven to be effective against this, e.g. in the form of thresholds (e.g. relative exchange rate developments compared to defined target rates), which at the same time act as a trigger event that prompts a change to (or at least the validation of) the hedging strategy that has been implemented.
The integration of risk indicators into the strategy represents a further key element of risk management. In this way hedging measures for the respective current risk profile of individual or even several currencies are derived using dynamic management approaches, e.g. by using cash-flow-at-risk according to the underlying financial mathematical models based on observed risk parameters such as the exchange rate volatility and correlation. As a result of this, targeted higher hedge ratios can be implemented for currencies that have a high risk potential, for example. This is a mechanism that has allowed one or two Treasury departments, which manage their risk positions in this way, to sleep soundly amidst the current situation on the EUR/USD market.
Finally, the constant monitoring and back-testing of all processes and currency management strategies are important to ensure that any possible need for adjustment is identified in a timely manner. In this way the key performance indicators (KPIs) that are specifically defined for the various applications play an important role. Therefore, KPIs are defined for the quality of the determination of the exposure and also in particular for the effectiveness of the hedging strategies. The subject in this regard is the current data against which the planned exposure is measured. Alternatively, benchmark data can also be used, which are used as targets to determine the extent to which the implemented strategies are advantageous (e.g. management using a cash-flow-at-risk approach) as opposed to a benchmarking strategy (e.g. constant hedging of a certain percentage of the exposure).
The trend in the current market environment is presently geared towards complete transparency of the risk position across the entire risk horizon, an effective, dynamic hedging strategy and monitoring of the implementation of the three pillars of foreign exchange management, which when applied in combination work together to strengthen one another. The demands for flexibility in the management of foreign exchange risks can only be accounted for by a robust range of risk management instruments, which the Treasury department puts in place in order to allow the best possible decisions to be made on the basis of the best possible information.
Source: KPMG Corporate Treasury News, Edition 78, March 2018
Author: Stephan Plein, Senior Manager, Finance Advisory, firstname.lastname@example.org
© 2018 KPMG AG Wirtschaftsprüfungsgesellschaft, ein Mitglied des KPMG-Netzwerks unabhängiger Mitgliedsfirmen, die KPMG International Cooperative (“KPMG International”), einer juristischen Person schweizerischen Rechts, angeschlossen sind. Alle Rechte vorbehalten.