Foreign exchange management: measuring the performance of a risk strategy

Foreign exchange management

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.

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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:

  • In profit-based performance measurement, the contribution of risk management to the a company's profit is evaluated, thus answering the question as to what financial added value is achieved by managing currency risk through risk management activities. The added value can be quantified for example in terms of the extent to which the implemented foreign exchange management strategy leads to participation in positive movements in exchange rates.
  • Risk-minimising performance measurement, on the other hand, focuses on risk avoidance. This method measures the reduction of foreign currency exposure through risk management, which, for example, can be reflected directly in achievement of the budget rate. 

Let us now have a specific look at three approaches in detail:

  1. Ex-post comparison of the implemented hedging strategy with a hypothetical strategy, where currency risk is not hedged ('market scenario') – In this method, the exchange rate is determined based on the implemented hedge ratio (on the basis of hedged and unhedged exposure volumes). This rate is then compared to the exchange rate in the market scenario. In the first scenario, the cash flows, which were hedged, are translated using the corresponding hedging rate in local currency, while in the market scenario, all cash flows are translated using the applicable spot exchange rate. Comparison of the calculations shows the positive or negative contribution to profit. Performance compared to a hypothetical hedge ratio can be determined as an additional indicator (so-called 'monkey' strategies). 
  2. Analysis of the quality of exposure planning – planned exposure is compared to historical planned and current exposure data by means of back testing. The realised current exposure is used as a benchmark for a particular period. Comparison with cash flows planned in prior periods for the current period directly shows the performance of the planning process. It can then be determined subsequently what exchange rate would have resulted by means of a hedging strategy implemented on the basis of current exposure. A comparison with the actually achieved exchange rate shows the performance of foreign exchange management with respect to the planning uncertainty inherent to exposure planning.
  3. Cost of currency hedging as a ratio of the hedged notional value – for example in the case of FX forwards, the spread on the spot exchange rate on transaction is considered a currency hedging cost (including other components such as the sales margin). This approach allows a comparison of the cost of hedging per unit of exposure over time (e.g. a cost of EUR x for 100,000 units of the exposure's currency). A comparison is possible for example on the basis of individual transactions, particular months or particular currency pairs. Based on this comparison, it can then be determined whether the cost of hedging risks is consistent with the objective of risk mitigation (e.g. on the basis of potential foreign exchange losses determined by means of historical exchange rate volatilities).

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.

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