FX can be complex. With combined challenges of ever changing market conditions; practical mechanics of FX products – forwards, options and market orders; establishing and managing relationships with FX brokers; ensuring hedging actions are in line with a company’s commercial strategy and risk appetite; and gaining internal alignment across operations, management and the Board on objectives and performance monitoring, FX risk can all too easily be put in the ‘too hard’ column or managed in a way where its effects (good or bad) are not clearly monitored or reported.
Companies can also argue that they’ve survived every downturn in the past without hedging, so they should be fine going forward, and this might be true for some!
Others may suggest that hedging is speculative, to which we would agree that it can be if it is improperly managed (of course, not hedging can also involve speculation). So, why hedge?
For us, there are three key considerations:
- WHAT IS YOUR COMPANY’S PURPOSE? “What is it that you do, and for whom?” If your company is having a positive impact on its stakeholders, and adverse FX movements erodes cash flow to where a company cannot continue delivering this impact, then there is merit in protecting against this happening. Once a purpose is clarified, we can ask, “What strategic initiatives are at risk due to FX market volatility if you are not hedging?”
At this point, we can list 2-4 initiatives – not just financial targets, but where future operating cash flow will be invested if financial targets are met. It could be an investment in staff, infrastructure, or strategic acquisitions, but the key is that in making these investments, the company is directly supporting its purpose. Conversely, missing these targets would create headwinds in pursuing this purpose, or to even continue operating as a going concern.
So now we have listed our key initiatives – how do we know if FX markets put these at risk?
- WHAT IS YOUR COMPANY’S COMMERCIAL RISK APPETITE? Finished financial forecasts are nice, and even comforting in a way. They give a clear, simple view of what a company intends to achieve, and the investments required to get there. International forecasts typically convert all FX costs and revenues back into the company’s main reporting currency at a budget FX rate. The question we love to ask Finance and Treasury teams is:
“How much can you afford to miss your FX forecasts by due to adverse FX movements while still being confident you will be able to fund your key strategic initiatives?”
Answers can vary widely based on a given company’s operating margins, liquidity, etc, so as an example, let’s say an Australian company forecasts USD10.5m in profit from its US operations over the next 12 months, and plans to convert this to AUD at an AUDUSD budget rate of 0.7000. This means the company is expecting to receive AUD15m from this USD10.5m. Let’s say that the company concludes it can comfortably afford its planned investments if it only received AUD14.25m, which is to say they are comfortable missing their AUD15m expectation by AUD750k, or 5%. We refer to this 5% as the company’s RISK APPETITE.
Okay, we’ve given a numeric definition to an often abstract term.. so what? For starters, if all key senior stakeholders agree on the company’s purpose, strategic initiatives, and risk appetite, then they are starting to achieve fundamental alignment on the goals of any hedging program. What remains is determining how much hedging is required to sufficiently mitigate the risk of adverse FX markets.
- FRAMING FX VOLATILITY IN THE CONTEXT OF RISK APPETITE
Continuing our example, if the company is comfortable missing expectations by 5%, how realistic is it that FX markets will move by more than this in a year?
If markets only move 2%, then arguably there is no need to hedge as there would still be a 3% buffer between outcomes and risk appetite.
However, a 20% adverse movement would result in the company exceeding its risk appetite by 15%. At these figures, at best, value-enhancing investments will likely need to be paused or financed in less favourable ways, i.e., with debt rather than organic cash flow. Worst case, companies with low liquidity will need to assess the difficult prospect of insolvency, inflicting associated stress and lost sleep on managers, employees and customers who are depending on the company’s success. Yes, FX can deliver outperformance with a 20% positive impact, but if an equivalent adverse year results in bankruptcy, this risk requires careful consideration.
So, how much can FX markets move in a year? In short, at least for USD, about 7% on average and 15-30% in extreme periods.
We can therefore say that a company with a 5% risk appetite that doesn’t hedge is exposed to exceeding its risk appetite by 2% each year on average (5% – 7%) and by 10 – 25% in extreme years. This can easily result in complete erosion of group earnings after netting the achieved AUD-equivalent USD revenue with the company’s domestic AUD costs.
In this context, hedging is not speculative, nor are its objectives lost in operational complexities; hedging can be framed as a necessary process to protects strategic initiatives that ensure the company continues sustainably fulfilling its purpose.
It is from this perspective – the extent and consequences of normal and extreme volatility exceeding risk appetite – that a company can succinctly assess whether FX hedging should be implemented.
From here, the next step is determining the amount of a forecast to hedge, considering the quality of forecasting processes and various key commercial aspects of the business, while acknowledging that over-hedging comes with its own risks. This is the stage where a hedging policy is built, which will be the topic of a future post.
If you are unsure where to begin or want to learn more, we would love to speak with you about your company’s challenges and objectives. We work with Australia’s leading FX risk advisory teams, ensuring our customers can rapidly access flexible ongoing services if required,
Furthermore, many operational tasks in FX hedging remain open to automation as relevant technology infrastructure at FX brokers and banks lags other industries (often for valid reasons); addressing this will greatly reduce the time and effort to implement and maintain an FX hedging program. This is why Equip FX is working with our FX broking partners to establish modern APIs that streamline the FX risk monitoring, deal execution, and data management processes, ensuring that protecting a company’s key initiatives is done in less time, with more clarity, consistency, and alignment.
I hope you have found this post helpful and thought provoking. We look forward to hearing from you and continuing to pursue our own purpose of fostering a more integrated Treasury ecosystem, helping businesses achieve more with less in FX risk management.
Tom Alexander; Co-founder & CEO
The below displays rolling 12-month volatility of major USD currency pairs over the past 5yrs. For example, we can say that in any given month, AUDUSD on average was 7.4% different from where it was 12 months prior. During Covid, year-on-year volatility peaked at 28%.
From this analysis, we can say that companies with USD exposure have recently faced annual volatility of around 7% (CADUSD being the exception) with peak volatility reaching 15-30%, depending on the currency pair.
 Deciding budget rates warrants its own separate article
 This clarity has the added benefit of giving managers and operating stakeholders clear expectations of what success looks like.
 Please see Appendix for more detail
 To be sure, this is not displaying rolling 12-month returns, but rather absolute volatility. Eg, AUDUSD appreciating or depreciating by 10% over a 12-month window will always be displayed as +10%.
 In this case, AUDUSD appreciated from 0.6169 in March 2020 to 0.7870 in February 2020.