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Premium Content Version   By Phil Lynch Introduction This month we look at Creating a Written FX Hedging Policy, where we…

Creating a Written FX Hedging Policy – Full Article and Checklist

Published September 21, 2018

Premium Content Version

 

By Phil Lynch

Introduction

This month we look at Creating a Written FX Hedging Policy, where we examine the necessary key elements for writing an effective policy.

This article is useful for anyone looking to protect their business from foreign exchange risk. It helps to be familiar with the FX Hedging Cycle, since a good policy is based around understanding this cycle. That said, you may find that formalising your FX policy is simpler than you think. A written FX policy can be as simple or sophisticated as you wish.

Does Your Business Need an FX Policy?

The first step is to identify if you want or need a policy. At EncoreFX, we advocate having a clear plan, strategy, or policy that is well executed. There are many benefits to creating a policy; some of my favourites include:

  • Not leaving FX risk to the mercy of a coin toss
  • Giving key stakeholders autonomy by allowing them to contribute to, review, and agree upon the risk management approach
  • Eliminating the risk of ‘bad’ FX decisions (because a policy dictates all FX decisions)

We are also big advocates of formalising plans by putting them in writing; a formalised policy removes any ambiguity about how individuals are to manage FX risk. Written plans also help create accountability.

It is worth noting that an FX policy does not have to be complicated. It could be as simple as ‘we will hedge a minimum of 50% of our forecast FX exposure out 6 months’ or ‘every sales order over NZD 100,000 will be hedged immediately’. Then again, it’s not always that simple. This article will explore some of those finer details.

There are other reasons why you might think about putting a policy in place, aside from just following best practice. Ask yourself:

  • Have you been burnt before because a currency rate changed significantly and you were a) not hedged or b) over hedged?
  • Are you a listed company with strong governance expectations?
  • Are you an NGO receiving donations, and require a higher level of care?
  • Is your team experienced enough to make FX decisions at their own discretion?
  • Are you looking to delegate responsibility for FX decisions to free up your own time?
  • Are you looking to prepare your business for sale and demonstrate your processes are all in order?

If you’re keen on putting your FX policy into writing, read on.

Keeping it Practical

Less-than-practical FX policies are common, ranging from ill-informed business decisions to hedge everything, to businesses believing they are better off covering nothing and seeing how things play out. Even expensive, multi-page FX policy documents are only as good as the individuals that have read and agreed to them. Conversely, what good is a single-page policy if all it does is stipulate that a business will ‘hedge against risk’ without providing a method as to how this should happen?

It’s natural for policies to vary significantly from company to company, but a good FX hedging policy will always answer four key questions that assist in practical implementation. These are:

  • What is being hedged? For example, is it forecast transactions or committed transactions? Are transactions grouped together based on their type of exposure, or is everything treated separately?
  • What are your objectives when hedging? Is it your main goal to protect margins? Or achieve stability? Something else?
  • What is the approach to hedging? For instance, back-to-back hedging or a more strategic approach?
  • How is it hedged? For example, are you hedging a percentage of the forecast or commitment? If a forecast, what is the timeframe it is hedged for?

A finance or treasury team will need to grasp these elements in order to execute on the policy.

A Simple Example

Let’s say you are an importer and wholesaler of office furniture. You have a steady stream of orders and are importing USD 1 million worth of stock each month. Your policy could be this simple:

  1. As importers of office furniture, we are exposed to USD 1 million worth of costs per month. Gross margin is reasonable (~25%) and prices are usually fixed for six-months.
  2. Our objective is to protect our profit margins.
  3. We will take a strategic hedging approach to ensure we protect our profit margins while adding value over time.
  4. Our policy is to hedge a minimum of 60% of forecast imports out six months, with a maximum of 100%. Hedging beyond six months requires board approval.

The Written Policy

Background Information / Overview

This section should contain background information on the international activities your business undertakes which result in foreign exchange exposures. It is worth noting that exposures can change over time, as can your approach to managing FX risk. There are typically two ways of managing changing exposures within a policy:

  1. Your policy outlines the exposures, your objectives, the approach to hedging, and how it is being hedged. In this case, if your exposure changes, your policy should also change.
  2. Your policy outlines the overall approach to FX risk management and stipulates which individual (eg CFO) or group (eg Risk Committee) sets schedules for the exposures, the approach, and how it is hedged. In this case, your policy adapts to changing exposures.

Categorising Exposures

Different exposures may be managed differently. There are two common splits when categorising exposures:

  1. Committed transactions
  2. Forecasted transactions

You may want additional categorisations. Are exposures regular or seasonal? How are one-off exposures categorised? Do different product lines require different categorisation? Are export revenues treated differently from imported cost of goods sold? Are different currency pairs treated differently? The variations are endless.

Outlining Your Objectives

It is important to outline your objectives in your policy as this will incorporate your business’s underlying values. A conservative business may have objectives to protect margins and mitigate foreign exchange risk while a higher risk business may wish to take a more active approach in FX markets.

Approach to Hedging

In this section, you need to outline your approach to hedging. This is usually done for each exposure category. There are four common approaches to hedging:

  1. Do nothing
  2. 100% hedged
  3. Pad profits / active hedging
  4. Strategic hedging

How it is Hedged

Now you’ll document how you intend to manage your FX risk. This is most applicable to those adopting an active or strategic hedging approach and often where you would stipulate policy driven hedge ratios. For example, you might decide that your policy is to hedge 60-100% of forecast exposure over a rolling 6-month period.  This gives you a baseline of policy driven cover (60%) that protects your margins. It also allows you to take advantage of favourable exchange rates if the opportunity arises.

It may be appropriate to outlay the types of instruments you are choosing to use. Some instruments might be perfectly tailored to your type of exposure. Others might be too risky to entertain. Knowing which instruments are appropriate requires an in-depth understanding of available hedging products; you may want to consult your trusted FX risk manager.

Other Considerations – A Checklist

Now that you have the foundations of a good policy, consider thinking about some of the finer points. We’ve prepared a checklist for you to work through.

Reporting, Measurement & Management

  • How do you quantify your risk?
  • How often do you update your exposures?
  • What reporting on your policy is required?
  • Is sensitivity analysis reporting required?
  • Who collates the reporting?
  • Is reporting systemised or spreadsheet based?
  • Who gets the reporting?
  • How regular is the reporting?
  • How often do you review your policy?
  • Which internal departments need to be kept informed of FX related issues? (eg audit, sales staff, etc)
  • Which external departments need to be kept informed of FX related issues? (eg customers, regulators, etc)
  • Who reviews, updates, and signs off on your policy/strategy?
  • How often is your policy/strategy reviewed?

Execution

  • What types of instruments should be approved for use?
  • What types of instruments (if any) are not approved for use?
  • Is there a minimum exposure size before your policy is applied? What is the cut-off?
  • Where can discretion in booking instruments be exercised?
  • Where can’t discretion in booking instruments be exercised?
  • Who are your authorised counterparties for booking transactions?
  • Who are your authorised representatives who can book transactions?
  • Do you have different roles for booking hedging instruments vs processing payments? Who handles what?
  • Do you need to stipulate no currency speculation?
  • Who monitors plan execution?
  • How are decisions made? Are decisions made strictly in accordance with the policy/plan?
  • Are decisions made by an individual or a group/committee?

Other Factors

  • How do your competitors manage FX risk?
  • Do you need to incorporate factors unrelated to foreign exchange, such as commodity prices or interest rates?
  • Do you have a budget for purchasing certain instruments?
  • Are your contracts executed online or offline?
  • Are your payments processed online or offline?
  • Do you require pricing agreements with your counterparty?
  • How are policy breaches dealt with?
  • What security measures are in place to protect your companies funds?
  • What fraud protection steps are in place when processing payments to new or changed beneficiaries?
  • How are forward trading / credit facilities managed?

Conclusion

Creating a written FX hedging policy has many benefits, but there can be a lot to consider when developing or reviewing your own. Make it a priority to consider the four practical elements of a good FX policy; if you would like a review of your existing policy or think it’s time to put one in place, contact me today.

Phil Lynch – Corporate Hedging Director – Asia Pacific

+64 9 941 4052

+64 21 516 826

plynch@encorefx.com

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