By Phil Lynch
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.
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:
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:
If you’re keen on putting your FX policy into writing, read on.
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:
A finance or treasury team will need to grasp these elements in order to execute on the policy.
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:
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:
Different exposures may be managed differently. There are two common splits when categorising exposures:
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.
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.
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:
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.
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.
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
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