Designing Foreign Currency Risk Management Policy for ...

DesigningForeignCurrencyRiskManagementPolicy

forMultinationalCompanies

ExecutiveMasterinInternationalFinanceMasterThesis

Student:A.SirvanCANITEZSupervisor:Dr.JeroenE.Ligterink

Date:August2016

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TABLEOFCONTENTS

1.INTRODUCTION 3

2.UNDERSTANDINGFXCURRENCYRISK 5

a)WhyisitinevitableforMNCstoexposeFXcurrencyrisk? 5b)WhatdoestheliteraturesayontheimportanceofmanagingFXcurrencyrisks? 6c)HowtoManageItEffectively:FinancialPolicies,OperationalHedgingandHedgingviaDerivatives 7

3.DESIGNINGANEFFECTIVEFXRISKMANAGEMENTPOLICY 9

a)Purpose 11b)Scope 12c)Objectives 14d)IdentificationandQuantificationofExposures 15e)ModelsfortheMeasurementoftheFXRateRisk 25f)IdentificationofHedgingStrategy 27

4.HEDGINGGUIDELINES 30

5.DEVELOPINGOPERATIONALSTRUCTUREFOREFFECTIVERISKMANAGEMENT 31

6.MONITORING,REPORTINGANDEVALUATION 32

7.CONCLUSION 33

BIBLIOGRAPHYANDWORKSCITED 37

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1.Introduction

Given the growing scale of cross-border trade of commodities, products and services,

internationalcapitalflowsandrapidspreadofscienceandtechnologywhichenabledreduction

of transportation and communication costs all around the world, it is fair to say that the

existenceofeconomicglobalizationisgettingstrongerandstronger.Asaresult,itisbeneficial

to keep inmindof economic determinants fromother economies as globalizationhasmade

economiesintheworldmoreintegratedthaneverbefore.(Han,LiangandWu,2015)

Thisisparticularlyimportantformultinationalcompanies(MNCs),whichstandbeforeamuch

widermarketandhighervarietyofrisksthandomesticcompaniesduetotheglobalpotential.

Thus theyaremoreexposed the risksofdifferenteconomies inwhich theyhaveoperations.

Although it is debated which risks correspond to which specific business aspect, one can

generally argue that the categories of international business risks can be divided into four

sectorsbeing;productrisks,commercialrisks,politicalrisksandfinancialrisksincludingforeign

exchange (FX) currency risks. This paper particularly focuses on the FX currency risk, which

affectscompany’sfinancialsfromassetsandliabilities,tocashflowandearnings.Thereforeif

notmanaged properly, itmay risk all the performance indicators, competitiveness and even

existenceofthecompany.

Although there have been many research papers and articles written by academics and

focusedoncertainpartsofriskmanagement,corporatetreasurers,aspractitioners,seemto

sufferfromlackofacomprehensiveroadmaptobuildaneffectiveFXRiskManagementPolicy

(will be referred as “Policy” for now on). This research paper aims to fulfill this gap by

buildingblocks,structuringaframeworkbytouchingalltherelevantpracticalmattersaswellas

providinginformationfromrelatedliterature.Thispaperdoesnotaddresstoaspecificindustry

ororganization,thereforeitprovidesgeneralrecommendations,wherepossible.

Anotheraimofthispaperistoquestionwhetheritisnecessarytobringafreshlooktocertain

concepts and rules related to FX risk management, which have already been known and

discussed formanyyearsandnotchangeda lot. For instance, it ispossible to finddifferent

classifications of FX currency risk in the literature. Some academicians prefer to consider 2

main categories; being “transactional” and “translational”while some researchers prefer to

add “economic” exposure among the other two as amain category. This paper defends an

alternative classification and divides transactional risk into three; being “committed”,

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“anticipated(economic)”and“exceptional”cashflowssimplybecausetheyareallpartofthe

company’scashflowwithdifferentcertaintyandfrequency.Ontheotherhand,translational

exposure is divided into two as “consolidation on balance sheet and income statement” as

generally accepted. Additionally, despite the fact that the definitions of different types of

exposurearequiteclearonpaper,isitreallyblackandwhiteinrealityoraretheregrayareas

whenitcomestoaholdingcompany,whichhasoperationsinmanycountriesviasubsidiaries

and jointventureswithdifferent functional currencies? In thataspect, the seemingly simple

examplesprovidedinthepapertargettocreateacleardistinctionbetweendifferenttypesof

exposuresaswellascomparingtheoperatingincomeresultsincaseofdifferentportions(i.e.

partlyorfully)ofhedging.Theseexamplesalsoshowwhetherprioritizationofdifferenttype

ofexposuresmakesasenseintermsoffinancialresults.

Inorder todesign aneffective FX riskmanagementpolicy, it is highly significant to start by

understanding the concept of FX currency risk, how and why it is created along with

questioning if it ispossible toavoid itornot.Naturally, if it ispossible toavoid it totallyor

eliminate partly, theremight be noor less necessity for all the cost and effort for hedging.

Given the real-world imperfections in the financialmarkets and the desire and necessity to

haveoperationsindifferentcountriesforcertainreasonsrelatedtobusiness(i.e.tocreatea

competitiveadvantagebybecomingcost-effectiveorproducingbetter-qualityproductsetc.),

itcouldbeunavoidabletoexposethiskindofrisks.Consideringthatwecannotavoidittotally,

nextlogicalquestionarisesabouthowtomanageiteffectively.Atthispoint,itisquestioned

whether it ispossible tomitigateexposureviasomeotherways,consideredas“operational

hedging”.

Havingclarifiedtheexposuretobehedgedviafinancialinstruments,thepapercontinueswith

designing the framework of an effective policy by stating the pillars; the purpose, scope,

objectives of the policy as well as identification and quantification of exposures. Following

that,thepaperbrieflytouchesdifferentmodelsforthemeasurementofFXrateriskandgives

alternative hedging strategies for various risk appetites. Subsequently, hedging guidelines,

developinganidealoperationalstructureaswellasmonitoring,reportingandevaluatingtools

concludesthepolicy.

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2.UnderstandingFXCurrencyRisk

a)WhyisitinevitableforMNCstoexposeFXcurrencyrisk?

Companies canbeexposed to FX currency risks due todifferent reasons such asbuying and

sellinggoods,servicesandproductsfrom/toforeigncountriesoreveniftheybuyandsellthem

from/todomesticsuppliers/clients,thepricescanbeindexedtoaforeigncurrency.Sincethis

paper addressesMNCs,which typically conduct their international activities through foreign-

affiliated companies often operating in different currency environments, understanding the

relationshipbetweentheparentanditsaffiliateswillbehighlightedinordertocapturehowFX

currencyriskcreated.

A parent must use procedures to transform foreign currency financial statements. The

proceduredependsonthecurrencyinwhichtheforeignaffiliateprimarilymakesitsoperating,

investing, and financing decisions—termed its functional currency. To identify an affiliate’s

functionalcurrency,theparentisrequiredtodistinguishbetweenaffiliateswhoseactivitiesare

integratedwiththeparent’sdomesticactivities(e.g.,theaffiliateservesasasalesoutletforthe

parentcompany)andthosewhoseactivitiesareself-containedwithintheforeignenvironment

(e.g.,theaffiliateproducesandsellslocally).Thus,asRobinsonandStocken(2013)suggest,the

affiliate’sfunctionalcurrencyservesasanindicatorofthe“real”locationofdecisionmakingfor

eachaffiliateandthusleadstheexposureofthedifferentdynamicsofeachcurrency.Onthe

otherhand, theparent company’s choiceof functional currency leads translational exposure

fromaffiliate/subsidiaryperspectiveaswellastransactionalexposurefromtheperspectiveof

parent,itself.

Inan idealizedworld,without informationandtransactionscosts,explicitor implicitcontract

periods (i.e. strictly written or implied agreements which maintain mutual relationship,

therefore affects pricing) andother obstacles to instantaneous price adjustments, deviations

fromvariousequilibriumconditionssuchaspurchasingpowerparity,thelawofoneprice,and

both the domestic and international Fisher effect would not occur; neither would firms be

exposedtoexchangerisk.Especially,ModiglianiandMiller(1958)showedthatfirmvalueand

financial policy decisions are unrelated in the absence of market imperfections. However,

because real-world imperfections inmarkets for real goods and services as well as financial

assetsdoexist,firms(andtheirvalues)canbesubjecttoexchangerisk.(Dufey,GunterandS.L.

Srinivasulu,1983)

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b)WhatdoestheliteraturesayontheimportanceofmanagingFXcurrencyrisks?

Now thatwe acknowledge the existence of FX currency risk for certain businesses, the next

questionarousesonhowtomanageitorevenshouldweevenbothertomanageit?Smithand

Stulz (1985) showed that hedging could increase the value of the firm by reducing the

probability,andthustheexpectedcosts,of financialdistress.Nanceetal. (1993)arguedthat

firmscanreducetheprobabilityofencounteringfinancialdistressnotonlybyhedging,butalso

bymaintainingmore liquid assets or lower dividend yields. They predicted that increases in

liquidityordecreasesinthedividendyieldreducetheprobabilityofhedging.Froot,Scharfstein

and Stein (1994) highlighted the importance of risk management by arguing that it lets

companiestransferfundsfromsituationsinwhichtheyhaveanexcesssupplytosituationsin

which theyhavea shortage; inotherwordsborrowing from themselves.On theotherhand,

Copeland and Joshi (1996) argued that anticipating the consequences of hedging is difficult

since so many other economic factors change when FX rates change. As a consequence,

hedging activity risks being wasteful to the firm’s shareholders, and may actually increase

exposure if management fails to reduce total risk by hedging, shareholder value may be

eroded.

In theory, most of the exposures of a company related to interest rate, currency, and

commodity price will not increase the risk of a well-diversified portfolio. Investors or

shareholders can eliminate it by holding diversified portfolios (Stulz, 1996). Given that

shareholders can easily diversify, they will be indifferent to companies, which reduce their

earningsvolatilitybymanagingtheirfinancialrisks,aslongastherearenoadditionalcosts.

However, in practice, the companies are concerned about total risk. High volatility in

earningshasthepotentialtocauserealfinancialcostssuchasbankruptcy,underinvestment

andexcessive taxation. Therefore, although there is abunchof controversial arguments in

literature,recentstudiesarguethatasuccessfulhedgingprogrammayincreaseshareholder

value by reducing costs related to differentmarket imperfections. (Hagelin and Pramborg,

2004)Withthehelpofaproper riskmanagement, thecompaniescan (i) reducedirectand

indirect costsof financial stress (suchas legal costsor reputational costs), (ii) avoidunder-

investments (due to conflict of interest between equity and bondholders of the company

during financial distress), (iii)manage tax liabilities efficiently, (iv) increase corporate debt

capacity.

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Although existing theories predict that firms hedge to mitigate financial constraints,

informationasymmetry,andagencyproblems,Giambonaetal(2014)claimedthatlackofdata

limitedtheabilitytotestthemsotheysurveyedpublicandprivatefirms’CFOsfromallaround

the world in early 2010 and found inconsistencies with existing theories. According to their

findings,fundamental-corporateobjectivessuchascashflowvolatilityorshareholders’interest

seemed behind reasons why firms hedge, but not as suggested by current theories. They

argued that personal risk aversion was important for corporate hedging as well as other

personalcharacteristicssuchasage,experience,education,andcompensation.

c)HowtoManageItEffectively:FinancialPolicies,OperationalHedgingandHedgingviaDerivatives

Iffinancialrisksarepotentiallycostlybutthespecificreasonsarehardtoisolateinsimpletests,

then a next logical step is to examine the interactions between derivative use and other

financial and operational policies (Aretz and Bartram, 2007). Some theoretical research has

tackled derivatives usage in this way. For instance, Leland (1998) illustrates how a dynamic

derivatives strategy affects capital structure and investment in the presence of financial

distressand(endogenous)agencycosts.Hedgingprimarilyincreasesfirmvaluethroughhigher

optimal debt levels (i.e., a greater tax shield) as opposed to lower expected taxes or lower

expected distress costs. The most important implication of Leland’s model is simply that

hedging decisionsmust be considered simultaneously with other financial decisions such as

determiningthepreferred levelandmaturityofdebt.Titman(1992)alsodisplays thatuseof

derivatives (specifically, interest rate swaps) should affect the amount andmaturity of debt.

Extending these lines of reasoning suggests that firms alsomust consider the interactions

betweenhedgingpolicyandfinancialdecisionssuchascashholdingsandpayoutpolicy.

Some studies also inspect the role of “operational hedging” and its relation to financial

hedging.Forexample,Mello,Parsons,andTriantis(1995)investigatetheinteractionbetween

production decisions and FX hedging when it is costly to change the country in which

productionoccurs.Additionally,GuayandKothari(2003)suggestthatthevalueofderivatives

positions is not significant enough to have important direct valuation effects and that prior

findingsmight be “driven by other risk-management activities (i.e., operational hedges) that

arecorrelatedwithderivativesuse” (p.426).This isalsoargued inanotherpaperbyBodnar,

Jong andMacrae (2002), inwhich they examine the influence of institutional differences on

corporateriskmanagementpracticesintheUSandtheNetherlands.Theyfindthat6%ofthe

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USfirmsand4%oftheDutchfirms indicatethatexposuresaremoreeffectivelymanagedby

othermeans, someof the foreign exchange exposuremay be shed bymeans other than by

usingderivatives.Operationalhedging, for instance,bymovingfactoriestocountrieswhere

foreign currency revenues are incurred, or financing in the foreign currency, may be

alternativestrategiestousingderivatives.Also,partofoperatingrevenuesandcostsmaybe

in the same foreign currency, thereby reducing the total foreign currency exposure to a

tolerable levelwithout using derivatives.Alternatively, leading and laggingmethod (which

refer mitigating possible losses by altering the timing of FX cash flows) can be used to

managetransactionalexposure.Forinstance,ifacurrencyisdeprecating,onewillpreferto

receive its receivablesasquickaspossiblewhilepreferring toholdon forpayments in the

samecurrency.

WhenitcomeshowtomanageFXcurrencyrisks,onemayalsoarguethatempiricalresearch

has yet to consider the potentially broad role of financial risk management in general and

derivativesusage inparticular.As anexception,GrahamandRogers (2002)directly estimate

theeffectofderivativesuseonleverageusingasimultaneousequationsmodel.Theyfindthat

derivativesusehasapositiveeffectonleverageandisolatethechangeinvalueofthedebttax

shield attributable to hedging and estimate that hedging indirectly increases firm value by

about1%.TheGrahamandRogersanalysisrevealsthattheresultofinterestisnottheeffectof

leverageonderivativeusebutinstead,theeffectofderivativesuseonleverage.

In one of their studies, Bartram, Brown and Fehle (2009) examine the use of derivatives by

7,319 firms in 50 countries that together comprise about 80% of the global market

capitalizationofnonfinancialcompanies,which is the firstcomprehensiveglobalexamination

of hedging practices and the use of foreign exchange, interest rate, and commodity price

derivatives.Thisanalysisshowsthatderivativesuseissignificantlyrelatedtootherimportant

financial characteristics such as leverage, debtmaturity, holdings of liquid assets, dividend

policy, and operational hedges. This finding suggests a need for further theoretical and

empirical analysis that incorporates the use of derivatives into broader models of financial

management.

They also highlight that firmswith less liquid derivativesmarkets, typically inmiddle-income

countries,arelesslikelytohedge.Thisfindingisconsistentwiththeassertionsofsomepolicy

makersthatderivativescouldbe important in limitingtheseverityofeconomicdownturns in

developingeconomies. The impactof this finding is reinforcedbyother results showing that

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these firms,which are typically located in countrieswith higher economic and financial risk,

prefer to hedge more often, ceteris paribus. Consequently, it is likely that financial policy

makers could facilitate corporations’ financial risk-management activities by pursuing

strategiesthatencouragethedevelopmentoflocal-currencyderivativesmarkets.

Considering the conclusions of the research papers in this subject, pursuing a series of

questionsasinExhibit1couldprovideaclearguideabouthowtoassessdifferentmethods

of hedging. The key, while answering to these questions, is to look from a cost-effective

perspective, naturally. For instance, moving the production facility to the country where

revenues are incurredmay be costlier than hedging via derivatives but putting an option

related to “leadingand lagging” in supplierand client contracts isprobablynot, given the

negotiation power of an MNC. Having investigated each and every possibility related to

operationalhedgingmethodsinconjunctionwithcriticalfinancialdecisions,acompanywill

concludewithasubstantialbasisthattherestoftheexposurewillbesubjecttohedgingvia

derivatives.

Exhibit1:AssessmentofAlternativeHedgingMethodsbeforeDerivatives

3.DesigninganEffectiveFXRiskManagementPolicy

Given the international environment variables such as political risk, international market

imperfections, complexity of operations, FX currency risk and local factors of countries on

one hand and opportunities for international diversification on the other, the MNCs are

Havehedgingdecisionsbeenconsideredsimultaneouslywithother6inancialdecisionssuchasthepreferredlevelofleverageandmaturityofdebt,cashholdingsandpayoutpolicy?

Isitpossibletomovefactoriestocountrieswhereforeigncurrencyrevenuesareincurred?

HaveyouinvestigatedtheinteractionbetweenproductiondecisionsandFXhedgingwhenitiscostlytochangethecountryinwhichproductionoccurs?

Haveyouinvestigatedthepossibilitytomatchthecurrencyforsomepartofoperatingrevenuesandcosts?

Isthecompanypolicy6lexibleenoughtoleadandlagreceivablesandpayableswhenitisofinterest?

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expectedtocontinuedoingbusinessonthesharpedgeofsword,inotherwordsinaworld

fullofrisksandopportunities,whichrequireshighlyeffectiveriskmanagementpolicies.

Furthermore, as Guillén and García-Canal suggest, in recent decades, due to a number of

reasons including slowdown in developed countries, MNCs shift their focus to emerging

markets (EM), which have higher potential for growth and higher profitmargins although

they bring along new risks such as exposure to FX currencies with higher interest rates,

volatility and fragility. To visualize the volatility comparison of stable currency pairs with

emergingmarketones,theGraph1couldbereferred.

Graph1:HistoricalVolatilityof3MATMOptionContractsforEURUSD,USDTRY,USDBRL(Bloomberg)

The historical volatility of 3-month at-the-money (ATM) option contracts (compiled via

Bloomberg and dates back to 2009) for EURUSD has been lower compared to USDTRY and

USDBRL;whichconcludesthatbeingexposedtoemergingcountryFXrisk isriskierandthus

requiressensitiveattentionandmanagement.

InordertomanagefinancialrisksarousingfromFXcurrencies inaneffectiveway, it ishighly

significant todesignapolicy,which is comprehensiveenough toaddresspurpose, scopeand

objectives as well as identification and quantification of exposures, hedging strategies,

allocationofresponsibilitiesandmonitoringtheeffectivenesssothatitembracesanyonewho

isinvolvedinriskmanagementprocessinthecompany.Benchmarkingstudiesamongpeersis

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anotherdimensionforaproperriskmanagementpolicyintermsofadoptionofbestpractices

acrosstheindustry.

a)Purpose

Ingeneraldocumentationterms,thepurposestatementisusedtooutlinewhythecompanyis

issuing the policy and what its desired effect or outcome should be. Adopting the same

approach,thispartoftheFXRiskManagementPolicyshouldaimtoserveastheintroduction,

whichclarifieswhatisintendedwiththispolicydocumentalongwiththeexpectedoutcome.

Two different examples are given below as assertions, which could serve as purpose

statements:

1.“Themainpurposeof thePolicy is toestablishan in-depthguidelinetomanageFX

currency risks across the company; including joint ventures 1 , subsidiaries 2 , and

affiliates3.

The Policy aims to give a common sense of FX currency risk by definition, how to

measure and mitigate the exposure along with assignment of responsibilities for

managingit.”

2.“ThePolicyprovidestheframeworkforacomprehensiveforeignexchangeexposure

management strategy in the context of the company’s financial objectives, existing

businessactivities,andoperatingenvironment.

Volatility in foreign exchange ratesmay affect the competitiveness, profitability, and

valuationofacompany’sinternationaloperations,inotherwords,mayleadincreased

costs and cause reduced market share and profit. This Policy is developed and

1An association of two or more individuals or companies engaged in a solitary business enterprise for profit without actualpartnershiporincorporation;alsocalledajointadventure(West'sEncyclopediaofAmericanLaw,edition2.(2008).RetrievedJune122016fromhttp://legal-dictionary.thefreedictionary.com/joint+venture)2In the law of corporations, a corporation or company owned by another corporation that controls at least amajority of theshares. (West's Encyclopedia of American Law, edition 2. (2008). Retrieved June 12 2016 from http://legal-dictionary.thefreedictionary.com/subsidiary)

3TheBlack's LawDictionary (1999) defines affiliate as a corporation that is related to another corporation by shareholdings orothermeansofcontrol;asubsidiary,parent,orsiblingcorporation.Otheronlinedictionariesdefineasubsidiaryasacompanyforwhichamajorityofthevotingstockisownedbyaholdingcompany,whileanaffiliateisacompanyinwhichanothercompanyhasaminorityinterest.

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documentedtodescribethecompany’sattitude,objectives,andappropriateresponses

whenmanagingforeignexchangerisk.”

b)Scope

Inordertobecosteffective,mostofthecompaniesprefernottohedgealltheexposureand

trytolimitpossiblecoverageandoptimizecosts.Inthatrespect,thispartofthePolicyshould

address which countries, currencies and/or subsidiaries are within the scope of the

documentation, hence actively managed. Additionally, MNCs have presence in more than

certainnumberofcountriesandevencontinentsbutduetoacoupleofreasons,applicationof

the same Policy for every country may not be enough to get the results intended.As an

example,insomecountries,hedgingtheexposuremighttobesoexpensivethatitwritesoff

theprofitexpected fromthesales itself.Thus,onemaychoosenot tohedge theexposure

deliberatelyormaymakeuseoflocalsolutionsforlessliquidcurrenciesinsteadofexecuting

therequirementsofageneralpolicy.

Toillustratewhatsortoflocalsolutionsareoutthere,itispossibletorefertherecentmoveby

the National Bank of Egypt. According to a Bloomberg article dated March 14, 2016

(http://www.bloomberg.com/news/articles/2016-03-14/egypt-s-biggest-lender-offers-hedge-

against-local-bond-risk),TheNationalBankofEgyptwouldofferdollarcalloptionsforuptoa

yeartoinvestorsbuyingTreasurybillsdenominatedinEgyptianpounds,whichguaranteesthe

foreignexchangeexit, includingthevalueofprincipalplusthecoupon.Thisproducthasbeen

introducedafterthecentralbank’sdecisiontoallowEgyptianPoundtoweakenbyalmost13%

in theofficialmarket,andaimed to restore foreign interest inEgypt’sdebtmarket.From an

MNCperspective,whichhasoperationsinEgypt,thusincomeinlocalcurrency,thismightbe

an alternativeway of hedging local currency risk. Instead of keeping the earnings in local

currency and taking the risk of weakening it by more than 10%, the company can buy

Treasury bills denominated in Egyptian pounds with dollar call option facility in order to

guaranteetherepatriationofearningsindollarvalueatmaturity.Naturally,thepriceofthe

Treasurybillswill includeoptionpremiumtherefore thecost-effectivenessof the transaction

shouldbecomparedtotheriskofunhedgedpositionandactaccordingly.

Consequently, the determination of scope is quite important in terms of getting efficient

results.Asasuggestion,onemayconsiderlimitingthescopewithapercentageofcoverage

according to the risk appetite of the company. For instance, some companies may find it

adequate if the Policy covers 70% of the income generated in the currencies, which were

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addressedbythePolicyinsteadofbeingfullyhedged.Asasecondexample,onemayconsider

limitingthescopewithEMcurrencies,whichhavehighervolatilitiescomparedtodeveloped

market(DM)currenciesasshownabove.Thirdly,athresholdcanbedeterminedintermsof

“materiality”andeverythingcanbehedgedexcessingthatamount.

Additionally,itmightbeusefultostudyonthecorrelationsofthecurrenciesexposedbefore

makingadecisiononthescope.Forinstance,thetablebelowshowsthecorrelationmatrixfor

variouscurrenciescalculatedwithdailybidpricesfortheperiod01/01/2012and30/06/2016.

Asonemayexpect,weseeaconsiderablepositivecorrelationbetweenAustralianDollar(AUD)

andNewZealandDollar(NZD).ThispairisfollowedbyMexicanPeso(MXN)andSouthAfrican

Rand (ZAR).On theotherhandAUDandCanadianDollar (CAD)hada correlationof -0.63. If

AUDandCADhavemovedinoppositedirections63%ofthetimestudied,havinganexposure

oflongAUDandlongCADmeanshavinglesspositionthanthesumofthemduetothefactthat

whenAUDhasrallied,CADhaspartlysold-off.Thus,inthisspecificcase,ifonehedges2units

of long AUD and long CAD (1 unit each), the positions might be over-hedged due to the

correlationof-0.63.

Exhibit2:AnExampleofCorrelationMatrix

Subsequently,ifthetwoexposurescanceleachotherincaseofaperfectcorrelationorif

relativelyhighcorrelationdecreases theexposure, itmaybewise toavoidentering into

twotransactionsordecreasetheamounttohedge.

Onecriticalpointhere istokeepinmindthatcorrelationsdochangeduetodivergence in

monetary policies, currency’s sensitivity to commodity prices, as well as economic and

political factors. Therefore, the Policy should address this fact by being as dynamic as

requiredifthescopehasbeendecidedaccordingtocorrelations.

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Intermsofscoping,allthechoiceswillbringdifferentadvantagesanddisadvantages.Butit

isadvisabletolookforanswerstothesequestions:

1. DoyouhaveexposuretorelativelyvolatileEMcurrencies?

(As Graph 1 shows, developed market (DM) currencies tend to be less volatile

comparedtoEMcurrencies,whichimplieslessFXriskfromacorporateview.)

2. Doyouconsiderthatexposureasmaterial?(i.e.15-20%ofincomegeneration)

3. Wouldyouconsiderthepredictabilityofcashflowashigh?

4. Isitpossibletohedgethatexposurewithfinancialinstruments?

5. Isthemarketliquidenoughtoprovidereasonablequotation?

(If the answers are “yes” for the first 5 questions, it is reasonable to keep these

currencieswithinthescopeduetothereasonsexplainedabove.)

6. Doesthecostofhedgingsweepawaytheprofitmadefromthatbusiness?

7. Are there less costly or alternative local solutions? (Just like Egypt example given

above)

8. Have you checked correlation matrix and found out near perfect or perfect

correlations?

9. Haveyoucheckedwhetherthecurrencyofexposureispeggedtoanothercurrency?

(Becauseifit’spegged,itisexpectedtobelessvolatileandnear-perfectlycorrelated

toanothercurrency.)

(If theanswersare “yes” for the last 4questions, it couldbewise to keep these

currenciesoutofthescopeinordertooptimizecosts.)

c)Objectives

Regardless of methods or scope to be adopted, one of the foremost objectives of the

Policy is the reduction of the volatility in financials to ensure sustainable growth and

return for stakeholders as well as general risk management gains mentioned in the

Introduction part. Depending on the company’s key performance indicators (KPI)

reductionof thevolatilitycanbeconsideredforbalancesheetand/or incomestatement

(i.e. earnings, EBITDA or EBITA). For instance, Philips prefers to use EBITA as a KPI4so

reductionofvolatility inEBITA is likely tobe theirmain targetwhileAkzoNobel5refers to

growthinEBIT.

4http://www.philips.com/corporate/resources/annualresults/2015/PhilipsFullAnnualReport2015_English.pdf5https://www.akzonobel.com/sites/live.corp.prod.an-platform.com/files/q2-report-2016.pdf

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The sub-objectives of the policy can be classified into two groups, being financial and

organizationalobjectives.Amongfinancialones,followingobjectivesarecanbeconsidered

asawholeorpartlyinaccordancewiththescope.

1. Toeliminatetheprobabilityofcostlylower-tailoutcomesinkeyfinancials

2. Tominimizethevolatilityofnon-functionalcurrencyfluctuationsonaconsolidated

basis

3. To assess and mitigate the potential exchange rate risk on receivables, payables,

asset&liability

4. To manage the potential impact of marking to market non-functional currency

exposuresandderivativesthroughtheincomestatement

As a part of comprehensive risk management document, the intended outcomes of the

policy from organizational perspective should also be clarified. In that respect, the

organizational objectives can be some of the following depending on the nature of the

company:

1. Todefinerolesandresponsibilitiesofpersonnelinchargeofriskmanagement

2. Toimproveefficiencyandsafetyofriskmanagementfunction

3. Toimparttransparencytotheriskmanagementfunction

4. Toadopt“bestpractices”

5. TosetbenchmarksforTreasurytooperatewithinrisklimitsandprudentialcontrols

d)IdentificationandQuantificationofExposures

The risk management literature identifies two classes of FX risk; being translational and

transactional. Brownlee, Wilson, Grayson and Conroy (2008) pinpoint that transaction

exposure exists during the normal course of international business transactionswhenever

twoormore currencies are involved and there is a lag between the date of a contract is

signed or goods delivered and the date of payment while translational exposures occur

because of the need to translate the financial statements of foreign subsidiaries and

affiliates into the currency of the parent company in order for consolidated financial

statementstobeprepared.

HagelinandPramborg(2002)refertoeconomicexposureaswellanddivideitinthree:the

exposureof committed transactions, theexposureof identifiable anticipated transactions,

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andcompetitiveexposure(unidentifiableanticipatedtransactions).Bytransactionexposure

they refer to the two former. They also think that competitive exposure is notwithin the

scopeofhedgingviauseofderivatives(typicallymanagedbyoperationalhedges)referring

that fewfirmstendtohedgethis typeofexposurewithcurrencyderivatives (Bodnaretal

1998). Additionally, Butler (1999) provides a discussion on the problems associated with

usingfinancialhedgestomanagelonger-termedcompetitiveexposure.

They also argue that transaction exposure and translation exposure tend to affect firms

differently.Transactionexposuretocurrencyriskreferstopotentialchangesinthevalueof

future cash flows as a result of unexpected changes in exchange rates. If competently

executed, transaction exposure hedges should reduce the variability of cash flows and

consequentlythevariabilityoffirmvalue.Translationexposure,ontheotherhand,arisesas

the financialaccountingstatementsof foreignaffiliatesare translated into thecurrencyof

theparentfirm.Thegeneralrecommendationofthefinanceliteratureisnottoworryabout

thistypeofexposureandthusnottohedgeit(seee.g.Butler,1999).Thereasonsforthisare

thattranslationgains(losses)tendtobe(i)unrealizedandhavelittledirectimpactonfirms’

cashflows,and(ii)poorestimatorsofrealchangesinfirmvalue.Thustheyconcludethatif

this is true, translation exposure management should be inefficient in reducing firms’ FX

exposure.

Consideringtheliterature,FXcurrencyriskscanbecategorizedasbelow:

Exhibit3:CategorizationofFXCurrencyRisk

Thetranslationalriskscanbeobservedupontheconsolidationofincomestatementand/or

balancesheet.WithinInternationalFinancialReportingStandards(IFRS),itisfairtosaythat

hedgingthetranslationriskonthebalancesheetiseasiercomparedtohedgingonearnings

FXCurrencyRisk

TranslationRisk

ConsolidationonBalanceSheet

ConsolidationonIncomeStatement

TransactionalRisk

CommittedExposures

AnticipatedExposures(EconomicExposures)

ExceptionalCashFlows

17

level due to restrictionsonhedge accounting treatment. For instance, let’s assume that a

EUR company is expected to generate GBP 50 million earnings in each quarter for the

comingone-yearperiodonconsolidatedbasis.Soattheendoftheyear,theGBPearnings

willbetranslatedattheaverageratefortheyear.Tohedgethecurrencyrisk,thecompany

canenterinto4forwardcontractstosellGBP50millioneachandbuyequivalentamountof

EURatthebeginningoftheyearwith3,6,9and12-monthmaturity.Attheendoftheyear,

any loss/profit on the average rate will be cancelled out by profit/loss on the forward

contractsprotectingthecompanyfromadversemovementsofthecurrencypair.However,

thiswillcausesomekindofvolatilityinquarterlyreportssinceforexample,therewillbe4

forwardcontractswithGBP200millionnotionalwhilethereisonlyGBP50millionofearning

at the end of Q1. Therefore at the end of each quarter, the consolidated P&L will be

showing changes in the mark-to-market (MtM) of the four forward contracts with less

underlyingexposuretomatch.Hence,itisimportanttokeepinmindthathedgingearnings

may cause temporary volatility in quarterly reports but it will be gone at the year-end

financials.

Transactional risk can be divided into three groups as committed exposures, anticipated

exposures(economic)andexceptionalcashflows.“Exceptional” isusedtorefercashflows

arousing fromone-time events likemergers or acquisitions,which need special attention.

ThereforetheyshouldnotbeincludedinthePolicytoenableflexibilityfromthem.

To understand transactional and translational risks on committed exposure basis, the

following illustrationsandhedgescenariosmightbehelpful. Let’sconsider thatwehavea

parentcompanywhosefunctionalcurrencyisEUR.ItgeneratesincomeinEUR,USDandSEK

whilethecostspaidtosuppliersareinEUR,SEKandGBP.Thiscompanyalsohasasubsidiary

intheUKwithafunctionalcurrencyofGBP.IthasGBPincomebutEURcosts.

18

Exhibit4:Cost&IncomePatternoftheParent&Subsidiary

Accordingtotheexamplefigures,GroupgeneratesoperatingincomeofEUR668.56withthe

exchangeratesbelow.

6

Exhibit5:OperatingProfitBreakdowninParent,SubsidiaryandGroupBase

SCENARIO1:

1) EURstrengthens15%againstallcurrencies

2) TheGrouphasnothedgedanyofthecurrencyrisk

6Scenarioratesshow15%strengtheningofEURagainstallcurrenciesandtransactioncostsareignoredforsimplicity.

19

Considering that the Group has not hedged any of the currency risk, in case of 15% of

strengtheninginEURwillcause13%ofdecreaseinGroup’soperatingprofit.

Exhibit6:OperatingProfitBreakdowninParent,SubsidiaryandGroupBaseunderScenario1

SCENARIO2:


2) TheGrouphashedgedexternaltransactionstolocalcurrencyofeachentitybefore

EURstrengthening

In this scenario, parent company and subsidiary hedge the external transactions (i.e.

excludingintercompanysales)beforeEURstrengthens15%againstallcurrencies.Sincethe

hedgesaredonetolocalcurrenciesofeachcompany,translatingUKsubsidiary’scostofEUR

60intoGBPcausestheincreaseofGBPexposurefromGroupperspective. Inasituationof

strengtheningEUR, thismakesour caseworse.Additionally,byparent company’shedging

thetransactionalexposureofGBP40,theoffsettingopportunitybetweenparentcompany’s

GBPexposureandthetranslationalexposurearousedbyUKsubsidiaryhasbeencancelled.

Consequently, this strategy brings more operating profit of EUR 18.07 compared to the

Scenario1.

20

Exhibit7:Cost&IncomePatternoftheParent&SubsidiaryunderScenario2


SCENARIO3:


2) TheGrouphashedgedonly internal transactions to local currencyofeachentity

beforeEURstrengthening

Under this scenario, although it is an internal transaction (i.e. intercompany sales), the

Group benefits by hedging a big chunk of its EUR costs in subsidiary basis and therefore

reducingtheGBPtranslationalexposure.

21

ThisisalsoanaccountingfriendlywaysinceInternationalAccountingStandards39(IAS39)

Paragraph80statesthat inconsolidatedfinancialstatementstheforeigncurrencyriskofa

highlyprobableforecastintragrouptransactionmayqualifyasahedgediteminacashflow

hedge, provided the transaction is denominated in a currency other than the functional

currencyoftheentityenteringintothattransactionandtheforeigncurrencyriskwillaffect

consolidatedprofitorloss.Forthispurposeanentitycanbeaparent,subsidiary,associate,

jointventureorbranch.



22

SCENARIO4:

1) TheGrouphashedgedbothinternalandexternaltransactionstolocalcurrencyof

eachentitybeforeEURstrengthening

This scenario eliminates transactional risk completely; therefore the bottom line is better

thanabovescenariosexceptbasecase.However,translationalriskstillexistsandthenatural

offset opportunities, which arouse by parent company’s GBP costs and subsidiary’s EUR

costs,arevanished.



23

SCENARIO5:

1) The Group has hedged both internal and external transactions to parent

company’scurrencybeforeEURstrengthening

Inthisscenario,translatinginternalandexternaltransactionsintoEUR,whichistheparent

company’s functional currency,eliminates transactionaland translational risks.Although it

bringsadesirablebottomlinecomparedtootherscenarios,thisapproachisnotaccounting

friendlybecausethetranslationriskofUKsubsidiarydoesnotrepresentaneligibleexposure

forhedgeaccounting. It ishighly likely that therewillbe timegapbetweentheprofitand

lossofhedgetransactionsandrecognitionofGBPearnings,whichwillcausevolatilityinP&L.

Additionally,notalltransactionalexposurescanberealizedascashflowsintheanticipated

future.


24


Exhibit 15 summarizes the outcome of different scenariosmentioned above. The case of

15%strengtheningofparentcompany’scurrencyagainstallcurrenciescauses13%decrease

inGroup’soperatingprofit.Itisalsotheworst-casescenarioforbothparentandsubsidiary

perspective.

However, in somecases,hedgingdecisions canbetter-offonlyoneparty;eitherparentor

subsidiary. For instance, just like in Scenario 3, hedging only internal transactions (i.e.

intercompany sales) will help protecting subsidiary’s operating profit but parent will still

suffer because of unhedged external deals. Therefore, it is important to pay attention

internalandexternaltransactionsdistributionbeforemakingadecisionaboutthescope.

Additionally,hedginginsubsidiarylevel(tolocalcurrency)andnotconsideringtheexposure

fromGroupperspectivecancauseadditionalexposureasseeninScenario2.EURexposure

foraGBPcompanyisconsideredtobeatransactionalexposurealthoughfromEURparent

companyperspective, itdoesnot representa translationalexposure since the currencyof

theexposurematcheswithfunctionalcurrencyoftheparentcompany.

Insomecases,asinScenario4,eliminatingtransactionalriskscompletelymayleadvanishing

ofsomenaturaloffsettingopportunities(i.e.GBPliabilitiesforEURparentcompanyorEUR

liabilities for GBP subsidiary). Thus, ideally, Scenario 5, which requires hedging of both

transactionalandtranslationalexposures,givesthebestfinancialresults.Yet,inreality,itis

notviablebecauseof(i)beingnothedgeaccountingfriendlyasexplainedaboveand(ii)time

gap for transactional exposures between anticipation and realization. Considering the

imperfectionsinrealworld,prioritizingthetransactionalexposuresincludingintercompany

transactionshavehigherpotentialtogivebetterresults,ifnotperfect.

25

Strategy Op.Profit

(Parent)

Op.Profit

(Subsidiary)

Op.Profit

(Group)

BaseCase

EUR348.56 EUR320.00 EUR668.56

Scenario1 Nohedge

EUR338.31 EUR254.78 EUR593.09

Scenario2 Hedgeonlyexternal

transactionstolocal

currencyofeachentity

EUR348.56 EUR262.61 EUR611.17

Scenario3 Hedgeonlyinternal

transactionstolocal


EUR338.31 EUR270.43 EUR608.75

Scenario4 Hedgebothinternaland

externaltransactionstolocal


EUR348.56 EUR278.26 EUR626.82

Scenario5 Hedgebothinternaland

externaltransactionsto

parentcompany’scurrency

EUR348.56 EUR320.00 EUR668.56

Exhibit15:SummaryTableofFinancialOutcomesofVariousScenarios

e)ModelsfortheMeasurementoftheFXRateRisk7

Havingdefinedthetypesofexposure,logicalnextstepisthemeasurementoftheserisks.As

VanDeventer,Imai,andMesler(2004)andHolton(2003)explainintheirbooks,measuring

currencyriskmaybehighlycomplex,atleastwithregardstotranslationandeconomicrisk.

Oneofthewidelyusedmethodisthevalue-at-risk(VaR)model,whichcanbedefinedasthe

maximumlossforagivenexposureoveragiventimehorizonwithX%confidence.TheVaR

measure of exchange rate risk is used by firms to estimate the riskiness of a foreign

exchange position resulting from a firm’s activities, including the foreign exchange

positionofitsTreasury,overacertaintimeperiodundernormalconditions.Accordingto

Holton(2003),theVaRcalculationdependson3parameters:

7ThispartisgivenforinformativepurposeswiththeaimofbrieflymentioningdifferentwaysofmeasurementoftheFXraterisksandtheirfeatures.Sincethispaperaimstoprovidepracticalguidance,thecalculationmethodsforthesemodelsarekeptbeyondthescope.

26

1. Theholdingperiod,i.e.,thelengthoftimeoverwhichtheforeignexchangeposition

isplannedtobeheld.Thetypicalholdingperiodis1day.

2. The confidence level at which the estimate is planned to be made. The usual

confidencelevelsare99percentand95percent.

3. TheunitofcurrencytobeusedforthedenominationoftheVaR.

However, as Papaioannou (2006) suggests the VaR does not define what happens to the

exposureforthe(100–X)%pointofconfidence,i.e.,theworst-casescenario.

Forexample, if theFXpositionhasa1-dayVaRofEUR10mnat95%confidence level, the

companyshouldexpectthatunderusualconditions,thevalueofthatpositionwilldecrease

nomorethatEUR10mnwith95%probabilityduring1dayperiod.Onecanalsorephraseit

bysayingthat thecompanyshouldexpect thevalueof thisexposuretodecreasebymore

than EUR 10mn on 5 out of 100 trading days. Since the VaRmodel does not define the

maximum loss with 100% confidence, firms often set operational limits, such as nominal

amountsorstoplossorders,inadditiontoVaRlimits,toreachthehighestpossiblecoverage

(PapaioannouandGatzonas,2002).

Thereare3significantmodelstocalculateVaR:

1. Historical simulation, which assumes that currency returns will have the same

distributionastheyhadinthepast

2. The variance-covariance model, which assumes that currency returns on a firm’s

totalforeignexchangepositionarealways(jointly)normallydistributedandthatthe

change in the value of the foreign exchange position is linearly dependent on all

currencyreturns

3. Monte Carlo simulation, which assumes that future currency returns will be

randomlydistributed

The historical simulation, whose main benefit is that it does not assume a normal

distributionofcurrencyreturns,isthesimplestoneamongthethreealthoughitrequiresa

largedatabaseandintensivecalculation.Theshortcomingsofvariance-covariancemodelare

its assumptions of normal distribution and linear dependency, although it allows for a

quickercalculation.MonteCarlomakesuseofvariance-covariancemodel’scomponentsby

simulating them randomly and handling the underlying distribution even if non-linear

factorsareinvolved.Sinceitrequiresintensivecalculations,mostcompaniesprefertodo

itwiththehelpofsoftware.

27

f)IdentificationofHedgingStrategy

Consideringthefactthathedgingwillcostmoney,itishighlyimportanttofindandapplya

cost-effectivestrategy,whichwillsuitcompany’spolicyaswellasitsbudget.

Forward rates are a function of interest rate differentials and therefore they have little

predictivepowerforfuturespotratesinshortandmediumterm.(Sanchez,2013andPolito,

2000)Thus,positivereturncanbegeneratedbytakinglongpositioninhighyieldcurrencies

againstlowyieldcurrencies;whichiscalled“carry”.(However,thisstrategyhasthepotential

to suffer fromviolent short-termdrawdownsespecially foremergingcurrenciesandoften

used by hedge fund.) Applying this to hedging, favorable carry can be considered as

incentivetohedgesinceforwardpointsaregainedandnegativecarrycanbeconsideredas

thenetcostofhedgingsinceforwardpointsarepaid.

Given the current literatureandpractice, thereareanumberofhedging strategies,being

static, rules-based, opportunistic, limited, proxy, “buy at-the-money forward (ATMF)

options”,“sellotheroptions”andasacombinationofsomeorallashybrid.

Statichedge referstotheposition,whichisputinplaceandkeptuntilthematurityofthe

contract. The usual instruments under this strategy are forward, futures and European

options.Incaseofchangingexposures,thisstrategymayleadlossescomparedtounhedged

positions.

Dependingontwoconditions,highyieldcurrenciesdon’ttendtodepreciatebymorethan

forwardpointsonaveragesostatichedgewith forwardcontracts tendtogenerate losses.

Forinstance,ifimpliedvolatilityistradingaboveitshistoricalaverage,itmaymeanthatthe

currency depreciation has already occurred. Also, if forward points are trading above its

historicalaverage,thecurrencyneedstodepreciatefurtherinordertocompensateforthe

elevated forward points being paid. Hence hedging with forward contracts are likely to

generate losses as the currencymay not depreciate asmuch as elevated forward points.

Thus, rules-basedhedgemaybedesignedforthesecurrenciesbydeterminingathreshold

for1YATMFimpliedvolatilityand1Yforwardpointsasa%ofspotthresholdandhedging

accordingly.

28

Opportunistichedgerequiresforecastingpossibilityofcurrencydepreciationquantitatively

and/orqualitativelyandhedgingonlywhennecessary.Therisk inthisstrategy is itsstrong

dependencyonbeingabletodetecttheupcomingcrises.

Limited hedge refers to hedge only for extreme scenarios via out-of-money option

contracts. For this strategycall spreads (inwhichequalnumberof calloptionsarebought

andsoldtogeneratelimitedprofitwithreasonableprices)canbeused.

Proxyhedgerequireshedgingexposurebyusingcorrelatedcurrencieswithlowercosts.The

riskappearsoncethecorrelationbreaksdown.

Asamitigationofhedgingcost, selling lowerstrikeputs inorder to fundcalls (i.e. collars)

can also be considered. By this way, upfront costs can be decreased or evenmade zero

althoughanimplicitopportunitycoststillexists.

The table below lists the most important advantage and disadvantage of each strategy

mentioned.

HedgeStrategy Pros Cons

Static Easytoexecute Notflexibleincaseofchanging

exposures

Rules-based Easytounderstand

Difficulttomanipulate

Relativelydifficulttoset-upin

termsofdecidingonrules

Opportunistic Cost-effectiveandflexible Requiresstrongforecastingof

currencytrends,whichisvery

difficultconsideringefficient

markets

Limited Cost-effective Providesprotectiononlyfor

extremescenarios

Proxy Cost-effective Dependsonhistoricalcorrelation

data

Exhibit16:ProsandConsofVariousHedgeStrategies

Theyallcanbehighlyeffectivedependingonthecurrencypair,duration,andriskappetite

of the company because they are addressing different needs of the organization. It has

29

alreadybeendiscussedthatundercertaincircumstances,managingtheFXcurrencyriskvia

financial instrumentsmaynotalwayscreatethe intendedvalue.For instance, itmightnot

bereasonabletohedgewhenthevolatilityandpredictability is lowwhilepartlyhedging

via option contracts might be a solution for the cases with low predictability and high

volatility.Optioncontractswillgivemoreflexibilitywhilepartlyhedgingwillpreventextra

costs in case of unwinding over-hedged positions caused by low predictability. If

predictabilityandvolatilityarebothhigh,hedgingsignificantportionviaforwardcontracts

could be economically efficient. As such, creating a “hybrid” approach, which means

making use of some of the strategies together, could be the best solution in order to

ensureflexibilityandeffectiveness.

Furthermore,duetothenatureofpredictabilityofbusiness(i.e.shorttermvisibilityforcash

flows is better than longer time horizons) “layered hedging” via options and forward

contractscanalsobeadoptedasa“hybrid”approach.

Maturity(Months)

3 6 9 12 15

ProportionforOptions 10% 15% 25% 30% 30%

ProportionforForwards 90% 75% 55% 40% 20%

TotalCoverage 100% 90% 80% 70% 50%

Exhibit17:AnExampleofLayeredHedgingModel

The illustrative table above shows this strategy for a 15-month period. Each quarter

requires a reviewof forecasted versus realized cash flows in order to keepupwith this

dynamichedgingstrategy.Forinstance, ifhedgedcashflowismorethanrealizedfigures

attheendofQ1,proportionofoptionsandforwardsforQ2shouldberearrangedsothat

totalcoveragedoesn’texceedtheauthorizedpercentage. Inthataspect,thisexampleof

layered approach incorporates static, rules-based and opportunistic hedging strategies

withinitself.

IAS39 limits the typesof derivatives tobeusedduringhedgeaccounting treatment8with

plainvanillaproducts likeforwardsandoptionswhileIFRS9allowstousebroaderrangeof

8Theimportanceofhedgeaccountingtreatmentisbrieflyexplainedwithanexamplein“d.IdentificationandQuantificationofExposures”part.

30

hedging instruments, i.e. non-derivative financial asset or liability measured at fair value

throughprofitorlossalthoughitstilldoesn’tallow(net)writtenoptions.

4.HedgingGuidelinesOncetheexposureisdeterminedthefollowingstepsshouldbefollowedtomanagetherisk

effectively:

Purpose& Benchmarking:Althoughmany corporates adopt “no speculation, only hedge”

approachforFXRiskManagementPolicy,therearealsoanumberofcorporatesthatdecide

to adopt amore aggressive approach, within which one of themain aims is to generate

financialincomeincludingFXgains.

Forecasting: It’s significant to develop a 6-month and/or 1-year forecast on the market

trendsforhighlyexposedcurrenciesandmakehedgingdecisionsaccordingly.Maindirection

ortrendwillalsoleadthechoiceofmosteffectivehedgingstrategy.

RiskEstimation&ThresholdDetermination:Basedontheforecasts,measuringthevalueat

riskisthenextlogicalstepforaneffectiveriskmanagement.Accordingtotheriskappetite

and tolerance of the company, some thresholds should be set for each currency pair

regardingtoVaR,stop-losslimitspertransactionand/orperday,hedgeratios.

HedgeInstruments:Dependingonthehedgestrategy,scopeandobjectivesofthecompany,

Treasury should be able to use various financial instruments including forwards, futures,

swaps,optionsandotherderivativeproducts.Theriskappetiteofthecompanyalsoplaysan

importantroleforthedeterminationoftheinstrumentstobeused.Forinstance,duetothe

nature of unlimited loss potential, most companies do not allow net written-option

positions. Therefore the company should have clear policies and procedures that define

roles and responsibilities and describe internal controls on the process of exercising and

expiringforeigncurrencyoptions.

Allocation of Responsibilities: There should be a clear guidance in the delegation of

responsibilities among Chief Financial Officer (CFO), Group Treasurer and Front Office,

BusinessUnits/BusinessTreasury,OperationsandAccounting&Controlling.CFOandGroup

Treasurerpositions areexpected tobeactive indetermining themain framework suchas

31

signing-off hedging strategies, clarifying the threshold and allowed instruments. As the

executionorgan,FrontOffice,isexpectedtohavethefollowingresponsibilities:

1. Monitoringthecompany’sconsolidatedexposure

2. Decidingwhichexposurethecompanymustmanagepriortotheothers

3. Determining currency exposure and hedge proposals for currencies in accordance

withPolicy

4. Forecastingexchangeratemovementsandtrends

5. Choosingthehedginginstrumentaswellasthetimingofexecution

6. Adjusting the company’s exposed position through measures consistent with the

Policy’sstatedobjectives

Business Units/Treasury have the support function by being the bridge between local

entitiesandheadquarters.Theyalsohaveasignificantroleforthedeterminationandeven

decreasingofexposurebyinvestigatingoperationalhedgingpossibilities.

5.DevelopingOperationalStructureforEffectiveRiskManagementAccordingtoBankforInternationalSettlements(BIS),operationalriskistheriskofdirector

indirectlossresultingfrominadequateorfailedinternalprocedures,people,andsystems,or

fromexternalevents.Operationalrisk for foreignexchange inparticular involvesproblems

withprocessing the transactions,productpricing,andvaluation.Operational riskmayalso

stem from poor planning and insufficient procedures, inadequate systems, failure to

properly supervise staff, defective controls, fraud, and human error. On the contrary of

financialorcreditrisk,itmaybedifficulttoquantifythecostsofoperationalrisks.Therecan

be direct and financial results of poormanagement of operational risk, just as when the

companysettles lateor settles inawrongcurrency.Therecanalsobe indirect results like

reputationalcostsinsomeothercases.

Operations, Accounting & Controlling and Compliance units are responsible formanaging

theoperationalriskasdescribedabove.Accounting&ControllingDepartmentisresponsible

for ensuring all transactions are properly recorded to the balance sheet and income

statement. Following the initial entry of transaction into general ledger, the position is

recurrentlymarkedtomarketuntil it isclosedundertheirsupervision.Inthatrespect, it is

32

important to conduct daily valuations for the outstanding positions and inform senior

management in case of any excess. Another critical responsibility of this group is the

compliance with hedge accounting principles in accordance with the latest regulation.

Especially with IFRS9, it is planned to bring some flexibilities for corporates as briefly

mentionedabove;thusitisanimportantdecisiontobemadewithallstakeholderswhento

and not to apply hedge accounting under the supervision of Accounting & Controlling

Department.

Another decision point under this subtitle is the level of centralization in terms of

operationalstructure.TherearedifferentapproachesthatcanbeseenamongMNCs.First

example is decentralized model, which gives the responsibility for determining risk

managementstrategytotheindividualsubsidiarycompaniesorbusinessdivisionswiththe

centralization of the principal riskmanagement functions, such as front office,mid-office

and back-office operations. Another example could be centralized approach,where all FX

risk management activities, from operational to strategic, are consolidated within the

corporatetreasury function.Asabalancedmodel,authorityandresponsibility forhedging

decisions and strategy can be split between the corporate treasury and the various

subsidiaries, resulting in amore collaborative approach to riskmanagement.According to

thestructureandsizeofcorporate,theremightbeprosandconsofeachmodelcompared

toothers.Itisalsorelatedtocorporatecultureandtheseniormanagement’swillingnessof

delegation of the power to subsidiaries; thus it is not possible to mention about one

approachtobe“better”thanothers.

Under Compliance Department’s supervision, all the staff including Operations, Business

TreasuryandFrontOfficeshouldfullyunderstandallFXriskmanagementstrategiesandthe

roleofeachparticipantwithin theFXprocess flow (i.e. counterparties, credit, compliance,

andinternalaudit).Policiesandproceduresshouldbedocumentedandupdatedperiodically

since business strategies, responsibilities and roles tend to change and evolve constantly.

Alongwithstrategiesandprocess flows,all staffshouldbe fullyawareofoperational risks

andwillingtomitigatethembyimplementingadequatecontrolpoints.

6.Monitoring,ReportingandEvaluation

Inordertoevaluatetheeffectivenessofthehedgestrategies,itisveryimportanttobeable

tomonitormark-to-market (MtM) valuations of the contracts, which have been used for

33

hedging. However, there might be some conditions which prevent MtM of an derivative

contract, suchaswhen themarket is inactive (whichmeansquotedprices arenot readily

and regularly available on real-time data providers like Thomson Reuters or Bloomberg

and/orthosepricesdonotrepresentactualandregularlyoccurringmarkettransactions)or

whentherangeofreasonablefairvaluesestimatesissignificantandtheprobabilitiesofthe

differentestimatescannotsensiblybeassessed.Especiallyafternewregulationsintroduced

followingthe2008financialcrisis,mostofthereal-timedataprovidersstartedofferingsome

valuation tools. As an example, Bloomberg’s valuation tool, BVAL provides rigorous,

transparent, and defensible pricing available at that day to help better identify,measure,

monitor and manage valuation uncertainties. They also provide “BVAL Score” which is a

numerical rating that shows the relative strength of the quantity and quality of market

inputsusedincalculatingtheBVALprice.Itmightbehandyusingthiskindofvaluationtools

eitherviatheterminal itselfortransferringthepricesprovidedbyobjectivesourcestothe

programusedbythecompany.

Mostvaluationtechniquesarebasedupondiscountedcashflowanalyses;inwhichexpected

futurecashflowsarecalculatedanddiscountedtopresentvalueusingadiscountingcurve.

Prior to considering credit risk, the expected future cash flowsmay be known ormay be

uncertainandrequireprojection.In‘Projection’case,marketforwardcurvesareutilized.In

optionmodels,theprobabilityofdifferentpotentialfutureoutcomesmustbeconsidered.In

addition, thevalueofsomeproductsmaybedependentonmorethanonemarket factor,

andinthesecasesitwilltypicallybenecessarytoconsiderhowmovements inonemarket

factormayaffecttheothermarketfactors.

At thispoint,Accounting&ControllingandComplianceDepartments takeresponsibility to

establishaccountingpoliciesforfairvalueandproceduresgoverningvaluationandtoensure

compliancewithallrelevantaccountingstandards.

7.Conclusion

Giventheinternationalenvironmentvariablessuchaspoliticalrisk,socialrisk,international

market imperfections,complexityofoperations,FXcurrencyriskandother local factorsof

countries,multinationalcompaniesarestrugglingtocontinuetheirbusinesses.Furthermore,

inrecentdecades,duetoanumberofreasonsincludingslowdownindevelopedcountries,

MNCs shift their focus to emergingmarkets, which have higher potential for growth and

34

higherprofitmarginsalthoughtheybringalongnewriskssuchasexposuretoFXcurrencies

with higher interest rates, volatility and fragility. Even though you consider that they

combine these risks with the opportunities of international diversification, they will still

requirehighlyeffectiveriskmanagementpolicies.

In that respect, due to the very nature of being involved in international operations and

investments,multinationalcompaniescanbequitevulnerableagainstdramaticchanges in

FXratesdependingontheirnetexposures.Although,intheory,mostoftheexposuresofa

company can be eliminated by investors via diversified portfolios, the companies are still

concernedabouttotalrisk.Highvolatilityinearningshasthepotentialtocauserealfinancial

costssuchasbankruptcy,underinvestmentandexcessivetaxation.Therefore,recentstudies

arguethatasuccessfulhedgingprogrammayincreaseshareholdervaluebyreducingcosts

relatedtodifferentmarketimperfections.

ThispaperparticularlyfocusesontheFXcurrencyrisksincethefluctuationsinFXrateshave

the potential to affect company’s KPIs, financials, profit margins, value of assets and

liabilities as well as equity. Therefore, if not managed properly, it may risk all the

performanceindicators,competitivenessandevenexistenceofthecompany.

WhenitcomestomanagingFXcurrencyriskseffectively,financialinstrumentsshouldnotbe

considered as the only option tomitigate risks. There can be different alternatives under

“operationalhedging”witharangeofvariouscosts.Thispaperprovidesclearguidanceon

how to assess these alternatives from a cost-effective perspective. Only after having

investigated each and every possibility related to operational hedging methods in

conjunctionwithcriticalfinancialdecisions,acompanycanconcludewithasubstantialbasis

that the restof theexposurewillbe subject tohedgingvia financial instruments,which is

themainfocusofthispaper.

Subsequently,thispaperpresentsallkeystepstobetakeninordertodesignaneffectiveFX

riskmanagementpolicyincludingthedefinitionofFXrisk,purpose,scopeandobjectivesas

wellasquantificationofexposureandvarioushedgestrategiesbasedonthenatureofthe

risk.

In termsof scoping, it is concluded that it isnotpossible tohedgeeverythingdue to cost

restraints. For instance, in some countries, hedging costs can write-off the profit of the

35

business;thus,itmightbewisetochoosenottohedgethe(whole)exposuredeliberatelyor

to make use of local solutions for less liquid currencies instead of executing the

requirements of a general policy. Thus, the determination of scope is quite important in

termsofgettingefficient results.Thispaperpresentsa fewsuggestionsaswellasasetof

questions,whichwillprovideaclearguidanceonscoping.

Inobjectivespart,itisarguedthatregardlessofmethodsorscopetobeadopted,oneofthe

foremost objectives of the Policy is the reduction of the volatility in financials to ensure

sustainable growthand return for stakeholders aswell as general riskmanagement gains.

However,eachcompanyhasdifferentfinancialKPIs,thusitisconcludedthatthereduction

of the volatility can be considered for different items of financial reports, like earnings,

EBITDAorEBITAandincludedinthePolicyinthatway.

Ultimately,thepaperprovidesanoverviewoftheissuesassociatedwithunderstandingand

managing FX risks by maintaining basic but realistic examples from corporates. In that

respect, these examples show 5 different scenarios, in which the parent and subsidiary

hedge different types of exposures partially or fully. The outcomes are represented in

operating profit. At the end, although Scenario 5, which requires hedging of both

transactionalandtranslationalexposures,givesthebestfinancialresults,itisconcludedthat

itisnotviablebecauseof(i)beingnothedgeaccountingfriendlyasexplainedaboveand(ii)

timegapfortransactionalexposuresbetweenanticipationandrealization.Consideringthe

imperfectionsinrealworld,prioritizingthetransactionalexposuresincludingintercompany

transactionshavehigherpotentialtogivebetterresults,ifnotperfect.

FX currency risk management is not a recent concept; thus, it is possible to find many

researchpapers,booksandarticles focusingondifferentpartsof it.However, this paper

provides a comprehensive step-by-step, practical guide to design an effective risk

management policy by combining the academic and the practitioner’s perspective. It also

questionswhetheritisnecessarytobringafreshlooktocertainconceptsandrulesrelated

toFXriskmanagement,whichhavealreadybeenknownanddiscussedformanyyearsand

not changed a lot. Finally it aims to structure a framework by touching all the relevant

practical matters as well as providing academic proof for recommendations given. In that

respect,itisimportanttoperceivethatitisnotpossibletorecommendoneverykeystepsince

eachcompanyhasdifferentdynamicsandthispaperisnotwrittenforaspecificcompany.In

order to address majority of MNCs, the aim of this paper is to provide all the relevant

36

informationinapracticalway,createawarenessofdifferentapproacheswhilechallengingthe

generally-acceptedrulesandyet,torefrainfromgivingstrongrecommendations.Ultimately,

thepolicyofeachcompanywillbetailor-made.

37

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