Treasurers should take into account certain key considerations when designing an appropriate foreign exchange (FX) treasury policy. Corporations are exposed to fluctuating FX rates from increased trade flows, outbound M&A growth opportunities, expansions, and access to foreign currency (FCY) borrowings. These activities will impact different areas of the balance sheet and cash flows in various ways, quantum, and frequency. Fluctuations in FCYs can have a material impact on a company's cost-effectiveness, profitability margins, and valuation of its international operations. An absence of an appropriate policy can leave a company exposed to negative outcomes.
An FX risk management policy/framework is essential
An effective policy should begin with a clear corporate strategy and objectives, as well as the identification of what are the key metrics that can demonstrate the successful execution of that strategy to its stakeholders – be it free cash flow, asset values, EBITDA, debt covenants (i.e. debt ratios, interest coverage ratio etc.).
Understanding a company's unique FX flows, assets/liabilities, and the related impact that currency movements may have on these key metrics, is essential in the design of a suitable risk management policy to ensure fundamental business objectives are not compromised by currency movements.
Recognising that it is both impractical and impossible to reduce currency volatility to zero, FX managers must prioritise the risks and put in place a policy and strategy that fits with the corporate's desired objectives, view, risk tolerance, and budget.
As businesses and the operating environment transform, so should the risk management policy to ensure it is fit for purpose and to help maximise shareholder value. However, this policy will not be the same for all and will be unique to each business.
Historical movement of implied volatility for selected currencies against the USD
The volatile nature of the FX market due to the changes in the capital markets, international trade, economic fundamentals, and political landscape has made it imperative for companies to take a disciplined and tested approach to managing FX risk. Prolonged periods of extreme FX movements are evident in the past and have contributed to significant volatility in companies' cash flows, balance sheet items, and profitability.
Data source: HSBC, Bloomberg. Please note: for illustrative purpose only, past performance is not a reliable indicator of future performance.
The absence of an FX management policy leaves a company unprepared to control the potential adverse effects of currency movements, potentially leading to increased costs, reduced market share, and lower profit margins
Continuous review, feedback and communication is required due to the changing corporate’s strategy, risk appetite and risk management goals, as illustrated below.
Adopting a risk management framework and the importance of governance
The risk management process is a framework for a corporate to assess its FCY exposure to risk (both threats and opportunities), and hence the ability to make timely, disciplined and informed decisions. Setting up an FX Risk Oversight Committee that spans across business units, disciplines, and levels within the corporate paves the way for better internal communication and buy-in of FX hedging programmes.
The FX Risk Oversight Committee may include the Chief Financial Officer (CFO), Treasurer, Assistant Treasurer, Corporate Controller, Director of Sales, Director of Tax, Head of overseas business unit etc.
Responsibilities performed by the risk oversight committee:
- Review cash flow forecasts and current exposure positions
- Approve and set delegated limits on position-taking and make decisions about new hedges to cover any open positions
- Examine the appropriateness of hedging instruments
- Set exchange rate levels to be used for pricing/budgeting decisions
- Review hedging programme performance
- Address hedging impact on accounting and tax issues
- Address treasury issues related to the currency settlement system
- ISDA, collateral agreements, and banking trading limits negotiation and implementation
- Implement systems for exposure identification, measurement, tracking, and quantification
- Formal documentation, update on treasury guidelines, and regular reviews of policies, controls, and performance
The absence of an FX foreign exchange management policy leaves a company unprepared to control the potential adverse effects of currency movements. This can lead to increased costs, reduced market share and lower profit margins. In order to avoid these negative outcomes, companies should develop and document a policy statement that describes the company's attitude, objectives, and appropriate responses when managing FCY foreign currency exposures.
Additional benefits of adopting a clearly stated policy include:
- Minimising any misunderstanding by establishing clear guidelines, involving senior management in policy formulation
- Integrated policy making in line with the firm's broader objectives, which leads to better and more realistic long-run strategies
- Establishment of a fair and transparent system for evaluating performance of treasury managers in their execution of the strategy
The treasury policy should clearly outline and explain the corporate's financial risk management objectives (i.e. its risk appetite/tolerance and corporate goals). Those responsible for the treasury function should ensure that the approved policies addressed in the FX treasury document are followed.
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