For many corporate treasurers, deciding what products to use in order to hedge their FX exposures is the easy part of the job. The hard part is working out exactly what their FX exposures are. Galen Stops reports.
When it comes to effectively hedging FX exposures, it seems that the biggest challenge facing corporate treasurers is simply getting an accurate view of what these exposures are.
“Getting a centralised view of our FX exposures is very difficult. It’s always an issue, it’s something that we work on constantly and we’ll probably never get to the point where we have a perfect view on this,” says a source at one European corporate with revenues over $22 billion.
Similarly, Joseph Peka, deputy treasurer at Urenco Group, comments: “Ensuring that the right exposures are being hedged and compliance with internal policies is where the bulk of my attention is focused. I would guess that 80% of my FX management time is focused on identifying exposures, reporting, planning, and developing systems, processes and controls for managing exposures.”
Obviously, for huge multinational companies the challenge is simply collecting the various foreign exchange exposures from all their business interests and subsidiaries across the globe in one place. And it’s worth pointing out that it’s not just business revenues that generate FX exposures, but also business expenses – a US car manufacturer that imports steel from China and electronics from Israel could still generate significant currency exposures even though all its operations and customers are domestic.
Another difficulty is that in some cases, different parts of the company are using different technology systems that aren’t integrated.
“A lot of companies are acquisitive as they grow and some of them tend to leave the acquired company with its own data system with the result that the poor guy sitting at corporate headquarters is looking at 20 different ERP systems to try and determine what the firm’s FX risk exposures are,” says Jonathan Tunney, managing director at AtlasFX and former director of FX at Hewlett-Packard, where he managed more than $100 billion in annual FX transactions.
Beyond this, however, there are also more structural issues that can make it more difficult for treasurers to access the data they need to manage their firm’s risk exposures. This is because, from an accounting point of view, there’s two types of exposures that every firm looks at.
One is short-term monetary assets and liabilities. This is the balance sheet exposure, which typically ends up in the foreign exchange gain or loss line somewhere between the net operating income line and the net income line and has an impact on earnings per share. The second is the cashflow exposures, which is the forecasted revenue and expense exposures. Essentially, this looks at the upcoming expenses and revenues and the denomination of each, and the aim is to derive a net exposure.
“Firms are always forecasting these exposures from an accounting point of view and a risk management point of view and these two are always seen as independent processes,” says Wolfgang Koester, CEO of FiREapps and a veteran corporate FX strategist. “And therein lies the problem. A majority of treasury departments do not have a password to their firm’s accounting system and often times it is not in just one accounting system. But the data that they need to effectively manage, for example their balance sheet exposure, is in those systems.”
A Multidimensional Problem
In some cases, the challenge in identifying risk exposures is exacerbated by the tools being used by corporate treasurers. Tunney points out that the majority of treasuries are still using excel spreadsheets to help manage their FX risk, and he argues that this approach is too basic.
“Excel, because it just has rows and columns, works really well with a twodimensional problem,” says Tunney. “But once you start talking about currencies you’re looking at different entities, different currencies, different line items, your profit and loss, etc – currency risk management is a multidimensional problem and that’s why Excel doesn’t actually work that well for it.”
Discussing the challenges that he faces getting an accurate view of Urenco’s FX exposures, Peka explains that the treasury department collates the group’s forecast cashflow exposure each month using software that is linked to the firm’s ERP system. This enables the department to receive detailed monthly data going out a number of years.
Peka says that Urenco’s business is characterised by lumpy cashflows that reflect deliveries of enriched uranium over the course of long-term contracts, and the firm’s policy is to hedge the exposures up to six years.
“We aim to achieve hedge accounting and so will hedge exposures that are highly probable forecast transactions. The challenges are that both the timing and values of these cashflows will change and so treasury has built a process for reporting, interaction and challenge with all business units to ensure that we understand these forecast exposures. The richness of the challenge is our understanding of the underlying contracts and business and so ensuring that we do not merely act as passive recipients of forecast data,” he comments.
Peka continues: “On balance sheet, exposures are challenging partly because the exposures may arise from how the business operates. Intragroup transactions mean that the group is exposed to P&L volatility as services are charged between countries and currencies. Ensuring consistent and transparent reporting is key. Being able to understand the currency of monetary assets, liabilities and debt across the group so that any residual exposure can be hedged requires timely accounting and reporting processes. All groups suffer the inherent risk between the time that the exposure arises, the exposures are aggregated, reported and residual exposures hedged. Anything that reduces that timeframe helps to minimise FX volatility.”
Part of the FiREapps product suite is designed to help corporates get a better view of their FX exposures, and Koester insists that technology is levelling the playing field between corporate treasuries.
“Interestingly enough, there’s not a direct correlation between the size of the companies and the sophistication of their FX management operations, there are companies with $100 million in revenue that are more sophisticated than $50 billion companies in this regard,” he says.The main barrier preventing the broader adoption of new technology, according to Koester, is not the cost or the implementation challenge, but simply getting the funding needed for it internally.
“The typical treasury department is 98% people cost, so for the treasury department to purchase any sort of technology is unusual and probably needs the CFO’s approval. The CFO is likely to have a lot of questions regarding the technology and then sometimes the treasury only gets to see the CFO once per week, whereas FP&A is in their room every single day, so who do you think gets the money?” he says.
More than one source cited corporate inertia as the main barrier to implementing new FX risk management technology, stating that if the existing system isn’t patently broken, then treasury departments are usually reluctant to change it. Part of this is simply career risk, if the treasurer implements new technology and then the company suffers FX-related losses, then it reflects badly on them. Part of it is because the existing systems can appear adequate and so sometimes it is only when there is a large currency move that it illuminates the extent to which the current system had left them exposed.
Explaining the friction points from his perspective when it comes to automating risk management, Peka comments: “On an end-to-end basis, identification of exposures to be hedged is fraught with challenges and any automation has to have built-in review and approval points. Handover between teams are inherent friction points. Clear communication between providers of risk exposures and the recipients of that data is vital.”
He continues: “Risk policy and appetite plays a part as well. Companies where the treasury function has low levels of discretion can be more easily automated. Where treasury plays a more active role either in determining or recommending the level of hedging needed, automation may be more limited.
“There is also huge danger in automation without interpretation. An example of this is the observation of increase in interest rate differential of even currency pairs of some majors. I have not seen any automated risk process that provide a brake when the commercial logic does not hold up.
“Balancing multiple risks is also a friction point. For example, balancing counterparty, liquidity, as well as currency risk means applying judgement by experienced staff on collective risks that are difficult to balance in simple terms.”
Understanding the Problem
The challenge of FX risk management for corporates was highlighted by a recent survey conducted by HSBC in which 72% of treasurers said that FX risk management is one of the most important aspects of their job, while 51% of CFOs said in the same survey that they believe FX to be the risk that their organisation is the least wellplaced to deal with.
“A lot of people, especially CFOs, don’t realise that this is not a treasury problem in isolation. In order to solve the foreign exchange problem for the company, they need the controller, treasury, FP&A and tax departments around the table to address it. And there’s technology that can help with this. That report shows you that most people don’t understand the problem yet, this is not just a treasury issue,” says Koester.
Other sources seemed unsurprised by the survey results, suggesting that it can be challenging for firms to find and retain personnel with the necessary experience to effectively manage their FX risk. One points out that because FX trading within a corporate firm is effectively “an inch wide and a mile deep”, it remains a very niche area and, as a result, there can be a dearth of understanding with regards to how the FX exposures fit into the broader business. Tunney suggests that this personnel problem is exacerbated when firms either use Excel spreadsheets or bespoke internal systems to help manage their FX risk.
“If you’re using Excel or bespoke technology, it becomes incredibly difficult to hand off the FX risk management to the next round of employees because often there’s no institutional memory for those kind of systems, they’re much more dependent on the individual, so it’s hard for the next person to come in and know how the different pieces fit together or the tools that they’re using,” he says.
Shifting Macro Trends
The current geopolitical backdrop – with tariffs throwing the future of global trade into a degree of insecurity, Brexit creating uncertainty in Europe, and central banks pursuing different interest rate policies, certainly has the potential to cause some sharp currency moves. Given this, is there a chance that the concerns highlighted by CFOs about their firms’ ability to manage FX risk will prove to be justified?
This question elicits a more mixed set of responses.
“In my experience, there is always something that looks set to move the markets,” sighs the European corporate. “Now it’s Brexit and Trump, but when it comes to currency markets, there’s always something that you need to be watching.”
Peka says that the spectre of a trade war and the inevitable currency volatility that would follow is an “undesirable factor” and says that if Brexit were to tip business away from London, then it might influence the way that his firm does business. For the latter of these issues, however, he points out that contingencies can be put in place and says that the risks involved are manageable in what remains “a developing landscape”.
Koester points out that these broader macro themes playing out are already having a significant impact on firms that aren’t properly managing their FX risk exposures. As an example of this, he points to Netflix, which missed its Q2 financial targets, in part because the US dollar strengthened significantly that quarter. Currency had a +$65 million impact on the firm’s international revenue year-on-year, but this is less than Netflix had forecast in Q1.
Interestingly for a firm of its size, Netflix noted in its Q2 report that it does not hedge its revenue with derivatives.
“Faster growth in international markets relative to the US creates a net revenue exposure to non-USD currencies. With the growth of our content production in 80 countries and expanding, we’ll move more of our operating costs to non-USD to provide a little more natural hedging, but we anticipate we’ll still continue to have much more expense in USD than revenue. We slowly adjust pricing over time to mitigate forex moves over the longer term, but when currency movements are rapid, they will affect our near-term operating margin. We’ll tend to outperform our near-term operating margin targets on dollar weakness and underperform on dollar strength,” the company said in the report.
Following the publication of the Q2 results, Netflix’s share price promptly dropped, at one point it was down double digits from the open that day, although it recovered to finish at $379.48, down 5% from the previous closing price.
Commenting on this, Koester says: “We saw a lot of European companies get hit in Q1 because of the dollar weakening, and now the reversal is going to hit a lot of American companies, so you’re going to start seeing more and more cases like Netflix, where firms are not applying best practices when it comes to FX risk management. But let me add this: I’m not in the business of telling people to hedge their risk away. What I am in the business of is telling people that they should know what their risks are and should communicate what risks they’re willing to take to their shareholders so that those shareholders are not surprised.”
The process that corporate treasurers are responsible for overseeing has become far more complicated than just examining simple cash flows, but part of the challenge is that the size of the treasury department does not necessarily increase corresponding to the revenue growth of the company or the complexity of the job. The complexity of the FX risk management element of the job, in particular, looks set to increase as volatility begins to creep back into currency markets that have remained unusually quiet for a number of years now.
The best solution for tackling this growing complexity is implementing technology and tools that enable treasury departments to get an accurate and timely view of the risk exposures that their firms face.
Of course, any new technology or system implementation comes with its own challenges, but the good news is that the tools that corporate treasurers need appear in many cases to be more accessible and affordable than ever. Although ERP systems remain the order of the day for now, fintechs offering global reporting of exposures as an overlay service for multiple and diverse systems increasingly offer a potential alternative.
Finally, though, it’s worth pointing out that technology alone cannot solve the challenges facing corporate treasuries when it comes to FX risk management. Because while it can help provide treasurers with a better view of their exposures, it cannot replicate the benefits of a qualified and experienced staff member that understands the nuances of the business.