Implementing a world-class cash flow hedging program in 10 steps
Corporates | Kennett Square, PA
Client Relationship Management
Corporates | Kennett Square, PA
To add certainty amid market volatility, geopolitical tension, and central bank actions, corporate financial organizations are increasingly starting new FX hedging programs, reviewing existing ones, and adding cash-flow hedging to avoid wide swings in key metrics, such as revenue, expense, operating income, margins, EBITDA, and net income.
Implementing these programs can pose challenges, however, because it requires forecasting future revenues, expenses, or capital expenditures — items that are not yet booked on the income statement but expose the company to forecast risk. Also, because your treasury team must work with various stakeholders to obtain forecast data, it often requires tight collaboration with other business units. This often adds complexity in terms of project management and technology support.
The following 10 steps provide a framework for developing a leading-practice program that aligns across the organization, avoids pitfalls, and achieves objectives.
1. Define the program objectives
To position your FX hedging strategy for success, start by defining what your program aims to achieve and how you will measure results. Consider questions such as:
- How does financial risk impact our overall financial position and how does our approach to managing it compare with our peers?
- What events or mechanisms will trigger the start of our cash-flow hedging program?
- How might our organizational structure, transaction flows, cash position, and tax burden impact our program?
- Should we base success on a quantitative metric, a qualitative goal, or both?
2. Quantify risk
Before you can take steps to reduce risk, you need to understand the total currency risk within your portfolio of exposures and identify the key risk drivers. Begin by aggregating foreign currency exposures from your various business units and validating their accuracy. Use this data to measure the margin risk your company is exposed to and assess its potential impact to financial performance in various FX market scenarios. With this analysis, you can refine your risk tolerance levels and priorities, confirm that your stated objectives can be achieved, and decide where to focus risk mitigation efforts for maximum efficiency and effectiveness.
3. Determine the hedging strategy
With your exposure profile and desired targets identified, next evaluate potential hedging strategies that will best align your program with its objectives. To identify a strategy that maximizes program effectiveness while minimizing the operational burden, delve into questions, such as:
- What is the magnitude and direction of currency exposures?
- Is data available with sufficient granularity to support economic and accounting decisions?
- Are there any natural offsets?
- How volatile are the currencies?
- Are there correlations that we should consider?
These discussions will inform strategic decisions, such as hedge tenor, ratios, instruments, and frequency. While economic priorities often serve as the primary driver behind a hedging strategy, applying hedge accounting to your cash flow program will align the timing of when hedge gains and losses are recognized with that of when the forecasted exposures impact earnings. Selecting the appropriate hedge accounting approach can maximize the flexibility and capacity of your hedging program while minimizing its P&L impact.
4. Assess the impact on treasury
From gathering and analyzing exposures, to executing and confirming trades, to settling trades and accounting for them, the cash-flow hedging process includes numerous touchpoints and data handoffs that must be timely and accurate. Understanding each of the functions in your program, along with the multiple systems and processes that support them (such as enterprise resource planning (ERP) systems, trading portals, cash management platforms, and even spreadsheets and phone calls) serves as a first step in identifying your hedging program’s impact on organizational people, processes, and technology. This assessment should also consider how your hedging program will impact how your business units measure performance.
5. Develop an ROI framework
To ensure your program meets objectives while operating cost-effectively, develop a framework to quantify the costs and benefits. This assessment should assess return on investment (ROI) holistically, including both the transaction and operational costs. Beyond determining whether the strategy is effective, this can identify areas for increased efficiencies and operational improvements.
6. Define a governance structure
Define processes and controls to ensure program oversight.
- How will users throughout the organization input and monitor data?
- How will you gather data for auditors and internal stakeholders?
- What controls and permission standards will you enact, so everyone can access the information necessary for their roles while the aggregate data is protected?
- Do you need a centralized repository where multiple users can input information, automatically monitoring your progress toward a full dataset?
Draft FX cash flow policy to memorialize program objectives and associated governance.
Reviewing and comparing your organization’s governance and policy documents against leading practices for risk management elevate the level of assurance that treasury can provide to senior management teams.
7. Identify KPIs and a monitoring mechanism
With objectives, processes, and controls in place, the next step is to outline the quantitative KPIs you will use to monitor effectiveness across the program. These should focus on key metrics that evaluate efforts to attain the desired risk reduction level. The goal here is to optimize your program throughout the process, so you can stay on track with program objectives. Once you’ve aligned on KPIs, think through the processes and tools you will need to support this monitoring program.
8. Develop an implementation roadmap
In preparation for executing your new hedging program, develop program implementation guidelines related to program launch, including strategy go-live, sequencing for key workflows, technology support, and associated timing. Map out clear roles and responsibilities for your centralized team and business units. Develop detailed workflow streams for the economic and accounting functions, including an ongoing reporting cadence. Remember that key activities will require both people and technology resources, which may shift over time.
9. Document procedures
Create detailed documentation that can serve as a playbook for your risk management objectives and strategies, along with how you will assess effectiveness at inception and on an ongoing basis. By developing a comprehensive process map, including how functional roles and processes should shift during specific crisis scenarios, your team can avoid lost time and critical errors.
10. Outline your change management plan
Hedging programs impact treasury, FP&A, accounting, tax, legal, and other business units, so it’s important to socialize your process across all stakeholders and align on the strategy. Clear communication across these 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 changes that occur outside of treasury. Define your approach for articulating the program objectives and impacts, making sure to consider ongoing business unit-level data gathering needs and performance measurement implications. Continue communicating between front, middle, and back offices to ensure the economic strategy aligns with financial reporting.
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.
Consider Resource implications
Given its high visibility, complexity, and impact on financial statements, cash-flow hedging programs often benefit from technology support and expert guidance to ensure leading practices and avoid regulatory pitfalls. This is especially true for lean treasury teams, who may not have this specialized expertise in house, and large organizations where data management can become unwieldy very quickly.
Chatham can provide expert guidance for all aspects of your FX hedging program, from strategic advice through trade execution to ongoing monitoring and support. We can partner with you to start a hedging program or review and enhance the effectiveness of your current program. To maximize your efficiency and flexibility, we provide operational support on executing FX hedges, with deep hedge accounting capabilities and best-in-class technology. Applying experience working with thousands of companies around the globe, we help you understand best practices in your industry, provide insights into how your peers are using FX hedges to minimize currency risk, and help you articulate your hedging strategy to all your stakeholders. To learn more or schedule an introductory call, complete the form below.
Download your playbook to get started
Ready to prepare your cash flow hedging program? Follow the 10 steps in our playbook.
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.23-0055
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