Managing FX risk in a strong U.S. dollar environment
Corporates | Kennett Square, PA
Fueled by widespread economic volatility, geopolitical uncertainty, and an increasingly hawkish Fed in the face of inflation, the U.S. dollar is the strongest it has been in 20 years. After companies became familiar with EUR-USD in the 1.20s, the currency pair has since plunged to below parity. This dollar strength broadly impacts U.S. companies by devaluing non-USD revenues from foreign subsidiaries, thus reducing earnings. Corporate finance teams are therefore increasingly focused on managing foreign currency risk and mitigating its impact on forecasting and strategic planning.
If your organization is concerned about FX risk, you likely fall into one of three categories. Below, we define the three most common categories companies find themselves in, along with recommendations for proceeding in today’s environment.
1. Considering a new hedging program
If you don’t currently manage your foreign currency exposures, the financial headwinds created by today’s dollar strength may have prompted you to consider a new FX hedging program. Rather than executing hedges as a knee-jerk reaction, use this wake-up call as an opportunity to develop a robust, thoughtful program that can benefit your organization long term. Consider fundamental questions, such as "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.
2. Adding a cash-flow FX hedging program
If you currently maintain a balance-sheet hedging program, you may be considering adding a cash-flow hedging program to address fundamental mismatches between revenues and expenses brought on by currency fluctuations. These impacts can be especially painful because they are reported under gross margin, which appears higher in the income statement than other income and expense. Because it can be difficult to forecast costs and revenue, especially in a foreign currency, implementing these programs can be challenging. However, a well-constructed program can deliver significant benefits, such as adding certainty to your forecasted revenue and expense and avoiding wide swings in earnings.
3. Reassessing existing FX hedging programs
Even if you have maintained an FX hedging program for years, today’s market may make you wonder whether your program is still functioning as intended. Perhaps underlying business changes, such as M&A or spin-offs, have altered your risk profile and challenged the assumptions on which your program is based. Objectives can also shift based on external factors, such as the competitive landscape, changes to your global risk footprint, or risk tolerance levels. Internal factors may also play a role, including changes in key personnel, initiatives to drive automation, or cost management. In this case, performing a holistic review of your FX hedging program can help you determine whether making strategic or tactical changes will improve program performance or reduce your cost of hedging.
Consider the cost of your hedge instruments
After weathering massive, unexpected changes to foreign currency exposures, many treasury and accounting teams are evaluating whether their programs still manage risk effectively and cost-efficiently.
For FX hedging, it often makes sense to reassess which currencies represent the highest risk to your organization and prioritize them for hedging. This can significantly reduce your risk profile without hedging every currency you’re exposed to. Understanding that you don’t need to reduce every risk to zero but rather narrow your band of outcomes to a manageable level, can provide both adequate risk protection and meaningful cost savings. With various financial instruments to choose from, including forward contracts, traditional options, and knock-ins/knock-outs, the volatile market can also change the cost — and therefore the value — of one instrument over another. For example, if your organization has euro exposure, option volatility, which drives option pricing, is at its highest point in five years on the EUR/USD. While this may make sense if you need to protect against a worst-case scenario, such as a cross-border acquisition that doesn’t close, it may be less attractive if you aim to create predictability for future earnings.
Reviewing and adjusting the tenor and horizon of your hedges can also enable you to adjust for a changing market environment and improve the cost-benefit equation. Additionally, your organization’s investments in people, systems, and work hours can represent a substantial portion of your program’s overall costs. Doing the work to quantify and manage these operational costs is a critical area for every treasury and accounting team to address.
Monitor your FX exposure
No matter which category your organization falls into, you can take steps to better manage FX risk. Once all stakeholders are aligned on the program’s goals and objectives, focus on quantifying your FX exposure and defining your risk tolerance levels and priorities. For exposure gathering purposes, integrating ERP systems and treasury platforms allows your treasury team to gather and consolidate balance sheet and cash flow exposures from ERPs at the local business level and streamline decentralized data gathering through system integrations. The automatic feed of exposure data from ERP systems enables your organization to make appropriate hedging decisions aligned with your objectives.
Adopt a reporting rhythm
The current market volatility has shone the spotlight on many companies’ FX exposure, leaving corporate treasurers to face tough questions from stakeholders both internal and external. To facilitate the process of informing those stakeholders in a concise and consistent manner, many companies are adopting automated reporting dashboards to provide periodic summaries. Such reports — often linked to internal data sources — can provide insight into hedge efficacy, counterparty exposure, hedge costs, MTM values, etc. These reports can also serve to streamline other post-trade processes such as hedge accounting.
A sound practice in any market, reviewing your FX hedging program to ensure it still meets its objectives is critical in today's strong-dollar environment. Talk to your relationship manager or complete the form below to learn how Chatham can support you in conducting an FX risk management program review.
Concerned about FX risk in today's environment?
Contact us to learn more about how Chatham can help you manage foreign currency risk.
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.22-0242
Our featured insights
The ChathamDirect homepage and notifications center
The new ChathamDirect homepage is designed to promote action, giving you one page where you can access market data, transaction data, system reports, quick links, and the latest insights from Chatham.
- Post Date
- Mar 27, 2023
7 ways to maximize FX and commodity hedging impact while minimizing costs
Hedge program costs can range from forward points, to trading costs, to fixed and variable operational costs that include systems and personnel. Program benefits often include risk reduction, operational ease, and favorable accounting treatment. This article will address leading practices and...
Chatham Financial upgrades ChathamDirect to support more adaptable financial risk management programs for treasury teams
Major additions include the industry’s first AI-powered Interest Rate Swap Loader and pre-built connectors for ERPs, TMS, and trading platforms to give true straight-through processing to every system utilized in treasury
- Post Date
- Nov 1, 2022
Video | ChathamDirect technology explained in 90 seconds
To navigate a complex, ever-changing economic landscape and protect more of your bottom-line earnings, your financial risk management system should support all your program objectives. Learn how you can streamline your process and unlock new economic strategies with ChathamDirect.
Buying treasury technology: all-in-one vs. best-of-breed
Managing corporate cash, liquidity, and risk in a volatile global marketplace requires treasury teams to invest in technology. While treasurers value technology’s ability to streamline processes and enable data-driven decision-making, the breadth of choices and overlapping capabilities can make...
Chatham's Q4 2022 outlook: Inflation, market volatility, and LIBOR transition
Watch Chatham's Managing Partner and Chair, Amol Dhargalkar, discuss key trends for the upcoming quarter like inflation, market volatility, and LIBOR transition.
- Post Date
- Sep 16, 2022
FX hedge execution: algorithmic trading considerations
While traditional phone and platform trading is still the most common approach for corporates hedging FX risk, interest in algorithmic execution has grown significantly in recent years. In this article, we’ll examine the fundamentals of algorithmic trading and assess the advantages and...
Performing a holistic review of your operational FX hedging program
Most companies engaged in operational FX hedging will perform at least a cursory annual review in accordance with specified policy requirements. That review often fails to include a holistic assessment of fundamental risk management questions, including “Should we be hedging?,” “How should we be...