Carpe Diem Global Partners recently interviewed 33 corporate and divisional treasury leaders of predominantly multi-national, public consumer products companies with revenues of $5 billion or greater, to seek their views on strategies and best practices to manage and mitigate foreign exchange risk.
This white paper explores the critical elements of managing FX risk, including specific information on sources of risk exposure, operational practices, and the decision-making process, among other elements.
Foreign exchange (FX) risk is a significant concern for companies operating in more than one country, as it can impact financial performance and earnings stability. To mitigate these risks, organizations employ a variety of strategies and practices. Here, we summarize the key insights from corporate treasury leaders to provide a comprehensive overview of managing FX risk.
Understanding Exposure
The first step in managing FX risk is to understand the nature and source of the exposure. This involves identifying where the exposure lies, netting out currencies to find true exposure levels, and determining whether the net exposure is significant enough to warrant hedging. Companies like those in the global banking and capital markets sector can help companies assess the risk profile of the business, understand the time horizon of volatility, and evaluate the exposure to make informed decisions.
Hedging Strategies
Companies use various hedging strategies to manage FX risk. Cash Flow Hedging involves hedging forecasted cash flows to mitigate risks associated with currency fluctuations. This approach is often used in conjunction with Balance Sheet Hedging, where companies hedge their balance sheet exposures using derivatives like forward contracts and options.
Forward Contracts: Many organizations favor forward contracts for balance sheet hedging due to their cost-effectiveness. Forward contracts are commonly used for large transactions.
Options: Options are also used but are considered riskier. They offer flexibility but require a higher premium, making them less common for large-scale hedging.
Cross Currency Swaps: These instruments are used to manage exposure in multiple currencies, providing a more comprehensive risk management solution.
Operational Practices
Effective management of FX risk requires collaboration across departments, including accounting, financial planning & analysis (FP&A), and treasury teams. This ensures that all parties agree on the strategy and understand the company’s risk profile.
Regular Exposure Analysis: Monthly assessments of FX exposure are common, often involving presentations to an FX committee for recommendations on hedging strategies based on current market conditions.
Technology Utilization: Organizations leverage software tools to extract data related to balance sheet exposure and monitor trades effectively. This includes real-time monitoring of trades and costs associated with FX transactions.
Risk Assessment and Decision-Making
Risk assessment is a critical component of managing FX risk. Companies need to assess the exposure and associated risk, check risk tolerance with leadership teams, and agree on limits for financial exposure and cash flow exposure with management.
Leadership Involvement: Senior management, especially CFOs, play a crucial role in defining the overall strategy for hedging based on risk tolerance and business objectives. They work closely with accounting teams to ensure accurate exposure analysis and align hedging strategies with financial goals.
Scenario Analysis: Running different scenarios helps companies evaluate the effectiveness of their hedging programs and adjust as needed. This involves assessing the impact of different market conditions on the company’s financial performance.
Challenges and Considerations
Managing FX risk can be particularly challenging for companies operating in multiple countries with varying access to financial instruments. Each region may require tailored strategies based on local market conditions.
Cost Management: Firms must consider the costs associated with hedging programs, including fees from banking partners. In some cases, companies have successfully negotiated reduced fees after identifying overcharges from banks.
Local Market Conditions: In regions like LATAM, cash pooling systems are used to identify exposure, but these systems can be complicated due to limited access to financial instruments.
Illustrations of Effective Management of FX Risk
Company A: Implemented a hedging program that won a Treasury group award. The program involved balance sheet analysis and proper exposure identification to minimize volatility.
Company B: Used spot trading for smaller transactions and hedged everything above a specific amount to manage exposure effectively.
Company C: Hedged when the exposure was significant, such as when transactions were plus or minus a million dollars. The company netted all currencies to find true exposure and made decisions based on that.
Conclusion
Managing foreign exchange risk involves a comprehensive approach that includes understanding exposure, employing various hedging strategies, utilizing operational practices, assessing risk, and considering local market conditions. Collaboration across departments, leadership involvement, and continuous evaluation of market conditions are essential for effective risk management. By leveraging technology and tailoring strategies to specific business needs, companies can minimize volatility and protect their financial performance.
Michael Whitehead Managing Partner
These market insights from Carpe Diem Global Partners are gathered from the firm’s extensive client work with Board, CEO, CXO, and CHRO leaders in public and private multinational companies. For deeper, custom insights, contact Michael Whitehead at mwhitehead@carpediempartners.com or Craig Streem at cstreem@carpediempartners.com.
Craig Streem
Managing Partner