Building an FX program from the ground up
When a company initially evaluates FX hedging, whether due to organic growth, acquisition, or a change in the business model or ownership structure, fundamental risk management questions arise. These usually boil down to "Should we be hedging?", “How should we be hedging?”, and “Where does hedging fit in our organizational activities?” A thoughtful approach to answering these questions leads to a more resilient and effective program that you can adapt as your organization continues to evolve.
(Related insight: Read, "Case study: Creating an FX hedging program")
Outlining objectives and defining the risk footprint
Objectives should specify metrics you will manage, as well as whether your desired outcome is reduced volatility or reduced downside. Metrics will often vary based on private vs. public ownership but should contemplate the future needs of your organization along with any immediate goals. These metrics will drive the collection of relevant data to evaluate and quantify the risk footprint. A high growth start up might need to balance an organizational emphasis on revenue against setting a foundation to target margins.
Identifying tensions and constraints
There are inherent tensions and competing priorities in currency risk management. Risk is often presented differently from the parent view than from the subsidiaries’ perspective. Accounting risk and economic risk can also present conflicting challenges. The levers associated with increasing levels of risk mitigation will often translate to greater costs through administrative effort, trading costs, or automation requirements. While the tensions in a new program are often simpler at inception, anticipating future needs can save time and energy when complexities arise. For example, a company that is embarking on their first foreign-denominated sales contracts can evaluate contractual FX language to set a precedent for the types of risk sharing they will employ and a means of tracking them as they grow.
Making strategic decisions
One of biggest decisions surrounding a new hedging program is when to start. Too often, companies wait for a material FX impact to shock the organization into evaluating risk. While this prompts swift action, it also puts the company in a reactive mindset. Alternatively, a proactive approach to defining a risk management program and policy while the risk footprint is simpler and the exposures are less material can offer a more effective evaluation of objectives and risk tolerance levels outside of a crisis. Starting a program while the footprint is simple also allows for a better understanding of the ability to manage risk, which can help inform the types of risks your organization is comfortable introducing.
Strategic decisions will also include the level of risk tolerance, the tenor of the hedging program, the types of permitted products, and even the currencies and ratios to be hedged. Many of these parameters are defined by the level of risk reduction they achieve and are informed by conducting an analysis to quantify the total currency risk within the portfolio of exposures. The ability to achieve preferred hedge accounting treatment can also materially influence strategy. Often, private companies will choose to adhere to these more stringent constraints to ensure a seamless transition if they should go public in the future.
Making tactical decisions
Implementing a new hedging program includes mapping out centralized or decentralized roles and responsibilities, as well as economic and accounting workflows with an ongoing reporting cadence. Key activities will require some combination of people and technology resources, which may shift over time. Resourcing can be particularly challenging when global growth is a product of acquisition, where the landscape of technology tools and people resources changes dramatically overnight. But we’ve partnered with companies that have leveraged the change in resources to implement stronger risk management programs.
Communicating the program
Hedging programs impact a wide array of stakeholders in an organization, including treasury, FP&A, accounting, tax, legal, and business units. Clear communication across stakeholder groups, from the definition of risk terminology through the orientation to recurring reports and expected results, can ensure a program that benefits the broader organization and can respond to needs that arise from changes that occur outside of treasury. Some of the most successful risk management programs we’ve seen started with communication about financial risk and why not to hedge initially, but defined future triggers to take action.
Companies’ needs will evolve at different rates and will factor in different sets of objectives and constraints. But the one constant element in a successful hedging program is the alignment of objectives, strategic and tactical decisions, and program communication.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0187