Conquering Currency Risk Management

Conquering currency risk management involves identifying, analyzing, and prioritizing various foreign exchange (FX) exposures, and developing and implementing a coordinated and systematic plan that utilizes company resources efficiently and effectively to mitigate and optimize FX risk. An important part of mitigating FX risk is hedging exposures such as revenues, expenses, receivables, payables, assets, liabilities, and equity.

The degree to which companies implement adequate foreign exchange risk management practices can vary substantially, from not managing the risk at all to engaging in robust hedging activities. As a result, the FX impact on the bottom line can vary widely across organizations.

Global companies face questions including, but not limited to: How to manage currency risk? How to draft a FX risk policy? Where to look for FX risk exposures? What currency risks to hedge and how? Which strategies meet FX hedge objectives? What are the economics? How to do FX accounting? That's a lot of questions! It's time to take the FX Initiative!

FX Initiative's foreign exchange risk management training starts with watching our online video series about:

1. Foreign Exchange (FX) Market Overview
2. FX Risk Exposures
3. FX Risk Management
4. FX Spot & Derivatives
5. Hedging FX Transactions
6. Hedging Foreign Subsidiaries

Then, review and test with quizzes and CPE exams, and reinforce learning using real examples with our:

• Currency Code Locator
• FX Risk Policy Drafter
• FX Derivative Speculator
• FX Transaction Simulator
• FX Subsidiary Consolidator

FX Initiative training is available 24/7 365 to help you with FX risk policies, FX accounting, FX hedging strategies, FX risk management, and more.

Are you ready to manage FX risk? Become a FX Initiative subscriber today and access our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Managing FX risk has become a higher priority for many firms in 2022 and it is now easier than ever to learn the fundamentals of currency risk management. Make this the year to reduce FX risk and reap rewards abroad by taking the FX Initiative for your international business today!

January 2023 Newsletter

New Year Knowledge: Read our January newsletter and discover the latest blog posts and insights from FX Initiative on currency risk management. We help finance, accounting, treasury, and sales professionals stay up to date with new training content, CPE webinars, and helpful tips & resources.

Scale the learning curve quickly and easily with our foreign exchange risk management training, which provides 24/7 365 access to our complete suite of foreign exchange (FX) continuing professional education (CPE), examples and events at FXCPE.com. Start Training >

View Newsletter

White Label FX Web Applications

FX Initiative's white label web applications are designed to help treasury professionals and FX sales teams with a wide variety of foreign exchange (FX) risk management challenges and opportunities. Whether you are creating a FX risk policy or analyzing economic and accounting scenarios, our risk models and strategy simulations share best practices in easily understandable formats.

Examples include:

Morningstar's Missing FX Risk Management

FX Initiative is fascinated with how global companies manage foreign exchange (FX) risk. This analysis focuses on Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia. Founded by Joe Manseuto in Chicago in 1984, Morningstar’s timeline outlines their expansion into Japan in 1998, Australia, New Zealand and Canada in 1999, and the opening of Morningstar Europe, Morningstar Asia, and Morningstar Korea in 2000. Today, the company has operations in 27 countries as outlined in their 2016 annual report (10-K):

The company’s Securities and Exchange Commission (SEC) filings offer 3 interesting highlights from a FX perspective:

1. Morningstar has direct exposure to 23+ currencies through their wholly owned or majority-owned operating subsidiaries.
2. 26% of Morningstar’s 2016 consolidated revenue was generated from operations outside of the United States.
3. Their most recent 10-Q for the second quarter of 2017 states that "approximately 69% of their cash, cash equivalents, and investments balance as of June 30, 2017 was held by their operations outside the United States."

The two main goals of a FX risk management program are to (1) minimize earnings volatility on the Income Statement and (2) preserve cash flows on the Balance Sheet. Hedging involves taking an offsetting position in a specific currency in order to reduce the impact of unfavorable foreign exchange rate fluctuations, whereby when the underlying position incurs a loss, the hedge incurs a gain, and vice versa. The goal of hedging currency risk is not to gain or lose, it’s to make the financial outcome more certain and predictable. Let’s examine Morningstar’s FX risk profile with a simple year over year comparison between 2015 and 2016 by examining their revenue, operating expense, and other income highlights.

First, let’s explore the impact to the Income Statement from a gross margin perspective (i.e. revenue minus operating expenses). In 2016, “foreign currency translations reduced revenue by about $9.5 million” and their “operating expense by $11.5 million”, for a $2.0 million favorable variance. In 2015, “foreign currency translations reduced revenue by about $26.9 million” and “operating expense by $23.9 million”, for a $3.0 million unfavorable variance.

Second, the impact to “Other income, net primarily includes foreign currency exchange gains and losses arising from the ordinary course of our business operations.” In 2016, “Other income, net” was a positive $6.1 million compared to a positive $1.2 million in 2015. This volatility comes from the “mark-to-market” revaluation of booked receivables and payables each period that is reported in earnings on a current basis. These exposures are booked and known, and serve as the foundation of foreign exchange “balance sheet hedge” programs that are employed by many companies.

As it relates to Morningstar’s discussion of their FX risk management strategy, they state “Our operations outside of the United States involve additional challenges that we may not be able to meet. There are risks inherent in doing business outside the United States, including challenges in currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.” They also state they “do not expect to repatriate earnings from our international subsidiaries in the foreseeable future.”

While Morningstar clearly discloses their substantial currency risk, the company surprisingly states that "We don't engage in currency hedging or have any positions in derivative instruments to hedge our currency risk." Their 2016 annual report also goes on to state that “Foreign currency movements were a factor in our 2016 results, although to a lesser extent than in 2015, as continued strength in the U.S. dollar reduced revenue from our international operations when translated into U.S. dollars. This has been an ongoing trend for several years and reduced revenue by $9.5 million in 2016 and $26.9 million in 2015.”

Morningstar.com’s articles offer various investor perspectives on hedging FX risk. For example, the article “Hedge Your Currency Risk When Investing Abroad” mentions that “Investors should definitely invest globally and they should hedge out at least part of their foreign risk.” Another example from the article titled “The Impact of Foreign-Currency Movements on Equity Portfolios” is that “Betting on currency movements is generally a fool’s game and should be avoided by the average investor.” Applying this advice, it appears that Morningstar is invested globally but doesn’t hedge any part of their currency risk, and their decision not to hedge is a bet on FX.

Finding the right balance between risk and reward is a classic tradeoff for any investor or organization. Morningstar is a highly respected global thought leader when it comes to investing, and they have clearly analyzed their corporate exposure to FX risk as it relates to revenue, operating income and net investments (as shown in the screenshots below). Additionally, Morningstar has an array of publications on currency such as their Currency Category Handbook, and offers data services such as their Morningstar Foreign Exchange Feeds. The company seems to have the personnel, operations, and resources to manage FX risk.

From an enterprise risk management perspective, foreign exchange risk is a non-core business risk that often poses more of a threat than an opportunity, whereas core business risks are related the strengths that a company is rewarded for taking on, such as investing in new products and research and development. Therefore, hedging foreign exchange risk allows firms like Morningstar to budget more reliably when engaging in international business in order to focus on their core strategic initiatives more effectively.

What are your thoughts on Morningstar’s approach to FX risk management? Each market participant must define their own risk appetite, and there is no “standard" protocol. However, in closing this analysis, a quote from Gary Cohn, the Director of the National Economic Council and former president and chief operating officer of Goldman Sachs, comes to mind: “If you don't invest in risk management, it doesn't matter what business you're in, it's a risky business.” Join the conversation and share your thoughts on FX risk management in the comments section.

To learn more about FX risk management, sign up for FX Initiative’s currency risk management training. Our educational videos, interactive examples, and webinar events help simplify complex currency risk management issues using real-world scenarios from leading organizations such as Apple. Our mission is to help banking and corporate treasury professionals deliver effective currency risk management results in a time efficient manner. Start learning best practices for mitigating FX risk by taking the FX Initiative today! Click here to for more information >

Image Sources: Morningstar Inc. 2016 Annual Report (10-K)

Due Diligence & Distinguishing FX Derivatives

Due diligence is a term that commonly applies to a business investigation, and it contributes significantly to informed decision making by assessing the costs, benefits, and risks of a transaction. As due diligence relates to foreign exchange (FX) risk management, firms can enhance their strategic decision making process by assessing the costs, benefits, and risks associated with currency derivatives, and recognizing their differences and similarities when hedging foreign currency transactions.

At the highest level, currency derivatives are financial contracts between two parties whose value is derived from the exchange rate of one or more underlying currencies. FX risk management involves mitigating currency risk to an acceptable level by understanding when and how to hedge using FX derivatives to achieve FX objectives. The first part of the FX risk management decision making process is determining a firm’s FX hedging objectives and strategy for achieving those objectives.

The two most common FX risk management hedging objectives are (1) minimizing foreign exchange gains and losses in earnings and (2) preserving cash flows. The most common currency derivatives used in practice are (1) forward contracts, (2) vanilla options, and (3) zero cost collars. Therefore, to achieve the 2 most common hedging objectives using the 3 most common currency derivatives, it is helpful to compare and contrast how each derivative achieves each hedging objective as follows:

1) Forward Contracts

• Objective 1: Minimizing Earnings Volatility - Forwards are particularly attractive for firms that seek a symmetrical payoff profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by far the most effective derivative for eliminating foreign exchange gains and losses to the greatest extent possible, and are used overwhelmingly in practice for all types of FX hedges.
• Objective 2: Preserving Cash Flows - Forward contracts do not require an upfront premium to be paid, unlike an option. However, a forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate, which may require a cash payment to be made in the future to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of forward contracts are their forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile relative to the spot foreign exchange rate.

2) Option Contracts

• Objective 1: Minimizing Earnings Volatility - Options are particularly attractive for firms that seek an asymmetrical payoff profile relative to the spot foreign exchange rate, where the hedge secures the value of an underlying position against unfavorable market moves beyond the strike rate, while retaining 100% participation in favorable market moves. Options do not provide the same degree of offset in earnings as a forward due to its asymmetrical payoff profile, and tend to be used for longer dated and/or uncertain exposures.
• Objective 2: Preserving Cash Flows - A purchased vanilla option requires a cash premium to be paid to the counterparty at inception, which can be a deterrent compared to a forward contract. However, an option will always expire with either a positive intrinsic value or zero fair value at maturity, ensuring no future cash payment is required by the option holder to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of vanilla option contracts are the premium paid upfront, the asymmetrical payoff profile relative to the spot foreign exchange rate, and the lack of obligation to make a payment at maturity.

3) Zero Cost Collars

• Objective 1: Minimizing Earnings Volatility - Zero cost collars are particularly attractive for firms that seek to establish a predefined range of foreign exchange rates where the value of the hedged FX transaction is secured on the downside by the collar “floor” and limited to the upside by the collar “ceiling" or "cap”. Zero cost collars provide less downside protection and less of an offset in earnings relative to a forward contract, but allow for participation in favorable market moves like an option contract with no upfront premium.
• Objective 2: Preserving Cash Flows - Zero cost collars do not require an upfront premium to be paid by combining two vanilla options, (1) a purchased out of the money option and (2) a sold out of the money option, whereby the premium paid on the purchased option is offset by the premium received from the sold option to create a zero cash outlay. However, a collar has the potential to finish in a zero fair value, asset or liability position at maturity, which may require a future cash payment to be made to settle the contract.
• 3 Distinguishing Characteristics: 3 key distinguishing characteristics of zero cost collars are the ability to participate in favorable foreign exchange rate movements with no upfront cost, the reduced downside protection relative to a forward contract, and the unique payoff profile of the collar range relative to the spot foreign exchange rate.

Overall, each company must decide their FX hedging objectives and strategy for achieving those objectives that balances minimizing earnings volatility and preserving cash flows. There is no one prescribed method for selecting a FX derivative, and firms can benefit by approaching the selection of a derivative from a hedge objective perspective. As the late, great economist Milton Friedman said, “there is no free lunch” in economics, and when selecting a FX strategy, firms can benefit from recognizing the tradeoffs, differences and similarities of how the 3 most common currency derivatives can be used to achieve the 2 most common FX hedging objectives.

To learn more about FX derivatives, you can explore our previous blog post on “How to Compare Currency Derivatives & Credit Considerations” and sign up for FX Initiative’s currency risk management training. Our FX Spot & Derivatives Course deconstructs forward contracts, option contracts, and zero cost collars to help you select an optimal hedge instrument. Additionally, our FX Derivative Speculator illustrates the economics and accounting of derivative positions to compare and contrast the payoff profiles, cash flows and accounting entries under virtually any FX rate scenario. Start doing your derivative due diligence today by taking the FX Initiative!

Are you curious how forwards, options, and zero cost collars work in practice? Click here to learn from real-world examples!

Cheers,

The FX Initiative Team
support@fxinitiative.com

Balancing Brexit & FX Balance Sheet Hedging

As Brexit continues to capture news headlines, FX Initiative is increasingly helping North American companies manage the currency risk associated with doing business in the United Kingdom (UK). Brexit refers to the prospective withdrawal of the United Kingdom from the European Union (EU), which was voted on in June of 2016. Since the referendum, the value of the British pound (GBP) versus the US dollar (USD) has fluctuated from highs near 1.4500 levels in June of 2016 to lows near 1.2000 levels in January of 2017. This approximate 15% decline in value has prompted many international companies to adapt their foreign exchange (FX) hedging programs to better stabilize earnings and preserve cash flows.

American companies exporting to the United Kingdom have seen significant fluctuations in their GBP denominated revenues and accounts receivables (A/R), which are translated into USD in their financial statements for accounting purposes. To state the obvious, the 15% fluctuation in GBP/USD exchange rates over a 15 month period has created sizable swings in earnings and cash flows for firms that operate with a non-GBP functional currency. To mitigate this volatility, one major US pharmaceutical company needed to reconsider their FX balance sheet hedge program to better respond to the changing political landscape and unpredictable currency market prices.

Balance sheet hedging is by far the most common approach among multinational corporations when hedging foreign exchange risk, and in the context of Brexit, refers to hedging GBP denominated receivables and payables on the balance sheet as part of a systematic hedge program at each period or month end, or upon booking a material foreign currency denominated transaction. This US pharmaceutical company was previously hedging at each month end to adjust and match the amount of the their underlying GBP receivables with the amount of their GBP forward contract hedges. However, the majority of their monthly receivable bookings occurred on the 15th of each month, and their mid-month A/R bookings were largely unhedged from the middle of the month through month end.

To address this problem, FX Initiative helped assess the mechanics of their balance sheet hedge program by looking at their financial reporting process and specifically at their accounting booking convention. An accounting booking convention refers to the foreign exchange rate used to record a transaction on the financial statements. In this case, they were using the daily spot rate, which meant they were exposed to changes in exchange rates for each mid-month booking of a material GBP receivable transaction. By probing all the way down to the accounting booking convention, this US company was able to quickly and effectively enhance their balance sheet hedge program by adding one additional “true-up” hedge mid-month.

Their revised approach meant that rather than only hedging at the end of each month, the company was now adjusting the amounts on their forward contract hedge both mid-month and at month end. The result of this fundamental fix was that the company is now hedging over 90% of their GBP exposure for the entire month, and the FX swings in their monthly and quarterly earnings have declined by over 50%. Regardless of whether you are a FX risk management expert or novice, knowing where to diagnose a FX exposure is critical and having the ability to drill down to a technical level of detail such as an accounting booking convention can help companies conquer currency market challenges more efficiently and effectively.

FX Initiative’s training and consulting services can help your global organization establish and improve your foreign exchange balance sheet hedge program. We use real-world examples from Apple to demonstrate how a balance sheet hedge works in practice, and our risk modeling tools enable you to practice your approach prior to implementation to get comfortable with the economics and accounting. While events like Brexit are hard to predict, a consistent and ongoing foreign exchange risk management program can proactively protect against changing political, regulatory, and economic environments. FX hedging is about making the outcome more certain, so give your company the FX certainty and predictably it needs to succeed abroad by taking the FX Initiative!

Ready to build a better FX balance sheet hedge program? Click here to start your Currency Risk Management training!

Cheers,

The FX Initiative Team
support@fxinitiative.com