In our first blog, Purpose & Volatility, we discussed why a company might choose to hedge its FX risk. We offered a purpose-led framework where a company’s key risk stakeholders first define what the company does, and for whom, and then align on what strategic objectives that support the pursuit of this purpose are at risk from adverse FX market movements.
We provided a high-level analysis showing that on average, USD varied by about 7% per year against other leading global currencies, and by as much as 30% in years of extreme volatility, such as during the height of Covid.
Our key conclusion was that if the size of these FX movements exceeds the company’s risk appetite, putting excessive stress on the ability to achieve strategic objectives (or worse, risking insolvency) then hedging could be a critical strategic choice.
In this blog we’re going to extend these ideas by introducing a simple flexible framework for creating an FX hedging policy, where the aim is ensuring that realised volatility stays within the confines of risk appetite. We’ll assess this framework using a quantitative model called Cash Flow at Risk (CFaR) to explore relationships across key risk variables, while emphasising practical qualitative considerations that address some of CFaR’s shortcomings.
At the end, I hope you feel further equipped with concepts that will help you better assess your own FX risk requirements.
How do we determine the required reduction in risk?
Let’s continue with the example from Purpose & Volatility, where an Australian company is forecasting net revenue of USD10.5m over the next 12months and has budgeted to convert this into AUD15m using an AUDUSD budget rate of 0.7000.
If the company is comfortable receiving only AUD14.25m, or 5% less than expected, then we like to say its risk appetite is 5% (AUD750k in this case).
If we know the company can expect AUDUSD to fluctuate between 7-30%, then the company needs enough hedging to reduce the impact of this volatility by 2-25% to ensure realised volatility is no more than 5%.
Typically with hedging policies, we focus on the more extreme case (say 25%) because a company can more readily find operational means of reducing costs or growing sales if there is only a 2% gap to cover (we could refer to this as finding ‘natural hedges’, or, ways to reduce risk without having to resort to financial derivatives). Equally, these extreme FX moves can set in quickly, in a matter of months, whereby the size and speed of the impact cannot be effectively managed reactively through operational adjustments.
So – how do we strip potential 25% FX volatility out of future cash flows?
And, how do we do this without creating excessive new risks or costs in the process? Depending on the specific commercial aspects of a company, a great starting point can be the ‘Descending Wedge’ hedging framework. This approach gives a very clear, simple mandate to risk managers and is easily communicable to senior managers or board members who may not be as versed in FX risk. The approach also accounts for declining confidence in the accuracy of cash flow forecasts as they go further into the future and for the potential credit risk of ‘out of the money’ hedges that could require margin calls by FX hedging counterparts. The descending wedge can also account for any FX pricing adjustments built into commercial contracts for both sales and costs. Here is what it looks like, in its most basic form:
With the following key attributes.
- The policy determines a minimum and maximum amount of hedging that a forecasted exposure should have against it during each period
- The policy goes a certain number of periods into the future (in this case a period is one month, and the policy goes 12 months into the future – the period type and duration are always company-specific)
- These minimum and maximum amounts reduce through time
- This is a ‘rolling’ policy, whereby Month 1 is the next month in the future from whatever month today is in, Month 2 is two months into the future, etc. Using the above policy as an example, if we are currently in January, then Month 4 is May, and it requires a minimum of 50% hedging against the May cash flow forecast. Come February, May is now Month 3 and requires a minimum of 75% hedging. This ensures we are consistently adding more hedging as cash flow and market conditions become relatively more certain across shorter time horizons. This is also done irrespective of our market view or whether we view a prevailing FX rate as favourable or adverse
Deciding what all these values ought to be is admittedly easier said than done, but let’s anchor our exploration of this with a simple idea:
“It’s better to be approximately right than precisely wrong”
With this in mind, we can create some very precise outputs with a purely quantitative method called Cash Flow at Risk (CFaR) to estimate what our minimum and maximum hedging percentages should be, while ensuring we include some practical flexibility.[1]
Further using our Australian company example, a CFaR analysis looks something like this:
Inputs
- Our cash flow forecast for USD (here we’re assuming our annual forecast is spread evenly across each month)
- Our hedging policy
- Historic FX market data
Calculations
- A Monte Carlo simulation of 1,000 future AUDUSD FX rate paths based on historic market data
- Converting our USD875k/month forecast into AUD against all 1,000 price paths
- Unhedged CFaR = the average AUD outcome across the 1,000 scenarios minus the 95% most adverse outcome across the 1,000 scenarios
Unhedged CFaR = AUD15m – AUD13m = AUD2m
- Repeating this process with simulated hedging based on the hedging policy
Hedged CFaR = AUD 15m – AUD14m = AUD1m
Outputs
This model and process provide some conceptual levers to assess whether we’re on track to reduce volatility to within our 5% (AUD750k) risk appetite. Unhedged, we are exposed to a 95% worst-case outcome that is ~AUD2m worse than expectations and our basic descending wedge policy reduces this 95% worst case outcome to ~AUD1m when hedging to our minimum requirements – a helpful reduction, but still not quite enough to align with our AUD750k tolerance.
To reduce minimum hedged CFaR further, we need to increase our minimum hedging levels and re-run the analysis. Herein we can cover some key considerations –
- Increasing required hedging in the short-term will have a lower reduction in CFaR than increasing hedging in the long term. This is intuitive in that a 95% worst case volatility over say 3months will always be lower than a 95% worst case volatility over say 10months – the longer the time, the more adverse an FX rate can become. However, simply increasing longer-dated hedging comes with its own risks.
- Cash flow forecasts are more accurate in the short-term. Said differently, placing a lot of hedging further out can cause problems if the cash flows requiring those hedges reduce or disappear altogether – the more hedging there is longer term, the more risk there is of ending up with hedging that is not required. If these hedges are out of the money, there is no underlying cashflow that is improving in value to offset the hedge; the company must simply pay the loss to their broker.
- Compounding this, we’ve just said a market can become more adverse the further into the future we go. A hedge placed 12months in the future has more time to go deeply out of the money than a hedge with a shorter maturity, which increases the risk of margin calls, depending on the hedging instrument being used.
So, if we want to further reduce our CFaR, it must be done in consideration of the risks created if we place too much hedging too far into the future with suboptimal hedging products. When we increase minimum hedging requirements as per the below (also increasing the maximums where required), then our minimum Hedged CFaR becomes AUD730k, just lower than our risk appetite of AUD750k, meaning this can be considered a viable hedging policy based on precise measurements.
Our minimum hedging levels can be viewed as our Critical Hedge Amount – the minimum amount of hedging required to stay within risk appetite in highly adverse market conditions. We hedge to these values each month regardless of where the underlying market is. The rolling nature of the policy ensures our hedge amounts and average hedge rates consistently build up over time.
The maximum hedging amount then serves a couple purposes:
- It provides latitude to the risk manager to place additional hedging when markets are favourable. This is not speculation – these maximums can be used when the prevailing market rates are more favourable than budget rates.
- The maximum amounts also help prevent over-hedging, which would otherwise create excess credit risk and margin calls or having hedges against expected cash flows that fail to materialise.
The reality of a hedging policy based on CFaR is that we are making very precise claims about an inherently uncertain future. Forecasted cash flows, commercial and market conditions will change. Ultimately, this is only a financial model based on various assumptions that will not be true in all circumstances. Another key drawback is that if cash flows are volatile, or fundamentally change through time, then the CFaR will also change, meaning the policy might need to be adjusted if a company is following a rigid quantification approach. Changing a policy can be challenging, often requiring a business case and sign-off by the company’s board. It is often better to allow some latitude in the policy to prevent having to change it more than once or twice per year.
Where CFaR shines is in allowing for the key parameters of forecasting, market volatility, hedging and the descending wedge policy framework to interact in a way that portrays realistic push-pull relationships. CFaR at its core is an academic tool, useful for educating and guiding dialogues around FX risk.
Summary
In conclusion, the descending wedge can be a fantastic FX hedging policy framework for businesses with reasonably predictable FX revenue or costs, and its purpose is two-fold:
- Ensure a minimum amount of hedging that reduces volatility in future cash flows to a level consistent with risk appetite
- Have a maximum amount of hedging that allows latitude to take advantage of favourable market conditions (typically, by securing hedging rates that are more favourable than budget rates), while limiting the risk of over-hedging or accumulating excessive margin call risk
This approach is as much art as science – quantitative models can help frame a conversation, but its precision must be viewed as imperfect, and ultimately practical human oversight is essential.
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If you would like to learn more about hedging policies, or even run a CFaR for your business, we would love to hear from you. We also 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 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 letter 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.
[1] CFaR is a sort of statistical cousin to the more common Value at Risk (VaR). Both apply FX volatility over a period, however the key difference is that CFaR applies volatility to a forecasted cash flow, whereas VaR applies FX volatility to a fixed portfolio of assets or liabilities (ie, an FX derivative book or perhaps an equity portfolio)
