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Creating a Written FX Hedging Policy

Published September 21, 2018

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

Writing a policy is not always straightforward, and is best done in partnership with a team of experts. We have reserved additional content (including a checklist of policy items) for businesses who are genuinely interested in working towards a best practice policy.

If you would like to read more about EncoreFX’s approach to writing a policy – you can click here. Once you enter your details, you will be emailed access to the full document and an EncoreFX representative will contact you to discuss what might work for you.

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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