Ctc Guide Fx

ctc guide

FX Risk Management:The Right Steps for a New Era

ctc guide FX Risk Management:The Right Steps for a New EraHow the evolution of FX programs and market uncertainty are driving a new way of looking at risk.

By Nilly Essaides

ContentsOverview Page 1

Why Now? Page 2

The Current State of U.S. Corporate Hedging Page 4

The Spectrum of Risk Management Programs Page 5

Case Studies Case Study 1: $40 billion Multinational Page 8 Case Study 2: Privately Owned U.S. Multinational Page 9 Case Study 3: $25 billion Multinational Page 11 Case Study 4: Newly Public Multinational Page 14 Case Study 5: Airline and FX Commodity Exposures Page 17 Case Study 6: Privately Held Canadian Multinational Page 20

The Disconnect Page 22

How to Build an Effective Program Page 25

Conclusion Page 28

www.AFPonline.org 2012 Association for Financial Professionals, Inc. All Rights Reserved 1

CTC GUIDE: Corporate FX Risk Management

OverviewForeign exchange risk is not a new issue for todays orga-nizations. Multinationals have struggled with it for years. However, the current financial and economic environment presents new challenges and opportunities, and they are triggering a reexamination of the way corporations manage their currency exposures. This is welcome news.

There are several reasons why currency risk is getting more attentionand not all of them are positive. What comes to mind first, of course, is the sharp decline of the euro. That, combined with the European debt crisis, has had a negative impact on the earnings of U.S.-based multinationals. The impact was evident in the many disappointing second-quarter 2012 earnings reports, and companies blamed the stronger dollar for substantial hits to their earnings per share (EPS). The media is also play-ing a role in the increased focus on currency risk. There have been numerous front-page stories about derivatives losses. While those media reports typically offer a one-sided view of the use of derivatives, those stories unfortu-nately tend to get the attention of Boards of Directors.

In addition, impending financial regulations are likely to change the way companies manage all sorts of risk, including currency exposure, primarily by making derivatives more expensive to trade and documentation more burdensome. Specifically, new capital require-ments for banks under the international regulatory framework known as Basel III, and new rules under the Dodd-Frank legislation in the U.S. are going to affect how much banks charge for products, access and ease of credit, and the kinds of reporting requirements with which companies will need to comply for some common risk management strategies.

But these may just be the headline reasons behind the greater emphasis on currency exposure. Experts in-terviewed for this guide point to a broader trend toward a systematic reevaluation of the substance and process of risk management. Specifically, they note treasurys growing role as a strategic partner and how its greater involvement with an organizations operations is allowing companies to do a better job at identifying their true economic exposures.

Additionally, constantly evolving treasury technology is finally reaching some critical mass. Many companies still rely on Excel spreadsheets to track exposures and

manage their risk management programs; however more are implementing treasury management systems (TMS) or niche applications, to handle the various steps in the risk-management process including exposure identifica-tion, risk analysis, trading and post-trade accounting and reporting. The availability of new tools, many of them provided on a more affordable Software as a Service (SaaS) basis and as portals (vs. installed applications), is making it possible for companies to manage risk in a more cost-effective way.

Still, there continues to be a big disconnect between what market experts say companies should do and what they actually do. This disconnect is evident in the six case studies in this report. This could be due in part just to timing: corporate policies evolve slowly while the markets move at a lightning pace. But much of it also is due to how management perceives risk, skewed corporate incen-tives and non-existent currency risk management perfor-mance metrics. Those things need to change. Its a new ballgame, said Craig Martin, Executive Director of AFPs Corporate Treasurers Council. [The recent rise in the dollar] is turning FX risk management on its head.

The fact that the dollar seems poised for a secular trend reversal is providing corporate risk managers with a unique opportunity to spearhead much-needed change. CFOs used to consider foreign exchange (FX) risk management an operational issue, said Ramon Bauza, Managing Director and Head of FX Risk Advisory with Deutsche Bank. But FX has shot up to the top of the list of strategic concerns. Bauza said hes had more conversa-tions with CFOs in the past few months than hes had in the past five years.

Also helping to spur change in FX risk management is treasurys elevated profile with senior management and Boards. Prior to the credit crunch of 2008, treasury was relatively underappreciated, said Robert Baldoni, who heads Ernst & Youngs Global Treasury Advisory Practice. The sharp emphasis on liquidity changed that perception. Treasurers are in front of senior managements and Boards now much more often, Baldoni said. Treasury is more visible and its contribution is more appreciated.

[The recent rise in the dollar] is turning FX risk management on its head.

2 2012 Association for Financial Professionals, Inc. All Rights Reserved www.AFPonline.org


Why Now?The experts interviewed for this guide listed several drivers that have combined to bring extra focus to FX risk management.

The stronger U.S. dollarThe dollar is up sharply since the start of the year,

and there are plenty of dollar bulls out there. For U.S.-based companies, this is a double-whammy. Their euro income is translating into fewer dollars just as sales in the euro-zone are taking a dip. While Europe no longer represents the greatest source of growth for U.S. companies, it remains the greatest source of exposure, according to Ivan Asensio, Head of FX Risk Advisory & Sales Structuring, HSBC Americas. The declining currency and increase in political risk in the euro-zone has driven a lot of risk management interest.

Impending regulationsRegulations will impact companies in a way thats not

easily foreseeable at the moment, said Amol Dhargalkar, Managing Director, Risk Management for Chatham Fi-nancial. While most companies have not yet made many

changes, regulations under Dodd-Frank will affect some more sophisticated treasury practices, such as the use of back-to-back trades with treasury centers.

Meanwhile, Basel III is the biggest thing that will impact corporate hedging in general, said the risk advisory professional at a large U.S. bank. It will re-ally change everything in a big way, and the banks are basically planning their futures based on very conserva-tive capital requirements. He predicted most banks will require margins for any forwards out further than 12 months. Even if companies do get a formal ex-emption, added the assistant treasurer at a large U.S. multinational corporation, the exemption would apply only to spot and short-term forwards, not options and non-deliverable forwards. The costs of maintaining a program will go up, Dhargalkar agreed.

Increased market volatility Tremendous volatility is driving the growing inter-

est in FX, said Joe Siu, Director, Risk Management for Corporates, and Dhargalkars colleague at Chatham.

Black swan events have become more common

Source: Chatham Financial



Black Swan events, those one in 100-year market shocks, are happening much more often Youve got to make sure your risk management program is top-notch. Best-in-class treasuries are thinking ahead. A program may have worked in the current environment, but organizations need to be faster and smarter in the use of resources in the next environment, noted Siu.

Information is flowing faster. The cost of being wrong is higher because the speed

with which info [sic] is being transmitted is faster, Dhargalkar cautioned. If the CFO knows before you do that theres an onshore vs. offshore market for China, thats not being viewed as acceptable. CFOs simply have much more access to information. This puts the onus on treasury to keep up and keep CFOs informed. Treasurers need to be ahead.

Not all the drivers spurring more emphasis on FX risk management are negative. There are also positive developments.

Treasurers are taking a leading role in their organizations. Experts like E&Ys Baldonis and Jacqui Drew, Senior Solution Consultant at Reval, explained that the treasury organization is gaining new ground. Treasurers are driving more projects to compare actual performance against risk management policy, reported Drew. She said Reval has noticed a definite uptick in the number of companies re-evaluating their approach. The driver, more often than not, has been the trea-surer. There is very senior management asking for his/her opinion.

Technology is offering greater visibility and control. While the [euro-zone] crisis may have been the immediate impetus, Drew said, she sees a broader trend: companies are asking themselves whether theyre doing the right things in the right way. One of the main areas of focus is the use of spreadsheets.

Corporates are now seeing the real risk in managing in spreadsheets because spreadsheets are not as dynamic and the company cant respond as quickly to changes in the market, she said. That is driving companies to look for other solutions to be able to get a consolidated view of their exposures and manage it in a centralized way.

Technology is the grease for the wheels of the treasury process, E&Ys Baldoni said. Thats prob-ably the biggest single change. While in the past companies have relied primarily on spreadsheets or bank systems or portals, Many of our clients are either implementing or upgrading third party or ERP (enterprise resource planning) trea-sury systems, from lower end to top end of the market.

Treasury is more involved in the business. This is perhaps most critical. More treasurers are getting involved in the running of their organizations, working closely with business units on the various steps of the risk management process. This is no doubt the result of treasurers growing strategic role, as has been chronicled by innumerable studies and reported by the Association for Financial Professionals (AFP). Its also an outcome of a new understanding of what really matters in risk management, namely exposure identification (more on this below). I think that business unit discussions are happening at [an] increased pace, said the assistant treasurer of a West Coast multinational. Theres con-tinuous sensibility to include FX in the basic business thinking more than there was in the past.

Treasury is getting more involved in the operational aspects of the business, i.e., in the identification, mea-surement and understanding of how risk is created, E&Ys Baldoni said. That evolution is an excellent change. In many companies, much of the cost/impact of FX risk is not always only on the FX line of the profit-and-loss (P&L) statement. Many times its bur-ied in cost of goods (COGS), Baldoni added. Treasury is helping the business dig deeper to make that impact more visible. According to Chathams Dhargalkar, Treasury is becoming a nerve center.

Technology is

the grease for

the wheels of the

treasury process.

Thats probably

the biggest single

change.

Corporates are now seeing the real risk in

managing in spreadsheets because spreadsheets

are not as dynamic and the company cant

respond as quickly to changes in the market.



There is no single way to hedge currency risk, according to Scott Bilter, co-founder of AtlasFX, a year-old firm started by a group of former corporate treasury practitio-ners. But there are many wrong ways. Bilter was Vice President of Finance at Hewlett-Packard (HP) and was instrumental in developing and running the companys FX risk management program.

An organizations internal business environment and the external investor/creditor community combine to define the nature of risk management programs. Public companies are much more concerned about reported earnings and P&L numbers (see Case Study 1). Private companies are typically focused on free cash flow (see Case Study 2). Highly leveraged companies may worry primarily about their creditors (see Case Study 6). Com-panies that are price makers in their markets can pass on

more of the risk in the form of higher prices than price followers can (see Case Study 3).

What risks companies choose to hedgeor notalso reflect their managements beliefs about risk and investor perception. Some companies believe investors are buying multinational stocks, in part, as a play on currencies, although few of them have actually sur-veyed their investors to confirm this view. Scott Bilter at AtlasFX disagrees. Ultimately, investors want pre-dictability, he said. HSBCs Asensio ran an analysis which explored the linkage between earnings surprises for stocks in the Dow Jones Index and the general direction of the U.S. dollar. Over [the] recent past, a strong U.S. dollar is associated, statistically speaking, with a greater incidence of earnings misses, as opposed to a weak U.S. dollar, he said.

The Current State of U.S. Corporate Hedging

Eliminate FX gains/losses

Minimize earnings volatility

Optimize U.S. dollar cash flow

Protect budget rate

Maintain competitive advantage

Source: Wells Fargo Foreign Exchange Risk Management Practices Survey

30% 24% 20% 14% 12%

38% 30% 17% 10% 5%

19% 15% 16% 24% 26%

7% 19% 21% 26% 27%

6% 12% 26% 26% 30%

Eliminate FX gains/losses

Minimize earnings volatility

Optimize U.S. dollar cash flow

Protect budget rate

Maintain competitive advantage

Source: Wells Fargo Foreign Exchange Risk Management Practices Survey

41% 15% 19% 14% 11%

17% 34% 23% 16% 10%

17% 15% 16% 25% 27%

19% 15% 18% 20% 28%

7% 21% 24% 25% 23%

zz Ranked first zz Second zz Third zz Fourth zz Ranked last

zz Ranked first zz Second zz Third zz Fourth zz Ranked last

Importance of Risk Management Objectives: Public

Importance of Risk Management Objectives: Private



The Spectrum of Risk Management ProgramsCorporate hedging programs fall into four broad categories:

1. No hedging Arguably, this is the most speculative of

hedge programs. Its important to realize that not hedging is a conscious decision, not a default or passive move. The reasons

companies decide not to hedge may be any or all of the following: a. Hedging is risky. Almost all mainstream

media stories portray hedging as risky. Badly researched news stories that call hedges bets give hedging a bad name.

b. Investors are looking for currency exposure. As noted above, some managements

believe investors buy their companies stock partly as a currency play.

c. FX goes up. FX goes down. In the end it all washes out. It depends on what end means. Companies can become financially insolvent and lose irretrievable market share long before the FX trends reverse.

2. Systematic hedging These are the most common risk manage-

ment programs. Bauza of Deutche Bank calls such programs evergreen, but they can also be labeled autopilot. With systematic hedging programs, a company has a clearly defined risk management policy that outlines what the company hedges, how much it hedges, when it does so and how. Treasurys success in this area is mainly measured by how well it executes such a policy. Very often the program involves hedging the

FX gain/loss line to eliminate P&L volatility. Sometimes the program also includes

hedging of some percentage of anticipated cash flow exposure, either on a rolling basis

(75 percent of the next quarter; 50 percent of the successive quarter, etc.) or as a set percentage for the year. (See more on rolling programs below. While they are often seen as sophisticated and are clearly better than not hedging, they can be very ineffective.)

3. Subjective hedging These programs give treasury some discretion in the amount, timing or choice

of instrument. They are closest to a best practice (see Case Studies 3, 4 and 5). Treasury can decide to hedge a higher ratio of exposure in cases where the risk is larger or the exposure is more certain, for example. It can also affect the timing of execution. The biggest problem with subjective hedging programs, as reported in this Guide, is that they are frequently not measured correctly, making it hard to tell whether the discretion paid off.

4. Active hedging These programs are rare. There is only one

case study of an active hedging program in this report (see Case Study 6). In this example, treasury has complete leeway to decide what, how much and when to hedge. Sometimes the programs include a minimum requirement (hedge 50 percent); sometimes not even that. The idea behind this type of program is that the FX trading desk acts as a profit center. While the company only trades against actual exposure (no naked positions), its harder to draw a clear line between hedging and speculating in

this regard.



There are two broad categories of FX exposure: eco-nomic and accounting. Too often companies focus on the second category. Most FX programs look shock-ingly the same, said Helen Kane, president of Hedge Trackers LLC.

An accounting expert and an ex-Deloitte CPA, Kane is the first to observe that companies get

distracted by hedge ac-counting. Thats because the Financial Account-ing Standards Board (FASB) Statement FAS 133 (which deals spe-cifically with reporting of derivatives and hedg-ing transactions) places all the attention on the

accounting consequences of the fluctuations in the value of the derivatives. Very few [organizations] are evaluating the hedge program performance against net income, she said, which is really what theyre trying to protect. Accountants seduced people away from the economics. Thats one of the reasons companies

typically start out by hedging their balance sheet (B/S) exposure on a one- to three-month basis. The B/S exposure is created when the non-functional currency monetary assets and liabilities of the company are re-measured at the end of the month in the consolida-tion process. Any changes over the month impact the FX gain/loss line of a companys P&L. An organiza-tions first step is almost always eliminating that noise. A 2011 Wells Fargo survey showed around 80 percent of companies manage balance sheet exposures (see Case Study 1).

Companies hedge balance sheet risk because such risk is more visible and because it hits the P&L. Managements dont like to see the volatility. That visibility is one of the reasons B/S risk is relatively easy to hedge: the information is typically in a companys ERP system. Granted, that is a rather big generalization. Its only relatively easier than collecting cash flow information. Companies actually face a lot of challenges trying to get at the data. (AtlasFX Bilter has published a superb article called Top 10 Mistakes Companies Make in FX Risk Management See www.atlasca.com/fx/resources. Among the top five is a poor balance sheet forecasting process.)

Iden

tifi

ed b

y co

mp

any?

Id

entif

ied

Not

iden

tifie

d

Real Not Real

Has real economic impact?

Phantom Risks Known Risks

Hidden Risks

Hidden gotchas and phantom risks

Quandrant KThese are known risks that have real economic impactShould be relatively easy to quantify, though not necessarily hedged

Quandrant PThese are phantom risks that a company has identified, but have no real economic impactCan cause unnecessary fire drills and unnecessary hedging

Quandrant HThese are hidden but real risksSome of these hidden risks may be impossible to identify unless stakeholders outside of treasury department are properly involved in FX risk management

Source: Chatham Financial

Very few [organizations] are evaluating the hedge program performance against net income, which is really what theyre trying to protect.



In addition, B/S hedges really address an account-ingnot an economicproblem, explained Kane. Take a step back and consider that you shouldnt hedge uneconomic exposures with real cash, thereby actually creating an exposure, Kane said. Some bal-ance sheet exposures are paper exposures. Sorting the real ones from the fake ones is treasurys job.

Kane provided the following examples of fake exposure: CompanyApaysitssubsidiariesonacost-plus

basis. Over time, in particular with large entities, that cost-plus balance grows and

grows. On the books of non-U.S. dollar-functional subsidiaries, this creates an

FX gain or loss, Kane explained. The rolling of this hedge every month creates a cash gain or loss on one side that would never be

recognized on the other. CompanyBhasalargepayabletoanIndian

subsidiary that is circled back to the company. The payable grows because companies dont want to trigger a tax event by actually paying it off. Meanwhile that payable is hedged with an ever-growing hedge monthly. Theres no reason this should be hedged; theyre dealing with a paper problem with real money.

Unfortunately, said HSBCs Asensio, theres even today a misconception that this type of hedging will protect your longer-term and medium-term plan rate. Hedging the balance sheet only will not get you there. Thats why companies are increasing their hedge horizon and adopting cash flow (CF) hedging programs.

Indeed, more companies are becoming aware of the limits of hedging only the balance sheet and are adopting different strategies for protecting their longer term economic exposures. The most common is the hedging of anticipated cash flow. Focusing on real cash exposure helps weed out real from fake risks. The most typical programs hedge a percentage of the CF exposure and they hedge a smaller share of the risk as they go forward.

It would be simpler if companies could hedge what they really want to hedge EPS and net income. But accounting literature doesnt allow it. Under current rules, those hedges would have to be marked to market in current income, creating the very visible volatility that managements seek to avoid. So many companies do what they can to shel-ter their results from FX movement by securing the value of the future cash flows from the business. The Wells Fargo survey put the percentage of companies that manage their cash flow risk at 40 percent.

Cash forecasting is not an exact

science and its accuracy depends

on the cooperation of a companys

business units, the companys

business model and the exposure

collection and aggregation tools a

company has on hand.

The difficulty is often in figuring out exactly what those cash flows are. Cash forecasting is not an exact science and its accuracy depends on the cooperation of a companys business units, the companys business model and the exposure collection and aggregation tools a company has on hand. While more compa-nies are implementing tools beyond spreadsheets, many still operate on spreadsheets, which makes it difficult to collect and aggregate exposures, and almost impossible to truly analyze them.

The other problem is that detecting the effects of FX risk on cash flows is a lot more complex than sim-ply looking at the FX gain/loss line. The effects are typically buried in Cost of Goods Sold (COGS), gross margins, market share and profits. Quantifying the effects is even harder, and many companies dont do it.



Case StudiesThe case studies are organized by the degree of leeway treasury has within the FX hedge program.

The first two companies have evergreen programs. One hedges only B/S exposures while the other

hedge only cash flows. The next three have varying degrees of discretion in deciding on the coverage

ratios and timing. One of them hedges very little, while putting in place a state of the art exposure

identification and monitoring program. Finally, the last company runs an all-out treasury profit center.

This company derives nearly half of its revenue from outside the U.S., with over 80 subsidiaries around the world. The result is an extensive balance sheet that is highly sensitive to fluctuations in currency values. Be-cause it is long on foreign currencies (i.e., it has more foreign currency revenues than expenses), the recent appreciation of the U.S. dollar (USD) has had a negative impact on its earnings.

Defining ExposureThe companys B/S FX exposure is created through the

monthly re-measurement of non-USD-denominated and recurring intellectual capital (IP) licensing fees (struc-tured as intercompany loans) paid by the various sub-sidiaries to a U.S. dollar-functional IP company. As the company has grown, its exposure has grown, said the assistant treasurer. Theres a lot of IP transfer and thus a lot of P&L exposure, the assistant treasurer said. We have a monthly systematic hedging program to minimize volatility to other income and expenses.

The company hedges between 15-18 currencies, including a significant number of emerging currencies from China, Latin America, Korea and Eastern Europe.

Case Study 1: $40 billion Multinational [Program Type: Systematic Hedger]This large multinational has exposures to many currencies and is primarily concerned about its balance sheet re-measurement risk. Rather than try to manage cash flow exposures, the company has developed a very systematic approach to managing the fluctuations in the FX gain/loss line by using monthly rolled swaps to lock in its accounting rate for the month. Its objective is to minimize the volatility in the translation of its assets and liabilities from multiple local currencies to U.S. dollars.

Our approach is that its hard to take a [currency] view; the markets are so volatile. The FX program is designed to neutralize the FX gain/loss line from that volatility and protects 80 percent of known risk. Treasury extracts the exposure data from Oracle Financials. We have good visibility to our underlying exposure, said the as-sistant treasurer. Instead of relying on separate forecasts from the companys finance group, the data is accessed directly and consolidated and netted by currency.

We have a net number that we manage, plus or mi-nus $20 million, explained the assistant treasurer, which represents the cost of hedging (some of the currencies the company hedges are pricey). This is not some arbitrary figure. A $50 million hit to the P&L would represent a penny-a-share loss. By managing the risk, we knock out volatility in P&L and can protect EPS more easily.

To ensure that we have effective hedges, we hedge on the same day that the month end accounting rates are set. The accounting rate is set on Day -3 every month, said the as-sistant treasurer. The company rolls monthly swaps to lock in the accounting rate. The trades are executed through FXall. Performance is strictly monitored, by currency, to ensure that $20 million band is maintained.



OverviewThis U.S. multinational is privately owned. Changes in stockholders equity are as important, or more impor-tant, than reported income. The company focuses on future cash flows and its ability to distribute a portion of those funds to the owners who are U.S. based. As a result, the company is not focused on its balance sheet re-measurement risk as exhibited by the FX gain/loss line, nor the short-term income fluctuations caused by the monthly mark-to-market of its hedge portfolio. It doesnt use hedge accounting. That automatically sets it apart from many of its peers, but also demonstrates how the nature of a business should drive the sort of hedge program treasury puts in place.

We focus on future cash flows generated by our projects, said the companys manager of foreign exchange. Our hedging of currency risk is all tied back to the projects. The company identifies as FX risk any net cash flows that are denominated in a currency other than the U.S. dollar. Projects have very different time frames and there is always risk related to their business operations, the FX manager said. The firm under-stands those operational risks and feels comfortable taking that risk. But that does not extend to currency markets. We dont have special expertise in forecasting currency rates.

The companys hedging policy is very conservative: hedge 100 percent of all identified risk, which is de-fined as non-USD-denominated expected cash flows on a net basis. We hedge using forwards. The companys treasury department has looked at options as an alter-native but has concluded that given the low-margin profile of its projects and the project-based profitability

analysis and compensation structure that is endemic to its culture, options premiums would be viewed as cutting into margins relative to forwards.

The company does business all over the world, including some very exotic locations. We try to manage our contracts so that we dont have signifi-cant exposure to emerging market currencies, the FX manager said. Consequently, we are exposed to majors, including Aussie, euro, Canada and Sterling. The company also has ongoing presence in several developing countries, which creates exposed positions. Theres growth in Africa. We structure those projects to eliminate direct current risk. The only time we ac-cept local currency as a receipt is when we have local currency costs.

Bidding in a non-local currency has not been a competitive hindrance for this organization. In most cases it has the flexibility to bid in multiple curren-cies. Most importantly, its major competitors are also multinational companies, thus facing similar currency-hedging constraints.

The duration of the hedges is relatively long, but not as long as the life of the project. Just because theres a contract does not mean there will be a cash flow in year seven or eight. What weve learned relative to long-term projects is that once you get out beyond 3-5 years, theres a lot of uncertainty; circum-stances change and those flows change, said the FX manager. Things that may look certain today really are not. To adjust for that, treasury discounts the cash flows, based on input from the projects, to what is more reliable, and hedges out only to that point.

While the company has gone as far out as 7-8

Case Study 2: Privately Owned U.S. Multinational [Systematic Hedger]This companys approach to FX risk management reflects the unique aspects of its business. It is privately owned and it is project-based. The result is a very cash-flow driven hedge program that seeks to eliminate any variability due to currency fluctuations from the companys expected non-USD cash flows.



years, more recently it has stayed within the 4-year timeframe. Because the company has stellar credit, the banks are more than happy to trade long. Ironically, the embedded counterparty credit risk is more of an issue for the company itself. While theres much more of a concern on the investment side, on the FX side theres been a more recent move to diversify the num-ber of counterparties.

All trades are executed through FXall. We found its the most efficient way, the FX manager said. On the longer-dated forwards, banks have to do the pricing manually and key that in. The trades are then pulled into the treasury management system (TMS) for straight-through processing (STP).

Like many of its large corporate peers, this organi-zation struggles to come up with effective metrics to assess the programs performance. The FX manager said its an area thats currently under development. Its a difficult process for us, he noted. Thats partly a reflection of the way the company reports its results internally: treasury hedges on a project basis, but financial reporting is done on a legal-entity basis.

Were developing metrics to get behind some of those numbers, to evaluate the forecast accuracy and the effectiveness of our hedge programs. The main point, he said, is to ensure the objective and the evalu-ation frameworks are anchored together. The way I look at things, your benchmark should be hedging 100 percent and you should justify why you hedged any less than that. Because the company has not erred on the side of under-hedging, like many U.S. companies, it has not had to alter its course as the dollar took a sharp turn upward.



Case Study 3: $25 billion Multinational [Subjective Hedger]This company began its FX risk management journey in the 1990s, after several offshore acquisitions, and has been evolving its strategy ever since. According to the treasurer, the learning is ongoing. The company hedges its balance sheet and some of its anticipated cash flows using forwards, with a keen focus on identifying the true exposure and working with the business to understand the effects of currency moves on its margins and bottom line.

Like other successful risk managers, this $25 billion company matches its currency management approach to the nature of its business. The company buys and sells products daily and does none of its own manufacturing. With over 50 percent of its sales coming from overseas, it experiences FX risk in various forms, and not all of them visible. Treasury works hard with the business and has put in place a sophisticated exposure-tracking mechanism to ensure its reducing the effects of currency fluctuations, using two distinct programs: hedging of monetary assets/liabilities (B/S exposures) and hedging of some anticipated cash flows with the goal of minimizing the impact of FX on margins.

The focus on margins is a product of this companys business model. Acting as a middleman, it buys and sells and profits from volume. Gross margins of 12 to 13 percent often translate into net margins of 2 to 3 percent. Currency can take a hefty bite out of that. And while the organization does have some economic exposures (that have no accounting manifestation, i.e., dollar-functional Asian entities), its currently consider-ing whether and how it can manage those risks.

BackgroundTreasury began working on managing currency risk

in the mid-1990s after several foreign acquisitions. It quickly became apparent that the new business lines associated with such acquisitions come with their own form of risk. At the time, the company had little expertise in FX, so treasury engaged a consultant to help map the risk and develop an FX risk management policy which would become the blueprint for how we identify FX risk, manage it and evaluate our effectiveness, the companys treasurer said.

At the time, the FX risk policy was quite compre-hensive, even though it only applied to a handful of foreign entities. But that comprehensive approach proved prescient as it has helped the company evolve its program into what it is today. The policy document is still sound today. It remains the foundation on how we execute, said the treasurer.

Back in its initial stages of managing FX exposure, the companys subsidiaries were dealing with multiple Euro-pean currencies. Currently, its geographic footprint has expanded to include Asia and Latin America. The focus then, and now, remains on stabilizing the impact of FX fluctuations on cash flows. While the companys treasurer concedes that currency fluctuation may affect reported results overall, the company believe the translational im-pact on earnings can be explained. We provide quarterly EPS guidance and supplement that guidance with an expected euro/dollar rate, he said. We are very keen to point out the impact of currency on reported results versus constant currency.

The collection of B/S information has matured over time. Back in the 1990s, the information was entirely decentralizedand so was hedge execution. In the later 1990s, the exposures were pulled into regional spread-sheets and executed through regional centers. Right now, the exposure is extracted directly from the companys various general ledgers (GLs) using FiREapps. The actual execution still occurs on a regional basis in Phoenix, Miami, Brussels and Hong Kong.

While there have been discussions about centralizing further, [we] prefer a regional approach as our vision is for the Treasury team to be a strategic partner of the business and local Finance team, which means we would like to have ongoing dialogue in local language, taking



into account local regulations and on a real time basis, the treasurer explained. We could easily staff a team in the U.S., but with our vision they would likely be work-ing around the clock to some extent. It may work for others, but not for us at this time.

The Excel spreadsheet era ended in the early 2000s. Like other organizations, this company found the technology has not kept track with the complexity of the work. We found that there was a lot of ineffectiveness and manual errors occurring, despite our best com-munication, said the treasurer. With 140 or so active subsidiaries, a lot can go wrong with data entry, exposure definition and consolidation under a highly manual process. We worked with our IT and Operational Ex-cellence team (internal black belts), to develop a leaner, more effective and efficient process.

The companys Treasury and the Operational Excel-lence team divided FX processes into three buckets: exposure identification, hedge trade execution and hedge accounting. Having not found an overarching solution for all three at the time, the company decided to go with the best of breed for each mega process. (It uses FiRE-apps, FXall and has a project on hold for hedge account-ing but was considering Reval.)

B/S Management Using FiREapps on a SaaS basis, treasury is able

to collect the balance sheet information from mul-tiple GLs into an actionable program. The Business Intelligence team extracts the GL files to FiREapps. Whereas before local finance teams spent a lot of time completing Excel templates based on their interpreta-tion of FX risk, now we have the ability to pull GL extracts into FiREapps based on standard revaluation rules and produce an exposure hedge recommendation for each subsidiary in a fraction of time it took under manual process, said the treasurer.

Treasury reviews the recommendationwhich takes into account existing hedgesand has a quick conversa-tion with local Finance Groups to validate the incremen-tal differences and how much to hedge. That conversa-tion happens at least weekly and sometimes as frequently as daily, depending on the size of the subsidiary or

exposure. If needed, hedges are entered daily as well. Some experts recommend against daily transac-

tions. Most companies simply hedge their next months accounting rate. But the treasurer of this company explained that the nature of his companys transaction profile requires the frequent adjustments.

We buy and sell [product] every day based on incoming orders as well as customer forecasts, but those forecasts can change materially depending on the market environment, he explained. That makes the monthly outlook less precise. Theres also the opportunity for meaningful early-pay discounts, which change the nature of cash outflows mid-month. Those cannot be effectively forecasted. Monthly hedges would leave the company exposed to too much intra-month risk.

The treasurer agrees that companies with very stable exposures can manage B/S risk with monthly hedges. He also pointed out that a lot depends on a companys posi-tion in the supply chain. As I see it, companies that are further up the chain in production, or may otherwise have a dominant position in the market, can often push the demand and price FX risk to their customers. If you have that dominant position you can be a little more ag-gressive and you can hedge based on that forecast. But a company like his thats often in between two 800 pound gorillas (large tech firms) often has to take on the pric-ing/FX risk daily. If this morning we pull up exposures that came into FiREapps last night, our exposure is lim-ited to todays forward rate versus yesterdays accounting rate, but we really do not suffer volatility due to forecast variance he said.

The companys treasury hedges B/S exposures on a net basis with the goal of hedging as close as possible to 100 percent, and therefore does not feel the need to have maturities structured to specific payment and receipt patterns. Rather, it schedules hedges to mature on a few days a month and continues to roll those hedges out 30-60 days based on the exposure needs at the time.

The exposures are hedged by the regional centers: they execute back-to-back trades with the various subsidiar-ies, aggregate and net the exposure for each currency pair and then execute a single external trade with one of the companys relationship banks. This reduces volume and



cost dramatically. The hedges are marked to market (fair value accounting) at the end of each month. The Euro-pean exposures are hedged by a financial entity that acts as an in-house bank, operated by the Treasury team.

The results for each reporting entity are reviewed monthly. If the FX gain/loss line is more than $100,000 to $200,000 per subsidiary, that prompts questions and treasury digs in deeper. Sometimes the answer is a simple booking error or a late booked transaction. But the discipline is there. We keenly focus on that metric as a detective control process, according to the treasurer.

Forecasted Cash FlowsThe companys approach to anticipated cash flows is

entirely different. Currently the risk identification and collection process is manual, and hedging decisions are handled on a one-off basis. The exposures are not easily captured by the ERP and not included in FiREapps (although the company is looking for ways they can incorporate it). Thats because the exposures are often in-visible in the financials, hidden initially in the purchase or sales order book, and showing up only as an impact to cost of sales or at the margin.

The nature of the exposure again is driven by the busi-ness. Exposure comes in several forms. The most sim-plistic is via a subsidiary that buys in dollars and sells in euros. But thats the rare case and generally not an issue. The more common and most significant exposure to the company is inventory risk, i.e., exposure to product that is purchased in dollars and sold in dollars but held in euros at the local currency functional entity in the interim. In such a case, the company is exposed to the impact of FX movement between the time it received the product in inventory and when it bills the customer. Some companies handle this by designating the associ-ated accounts payable as a hedge of the inventory. But if the exposures become too large, the timing mismatch between the accounts payable and the inventory holding period can lead to meaningful earnings volatility.

Another FX risk arises when the company quotes a sale in local currency, but needs to source the product in foreign currency. In addition, the product might be backordered or not scheduled to be billed for a long

time (i.e., two months later). Those exposures are harder to detect and measure. The impact is on gross margin and could be meaningful.

To hedge that risk, the companys regional trea-sury centers work together with the business units on upcoming deals. More conversations have to occur around [that sort of risk], the treasurer said. Its the business telling us that the risk is truly an anticipated one, and what is the tenor of this risk. Once the data is collected, its executed and aggregated with the data thats collected through FiREapps, and the entire pro-cess is fully integrated with FXall for STP.

Theres also a big difference in the magnitude of the balance sheet vs. cash flow program: the companys B/S exposures aggregate to around $700-800 million, whereas the anticipated CFs are at around $200 mil-lion. Alsounlike B/S hedgesCF exposures are not consolidated and netted. Rather, they are structured individually for each entity. There may well be some opportunities there for netting but the exposures are so specific to each entity, and each follows the subsidiar-ies-specific profile, which is needed to achieve special hedge accounting.

One the exposure is identified, hedging strategies (using forwards) are determined by the tenor of the exposure and its materiality. Duration can be 45-60 days. The company is sensitive to the uncertainty of timing, but uses rolling forward strategies to stay protected. We dont have high margins, according to the treasurer, so for the most part the premiums associated with options are generally cost prohibitive for our business.

Another difference between the companys B/S and the CF programs is that the CF program is not yet methodically measured to assess its effectiveness. The treasurer acknowledged that its an area that requires further attention. In a way, the solution is straightfor-ward given treasurys clear mandate: protect margins. The information treasury needs is: are the margins achieved in local currency similar to the margins expected at the time of sale? However, this is not the end of this story. The program continues to mature as its mandate and exposure become more diverse. Its a never ending journey.



The multibillion dollar organizations currency manage-ment program is relatively new, an FX risk policy was approved, an FX Risk Management Committee was established and the program itself has been evolving over the past year. We are proud of the work were doing, the treasurer said. We have good tools, and models that we feel are telling us the right story about our cash flows.

The company has offices in 20 countries and is dealing in all of the major and some of the minor currencies, including Australian, Korean, Indian, Brazilian, and Chi-nese as well as small operations in Africa and the Middle East. We have around 15 primary currencies in our portfolio, explained the treasurer. Treasury prioritizes by emphasizing the most material exposures. Even then focuses on net exposures, which are not as large, because it has some currency inflows and outflows that offset and correlate. At this time the company is primarily focused on cash flow (a.k.a., transactional) exposures as opposed to net income or B/S translation.

The first step was putting in place a solid methodology for identifying FX exposure: We manage the majority of the exposure not so much by hedging but by monitoring the cash flows and selectively spot trading. We use Bloom-bergs RFQ portal, which ensures us competitive market rates for our routine trades, according to the treasurer.

Whats unique about this companys program is how much work has been done to figure out the true nature of its FX risk profile. We spent a lot of time working to understand our business, noodling over how we define

the exposures, peeling it like onion, she said. For ex-ample, In some areas cash flows are known. Others have a high degree of uncertainty in terms of amount and timing. The efforts help in getting to the right data and aggregating the net exposure.

Like many other U.S.-based corporations, the companys budget process is consolidated into U.S. dollars. Accounting systems often dont capture the local currency equivalent. That can leave treasury in the dark. Through its intense collaboration with FP&A and accounting, treasury was able to change the way the information is captured so that it has better vis-ibility into its most material cash flows. Building such a cross-departmental team was successful and received strong support from senior management. The tone was set at the top, the treasurer said.

Once net transactional exposures are identified, they are run through a Value at Risk (VaR) model on a com-bined basis to account for correlations to determine mag-nitude of the risk. The VaR analysis has been in place at this company for only six months (as of August 2012), so treasury is still honing the model. The treasurer can envision a time when its FX risk management policy would define an acceptable VaR, and then use policy thresholds to trigger hedging activity. But the companys not there yet. Treasury wants to study the results of the analysis over time to develop an understanding of what is acceptable and what movements should make the company uncomfortable.

Case Study 4: Newly Public Multinational [Subjective Hedger]This companys FX risk management program is in some ways still under development while in others it is light years ahead. As a USD-denominated company, the treasury department spent almost a year working with Financial Planning & Analysis (FP&A) and Accounting to identify the companys forecasted non-USD cash flows and global net long/short positions. Treasury determined which exposures are most material and then implemented a model that captures and quantifies the companys cash flows that are at risk. While this hasnt yet led to a large volume of derivatives trades, the solid founda-tion gives the treasury department a comfort level that when it does execute, its going to hedge the right things. And thats as sophisticated as it gets.



One result of the greater focus on cash and materiality has been a relatively small hedge book. The company has only entered into three derivatives, all related to specific investment cash flows. The treasurer explained that on a net basis, the VaR on other operational cash flows is not material and/or certain enough to warrant active hedg-ing. That may well change with time.

With regards to the hedges the company placed,Twoarehedgesofaeuro-denominatedinvestment

on the companys dollar books. The investment has a relatively clear profile on the amount and timing of cash flow return of capital, the treasurer said. Treasury purchased forwards at the time they made the investment to ensure that on a USD basis, the full amount of invested capital would be returned. We use forwards when the duration of the expected cash flow is fixed, said the treasurer, and were seeking to lock in a rate over the life of the investment.

Theothercaseinvolvesayen-denominatedsecuritywith a longer term horizon. Because of the inher-ent uncertainty regarding the timing of cash flows, treasury used options (a zero cost collar) instead of a forward.

What this company has done is take its FX hedging strategy one a step at a time. First, write a policy; second, embark on a project to identify the net exposures; and third, put in place a framework to analyze exposures. While there was pressure on treasury to do some-thing, this treasurer realized that you can do more harm than good by taking action without good data. It has taken a lot of patience and cross-departmental col-laboration to properly build the framework. The next steps will involve studying the risks over time to evolve thinking and sophistication around which exposures to hedge and derivative products to employ.



Policy FirstAnticipating the need for a more methodical approach to managing currency risk, and very keen to have the appropriate governance structure in place, the company approved an FX policy and formed an FX Risk Manage-ment Committee including the Treasurer, Chief Financial Officer, Chief Risk Officer, and Chief Accounting Officer. The policy sets out the roles of each involved party and department, defines the hedging objectives, and grants authority for approval of FX risk management strategies. Treasury doesnt have unilateral authority to decide the hedge/not hedge al-ternatives and take action, the treasurer said. She expects the policy it to evolve overtime with input and approval from the FX Risk Man-agement Committee. Its a living document.

Here, in summary, is the content of the companys policy:

Purpose:The purpose of this policy is to protect the Firms cash position and cash flows in USD caused by foreign exchange exposures in our operations.

Overall Objectives: Define policies and procedures to govern

cross currency exposure identification as well as authorization and execution of related risk management strategies.

Define policies and procedures to govern foreign exchange hedge authorization and execution.

Policy Highlights: Exposures will be reviewed and associated

risk management strategies approved via a standard template. (The company utilizes a Sharepoint database to collect and retain standard information on all exposures as well as related signature approvals).

It is not the policy of the firm to hedge 100 percent of all identified exposures;

rather each will be evaluated on a case by case basis.

In cases where the firm loans money to affiliated entities, the borrowing entity will bear associated cross currency risk, as possible.Thus, all risk management

mitigation strategies should be evaluated and approved as appropriate for the

borrowing entity. Hedges executed under this policy are not

to be speculative in nature. Engaging in derivative transactions includes entering into, negotiating, approving, and executing related contracts as well as reviewing the accounting and tax designations. The Firm may obtain related advice from

outside advisors (accounting, tax, legal or hedging) as necessary. However, all transactions require internal approval,

as indicated. Prior to execution of any spot trades, each

payment must first be fully approved via the Firms payment management system.

Non-U.S. offices are to be funded from headquarters in their local currency

when possible. Hedges must be properly approved in

advance with notifications by Treasury to Corporate Accounting and Tax.

Exceptions to the policy must be approved in writing by the FX Risk Management Committee.



This airline is a global operation, with a presence in approximately 60 countries and exposure to 48 different currencies. But that does not mean it has a very high volume of hedges, or that it hedges every exposure in an autopilot [sic] fashion.

Identifying RiskBecause of industry regulation, even though the

company has extensive foreign presence, its legal entity structure is uncomplicated. Offshore operations are registered as branches (of the corporation) rather than stand-alone subsidiaries. The result is a very simple balance sheet, without the typical re-measurement risk which afflicts many global corporations. I dont have the nightmare that other companies do, said the direc-tor of cash operations.

Equally helpful is the organization-wide use of SAP, the ERP program. Accounts payable (AP) and accounts receivable (AR) are highly centralized. Files go out over-night to Citibank and payments are initiated all over the world. While the company does have staff in a few off-shore locations to help with uploading files, everything is centralized and I have a lot of visibility of all AP and AR, according to the cash operations director. That means treasury can see whether theres enough money in overseas accounts to pay local currency expenses; anything that is left is repatriated weekly and exchanged on the FX spot market. The legal entity structure also affects the companys cash flow exposure profile: it has no tax or repatriation issues. I can repatriate cash daily, the director explained.

In general, overseas balances are thus very low, around $200 million. Hence the minimal balance sheet expo-sure. Its the chronic difference between foreign cur-rency revenue and expenses that constitutes its cash flow risk. Thats what I hedge, she said.

Reducing VolatilityWhile the airline is exposed to multiple currencies, its

two biggest exposures account for over half of its total exposure. Those are denominated in yen (JPY) and the Canadian dollar (CAD). Those are the only two that I hedge, said the cash operations director.

To determine which currencies to hedge, the company went through a detailed analysis which looked at all of its revenue/expense mismatches in a total of 48 currencies to identify the companys net exposure. The next step was to use VaR analysis to pinpoint the VaR for each of the currenciers as well as the combined exposures.

What the company foundand what many others will probably find as wellis that its VaR was a lot lower when the currencies were analyzed en masse. Diversification decreased VaR by 40 percent, the cash operations director said, leaving four main exposures: JPY, CAD, the euro and the Brazilian real. When the company looked at what would happen if it hedged 80 percent of its JPY and CAD exposure, it found VaR was another 43 percent lower. By identifying the chief culprits and managing only the first two, the company was able to mitigate FX risk to a point where it felt comfortable leaving the rest of its FX exposures unhedged. It thus dramatically reduced its FX risk while optimizing the programs cost effectiveness.

Case Study 5: Airline with FX and Commodity Exposures [Subjective Hedger]This multibillion dollar corporation is in a highly regulated industry. This drives sources of risk, the timing of its exposures and what it does and does not hedge. Whats most interesting about the companys FX risk management program is that it combines discretionary and systematic elements, thus ensuring a base level of coverage as well as giving treasury some leeway to affect timing and coverage ratio. Unlike many companies, this organization does not manage its balance sheet exposure, but actively hedges its forecasted cash flow risk (like many, its long on foreign currencies). Its also unique in that it attempts to methodically measure some aspects of its hedging programs performance.



Another unique aspect of this companys FX exposure strategy is that treasury has a very good handle on its forecast. Thats an area where many companies struggle. The visibility of the organizations centralized ERP and historical trends have demonstrated that cash flows can be very accurate as long as three years out. So the program matches the forecast: the companys strategy involves hedging long term on a rolling basis. We are very lucky, admitted the practitioner.

There are a couple of elements that drive the accuracy of this organizations forecast. First, theres history. The companys revenues and expenses have been very stable for years in Europe, Asia and Canada, giving treasury a high level of comfort. Next, theres the business model. Hard times may mean the company drops a couple of flights per region. But thats not going to significantly change the character of its FX exposure. Fewer flights translate into less revenue but also less cost. To make a real dent, the company would have to pull out of a region entirely: an unprecedented and unlikely move. Were it to happen, hedging would be the least of its concerns. On a net basis, our exposures stay the same, the treasury professional said.

This is not to say the company is not sensitive to po-tential variations in its net position. Its rolling program reflects the inevitable deterioration in forecast accuracy overtime. Designed again with the help of Citi, the cash flow hedging program begins with a 50 percent hedge of the next quarter, with declining coverage ratio over time. Every quarter, the percentage goes down by 4.2 percent. That means the very last quarter, out three years, is only hedged 4.2 percent. Every quarter end, we move that triangle up, the cash operations director explained. So every quarter, treasury layers on additional hedges for the next quarter, and so on, using forwards.

This type of rolling hedge program is not uncommon for companies that hedge past the next quarter. But it has a couple of unique aspects. First, it starts off with 50 percent. Many companies cover a higher percentage of their next quarters net exposureas high as 80 percent. Second, the percentage goes up by only 4.2 percent on a quarterly basis. Most rolling hedge programs go up by a higher percent.

Theres a reason for this. Hedging requires bank credit. And this company uses up much of its credit on fuel hedges. Thats not surprising. Commodity risk dwarfs FX risk for many companies. Thats a point made repeatedly by the experts interviewed for this report. They note that many companies have not analyzed their commodity risk and its size and impact vis--vis their FX exposures. Importantly, the two must be looked at in unison. FX and commodity hedges place demands on bank credit, and many companies do not want to tie up cash in margins.

Surprisingly perhaps, hedges are executed over the phone. Thats increasingly rare as more companies use online tools like FXall and Bloomberg to get their bids and execute trades. This was a conscious decision which reflects another aspect of companys hedge program. The timing of execution of quarterly hedges is discretionary. Thats somewhat unusual. Many companies that hedge based on a mandated rolling basis deploy an autopilot approach to execution: they layer on the hedge on the first day of the quarter using a competitive bid. This company lets treasury decide when to put on the hedge.

It makes sense then that this company keeps talking to its five relationship banks about the right timing for its cash flow hedges (spot is traded via Bloomberg). We hedge throughout the quarter, explained the practitio-ner. Talking to the banks helps us keep an eye on the market. If theres a positive move, its time to layer on the hedge. What treasury does is provide its banks with advance notice about the general timing and amounts it wants to hedge, and typically put in an open order at the next technical level. We do it opportunistically.

The confirmation/settlement aspects of the process, however, are highly automated, using Bloomberg, the ERP FX module and MISys. With spot, the process starts with Bloomberg. With forwards, we skip the Bloomberg part, the cash operations director explained. After discussing the trades with the counterparts, the trades are keyed into SAP and executed through MISys.

That brings us to one of the most interesting aspects of this program. While the companys FX policy clearly defines the rolling hedge strategy approach described above (which covers up to 50 percent of the companys



FX exposure), the remaining 50 percent is open to what this practitioner called tactical hedges. What she means is that treasury has full discretion to layer on additional hedges up to 100 percent of the net exposure if market rates are particularly attractive. Its important to note that when the company defines its exposure it only looks at netthat is a much smaller amount than its gross notional risk.

MetricsThe company treads carefully and measures methodi-

cally. So far it has only applied its tactical hedging pro-gram to the yen. Because the tactical program is defined separately, its also measured separately. The systematic hedges are designed to reduce volatility and are measured against the volatility of an unhedged portfolio. Tactical hedges are then measured against the systematic pro-gram. Basically, the company looks at its hedged port-folio and whether the tactical aspect helped it perform better than it would have if it only hedged systematically.

In fact, at the time of the interview for this Guide, this companys treasury had just completed a report to management about its tactical program. This practitio-ner stressed how important it is to ensure senior management fully understands the different aspects of the hedge program, that its fully on board, and that communication is always clear. Thats a point that cannot be stressed enough: both the nature and the performance of the program must be clearly explained to management and the board.

We looked at how our portfolio behaved against how it would have looked had we done systematic only and not tactically, said the practitioner. The report looks back two years. By charting the line of the port-folios performance, the company is able to see how the different scenarios would have played out. Hopefully the tactically hedged portfolio looks flatter, noted the practitioner.

The company also measures its savings from trading spot on Bloomberg. Thats how it managed to justify the expense of the terminal. It doesnt however measure the benefits reaped from controlling the timing of the execu-tion. In a perfect world, it would.

This treasurer was careful to point out that the true FX exposure to her company is more complicated than just the currency impact. Thats an important point and is true for any company. That is why its so hard to measure the performance of hedge programs or assess the true im-pact of FX exposure on the bottom line. This comment was in reaction to the recent wave of news reports about the negative profit impact of the appreciating USD.

The correlation with currency is not that clean, said the practitioner. Its very hard to isolate on the revenue side what was caused by [a] currency move or 100 other things. For example, for this company, when the yen appreciates, theres an impact on translated results. But Japanese customers are also more likely to travel. Theres often, too, a shift in the point of purchase of the tickets, from the U.S. to Japan. All of these economic factors play into the ultimate result for the quarter.



We dont have a very sophisticated strategy, stressed the companys assistant treasurer. Were very entrepreneur-ial and open minded, she said. To anyone who might argue that trying to beat the market is speculative she countered: Every hedge is speculative. This organiza-tion places value on its treasurys expertise. Its certainly a controversial point of view but its one that has worked wonders for this companyso far. Our hedging strat-egy has saved the company millions, she reported.

To counter the relative freedom of the program, treasury is placed within a very strict governance frame-work, according to the assistant treasurer. The hedging policy requires Chairman-level approval for each hedge strategy. Treasury has to present the facts, explain its strategy and gain management support for its approach. This works on two levels: Treasury is always overseen and any losseswere they to occuroccur with man-agements explicit approval.

Playing an Active RoleThis organizations treasury works by being constantly

involved in the market, watching rates as well as talking to the companys banks about approaches and strate-gies that are working or are popular. We like to use forwards, the treasurer said. Once weve narrowed our choices, it boils down to a very simple product, she said, although on some occasions the company has elected to use options and collars.

To understand this companys strategy one has to understand its management philosophy and the context within which it reviews its P&L performance. While many companies worry about investors, this ones main

concern is exclusively its creditors. Since it is highly lever-aged and depends on its banks to extend further credit, the number one goal is to deliver the results the banks expect. The balance sheet is naturally hedged to some extent, so the only proactive balance sheet hedging done involves the conversion of loans from one currency to another. What we actively hedge is primarily income risk, explained the assistant treasurer.

The program focuses on the net long/short position on a cash basis, looking at its full fiscal year and its average position for the year. The company is CAD-based and gets paid in euros, pesos, Australian dollars (AUD), and USD, among other currencies. To identify its exposures, treasury collects cash flow forecasting information using an Excel template from multiple locations and in mul-tiple currencies. It then consolidates those inputs. We can see right across the board, the assistant treasurer said. The program would only hedge 50 to 60 percent of the exposures identified in each currency.

The problem many companies face is the cumbersome nature and the error-sensitivity of spreadsheets, facts that have caused a significant increase in the use of treasury technology. But the manual approach works for this organization (and budgets are tight). This is probably the most common reason companies dont switch from using Excel to a TMS.

The budget rate is determined by canvassing various market sources and is CFO approved. The next task is to deliver on the budget to the banks. Once we set the budget rate, our objective is to beat it. The budget becomes our benchmark, and [is] the basis for the fore-cast that we give our creditors, she said. We provide

Case Study 6: Privately Held Canadian Multinational [Active Hedger]This Canadian, privately held company supplies the auto industry and several other business sectors. It has operations in 60 locations in 18 countries, with a presence in Europe, Latin America, North America and Asia Pacific. Unlike many organizations, it has what its assistant treasurer describes as an entrepreneurial approach to the management of FX risk. That is, treasury is a profit center and it seeks to optimize its hedges against a budget rate. In large part, its approach is driven by the desire to meet or exceed its business plan ensuring the continuous flow of credit from its lenders.



our corporate plan and we like to deliver on it. Its very important to us, our credibility and our integrity.

For example, for Fiscal Year 2013, this companys treasury forecasted a budget rate of USD/CAD par. Now were looking for opportunities to lock it in or outperform it. That means that when the CAD is weaker than par, treasury layers in more hedges. The goal is to hedge out one full fiscal years expected exposures. The layering approach allows us to capture peak levels.

She noted that this company is not, of course, the only player in the market. This drives its hedging behavior. Typically when the CAD weakens everybody jumps on it and it quickly goes the other way, she said. Then we wait it out and wait for it to come back. We anticipate the market and layer our hedges accordingly. We dont execute one mandate to lock in. We dont just pull the trigger and put on the hedges on a shelf. In the process theyve managed to get some really good deals. Weve been very profitable so far.

She conceded that many if not most corporate hedgers are very mandated: they protect X percent of their exposure for a certain duration. But being private allows us to take a different approach. Indeed, were not opposed to profit taking, she added. If the forwards are deep in the money, treasury will liquidate or unwind them and put the profit in the bank. Youre basically bringing to the present the net present value (NPV) of future opportunity.

The company has incorporated foreign currency borrowing into its arsenal of hedge products. We can really change the dynamics of the balance sheet by changing the denomination of our debt. If we borrow $100 million USD at par and a month from now the CAD is 5 cents stronger than the USD, we can lock in that gain, she explained. In CAD terms, my debt just got smaller. I will buy USD at $.95, pay off the USD loan and effectively make CAD $5 million.

The one thing about active hedge programs is that theyre easy to measure. Performance is methodically measured against a very clear benchmark: the budget rate. We have saved multiple millions this way, ac-cording to this practitioner.

But what happens when the market goes the other way? What if the hedges start generating losses? So far it hasnt happened for this company. But that doesnt mean there wont be opportunity costs. A hedge is still a hedge even if it is out of the money. The market is more predictable than you think, she said.



The Disconnect The case studies above illustrate that even though U.S. companies have been facing significant FX exposures for a long time, there is no single, best approach to manag-ing FX risk. In looking at some of the recently released quarterly earnings, there is no foolproof system either.

What was really striking in the findings from the research for this report is the gap between what experts think companies should doi.e., focus on economics, use options, hedge moreand the programs they actu-ally have in place. Experts insisted that companies are at a crossroads: risk management as we know it is going to change if U.S. companies are to prosper in this new FX environment. None of the companies interviewed for this report have recently reshuffled their program[s] or changed their approach to FX exposure. There needs to be a seismic shift with respect to FX as part of the bottom line, said HSBCs Asensio. Its going to take a generation, he said, before it is part of corporate culture.

While it is clear that there has been an evolution in some companies approaches to FX risk management, e.g., a greater emphasis on working with their business units to identify risk and correctly define FX exposures, there is also a continued reliance on what has proven to be a failed approach in many recent cases (even for com-panies considered to be best-in-class hedgers).

Companies continue to underestimate the significance of currency risk. Thats may be the intuitive response when looking at the EPS data. Research confirms this view. In 2011, Deloitte published a study of the effects of the 2010 volatility in AUD/USD rates. The survey results showed that while over half of the participants in the survey experienced a negative impact from the volatility in the rate, over 70 percent were not making any changes to their FX risk programs. A later study by Wells Fargo revealed that about a third of companies were more concerned about FX risk in general last year. Of those, only half increased their coverage ratio. A quarter extended the duration of the hedges.

Perhaps most jarring are results from AFPs own Janu-ary 2012 Risk Survey (www.afponline.org/RiskSurvey). While financial risk was the primary area of concern for organizations surveyed (cited by 72 percent of survey participants), liquidity and credit risk were cited as the most pressing. Foreign exchange is anticipated to have a significant impact on earnings for just a quarter of orga-nizations, according to the surveys key findings.

This seemingly nonchalant reaction to FX risk can be interpreted in two ways. Oneviewisthatcompaniesremainblindtothe

changing landscape of risk. This line of reasoning

Categories of Risk that Generate the Greatest Concern(Percent of Organizations)

Revenues Revenues Under Over Publicly Privately All $1 billion $1 billion Traded Owned Financial (credit, liquidity, interest rate, currency/FX) 72% 73% 69% 68% 71%

Macroeconomic (GDP growth, inflation) 38 42 40 44 38

Business/Operations (supply chain disruptions, production interruptions, litigation, labor, outsourcing, IT) 36 36 35 33 35

External (country risk, regulatory, natural disaster) 27 29 23 14 27

Commodities (power & heat, crude oil & distillates, agricultural, metals) 22 16 29 27 22



may explain the disconnect between experts views and corporate behavior by dismissing third party agendas, e.g., companies counter that banks want to sell derivatives, advisory firms want to collect fees and software vendors want to push product.

Thesecondislesscritical:companiesaresimplynot swayed by turmoil in the market. Solid risk management programs are designed to minimize volatility regardless of market conditions. While that is absolutely true, it only works if the programs are truly designed to manage volatility, which many of them arent.

The reality is that there are some very powerful forces and ingrained practices that are preventing companies from seeing the extent of their FX exposures and thus preventing them from implementing a truly comprehen-sive program (see best practice list below). They include:GrowingupwithaweakeningdollarHavingnoeffectivemetricstomeasureperformance

(and directly linked to that)LackingtherightincentivestomanageriskDearthofavailableresources.

A Stronger DollarWhile its hard to tell from the often purposefully

convoluted discussions of risk management in public financial statements, the most likely reason for the recent pain is that U.S. companies simply dont hedge enough. U.S. companies have been chronically under-hedged, said HSBCs Asensio. I have seen this bias develop.

For a decade or so, that approach seemed to work. If you take away the first two years of the euros existence, it has appreciated from 0.80 to 1.60 at its peak in 2008, Asensio said. This [the dollars rise] is sending shock waves through the system. The frequency by which FX is the sole driver of pain is really increasing.Hedging bits and pieces of risk, and hedging only a small percent of the overall risk is not going to work in this strong dollar environment. Specifically referring to the practice of rolling hedge programs, Deutche Banks Bauza said: Es-pecially if you use forwards you created a situation where you are on average only 50 percent hedged. On average, youre taking a fair amount of FX risk.

For many companies, the decision to hedge less is

cost driven. With built-in forecast accuracy concerns, companies choose to hedge a smaller percentage of their anticipated risk. Still, they dont want to shell the upfront premium required for an option (a more ideal tool in this case). The shift in the dollar is having an impact on the choice of hedge instruments. Both Bauza and Asensio reported a noticeable increase in corporate interest in options. Agreed the treasurer of a $40 billion multinational corporation: Options provide a great way to buy protection when cash flow timing and amount are less certain. (See the September 2012 issue of AFPs Exchange magazine for more on options.)

Admittedly, its still hard to find examples of compa-nies that use options. HSBCs Asensio said, The speed at which things move in a corporate environment is not as fast as the market moves. It may take a year to get through the various approval phases.

But there are some early signs of success. Look at Google. Google uses options. And gains on Googles options position helped alleviate the pain from the stronger dollar in the second quarter of 2012. Google currency hedging probably helped the company lessen the hit of a stronger dollar in the second quarter, reducing revenue by 2.1 percent instead of 3.7 percent, Carlos Kirjner, an analyst at Sanford C. Bernstein & Co., was quoted as saying, in a July 11 report in The Wall Street Journal.

The recent spate of reported EPS hits has certainly garnered the attention of company senior management, analysts and media attention. Thats both good and bad news for treasurers. The bad news is that treasurers are coming under pressure to explain why the programs are not delivering better protection. The good news is that they can definitely get a chance to talk to their CFOs and Boards about risk. Inevitably when theres a large movement the phone rings, said Hedge Trackers Kane. Unfortunately a lot of the work after that is plugging a hole. It doesnt get the attention it deserves without the jolt, when the water is flowing over the dam.

Lack of Clear MetricsThe tendency to manage against a weaker dollar is

compounded by another chronic problem: the lack of clear and effective metrics. Without measures that truly



indicate how well a program is actually managing risk, how can treasury tell its not doing a good job? For years, the overall results looked good because the dollar got weaker. So there was less of an emphasis on developing effective methods of measuring performance. As the dollar changes direction, there will be a lot of CFOs and investors asking tough questions. We do see a signifi-cant number of companies stepping back to reevaluate their program, said Declan McGivern, Global Solutions Advisory Head at Citibank. The challenge, he said, is what to benchmark against.

A program may hedge 75 percent out six months, and 50 percent nine months out. Whos to say thats right or not, McGivern noted. While theres an appetite to reas-sess, he continued, without a reliable benchmark, compa-nies cannot figure out whether their programs are effective.

Treasury metrics in general is a difficult area. As the CTC Guide to Treasury Metrics revealed, only half of companies have them. And the figures would be even lower in the FX risk area for sure. There are some very big risks inherent in having poor metrics. Most importantly, theres no clear path as to how to adjust behavior. In addition, there is career risk at stake. Big derivative losses or ineffective hedge programs can attract the wrong kind of attention. Unless theyre put in a broader context, FX gains/losses on their own can get treasury in trouble.

The case studies in this guide highlight some approaches companies have taken to measure FX risk performance. What these case studies clearly illustrate is that the metrics must match the program. Measuring the effectiveness of simple B/S hedge programs is often done by simply look-ing at the FX Gain/Loss line on a statement. Treasury may do a top notch job bringing the line down to zero, but such a line-item says nothing about the companys overall exposure to currency risk. Profit center treasuries have it the easiest. Like the company discussed Case Study 6 in this Guide, they can measure performance but do so by comparing their results to the companys budget rate. If they bested it, they did a good job.

Most companies hedge programs fall somewhere in the middle: they hedge some of their risks. They have some discretion in how much and when to hedge it. How do you measure that? Even more to the point, what do you use to measure it?

The airline case study (Case Study 5) illustrates one of the best answers: focus on the main objective and link the measures to that objective. In the case of the airline, the goal is minimizing the volatility to cash flow. The company uses VaR to measure the volatility of its exposures unhedged. It then charts the volatility of the hedged position. The second one should look flatter.

The best way to measure the effectiveness of an FX risk program is to directly link evaluation to objective. And that assumes the company has done a good job defining its objectives and tracking down all the expo-suretwo big assumptions. Its very difficult to make universal statements, said the assistant treasurer at a West Coast company. People have tried it. I havent heard of single success story.

To develop the right metrics, companies need to figure out what they care about. Public companies care about EPS, said Chathams Dhargalkar. Some may also look carefully at operating or gross margin. Best in class risk management companies use technology to create scenarios of what their risk is around those key metrics. They have to decide whats acceptable: is it a penny or five pennies per EPS? for example, he explained. Then do the calculation to detect how currencies will impact those metrics. Once that first step is done, you take into the account the hedging program. The end result should bring the company closer to its level of tolerance. That, of course, assumes you have your accounting under FAS 133/IAS 39 under control.

Of course, systems that allow companies to do what-if scenario analysis are not cheap. Thats been holding many organizations back. But without that information the tension surrounding the performance of the program will remain unresolved. Technology is the enabler to having real conversations with real numbers in a more scalable way. You cant build another [Excel] spreadsheet every time an event occurs.

Metrics are the million dollar question, said Krish-nan Iyengar, Vice President of Global Solutions at Reval. While more companies are relying on vendors to handle the accounting portion of the post-trade process, many of them look at effectiveness from an accounting stand-point and not from a program performance standpoint. Thats not woven into the process. Its surprising.



How to Build an Effective ProgramFX risk management is a process which includes the fol-lowing steps:ExposuregatheringExposureanalytics/evaluationHedgingPost-tradesettlement,reporting,accountingPerformanceevaluation(separatefromaccounting

effectiveness).

Understand the ExposureLooking at what Revals Iyengar called the risk man-

agement life cycle, this is the most important

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