From the September 2009 issue of Treasury & Risk magazine

All Eyes on FX Risk

Volatile currency markets and a blindness to some exposures were taking some nasty swipes at the income of $1.3 billion ADC, a Minneapolis telecommunications equipment company, in late 2008.

"We believed that we were doing the best that we could with our existing tools and resources," reports Jason Cohen, vice president and treasurer, "but as the market became more volatile we knew there were exposures on our books that we weren't finding or hedging. We have 3,000 [general ledger] accounts, and the only way we could have found those exposures with our old system would have been to go through all those accounts one by one. We didn't know exactly what we were missing as the environment turned more uncertain, but we knew we were not satisfied with the results." About 40% of ADC's business is international and it has exposure to approximately 60 different currency pairs.

So ADC turned to technology and last April started using FiREapps software to find all the accounts buried in the company's SAP accounting system subject to revaluation with currency changes and report them frequently. Once FiREapps reported the full exposure, Cohen discovered that "we had been missing about 30% of our exposures each month. And with a total exposure of $50 million to $60 million, that meant we were missing about $17 million of exposures when we did our hedging." That explained why ADC's net income had sometimes taken a revaluation hit. With greatly improved visibility into exposures, "we were able to improve the effectiveness of our hedging substantially, and we couldn't have done it without the new system," he says.

ADC uploads files from SAP to FiREapps, a hosted solution that provides foreign exchange exposure analytics and reporting. With the exposures identified, Cohen calls FX trading desks and buys the hedges he chooses. ADC's hedging strategy has not changed fundamentally, but now that Cohen is shooting with 20/20 vision, he regularly hits the target. ADC gets not only more complete, but more frequent visibility into what can be moving targets. The old system, a homegrown spreadsheet tool, collected limited information on a monthly basis. The new system, which provides reports on demand, allows Cohen to hedge more dynamically and make adjustments within a given month.

Like ADC, many companies are finding that turbulence in the currency markets requires new tools and tactics. It's easy to say more volatility calls for tighter hedging, but in forward-looking hedging programs, it's a real challenge to know what to hedge when forecasts are fogging up due to faltering operations, says Beth Neesham, Philadelphia-based managing director and FX trader at PNC Capital Markets. "You can't hedge the exposure that will be created by a manufacturing plant in Mexico if you don't know what the production at that plant will be." The net result of that fogginess was a dramatic drop in FX hedging activity in the fourth quarter of 2008 and the first quarter of 2009, she points out.

With so much uncertainty about exposures, treasuries have shortened the duration of their hedges, reports Chris Bond, a managing director at HSBC Securities USA. "They're hedging more frequently for shorter periods and then rolling over the hedges to cover known exposures. They're executing strips of forward contracts that ladder in hedges over different maturities. And many are moving to outright currency options because of the tight credit markets." Longer-maturity forward contracts result in a higher rate of credit utilization, Bond explains. And treasurers don't want to over-hedge for fear of not qualifying for effective hedge accounting under FAS 133 rules. Not qualifying could create a potential cost, he notes.

"The volatility of currency movements and the impact on financial results come at a time when the operating environment is already difficult," says Phillip Harrison, managing director for FX sales and trading at SunTrust Bank. "Boards are asking questions they don't usually ask."

"A lot of companies are reviewing the effectiveness of their FX risk management programs," Harrison says. "They may have policies that approve the use of certain instruments, but now they're getting outcomes they didn't expect. So they're getting help in reviewing those policies and making adjustments."

Currency hedging has also been complicated by concerns about counterparty risk. "Treasurers didn't know which banks to deal with last fall, which contributed to the pullback, but things are returning to normal," albeit at lower levels, Neesham says.

The push to tap liquidity has increased companies' interest in repatriating funds held overseas, Bond says, and raised the value of protecting those funds from losses resulting from exchange rate fluctuations.

For currency hedgers, it has been a rough ride. Through the first half of 2008, the dollar was relatively weak and companies with overseas operations were enjoying strong translation gains from overseas revenue that wasn't hedged, Bond reports. Then the crisis set off a flight to quality that sent the dollar higher. "Many treasuries were unprepared for the speed and extent of the U.S. dollar rebound, and many took a double hit" as the exchange rate moved against them and revenue dropped when overseas sales softened because of the recession, he says.

But once treasuries gain confidence in the size of their exposures, they "want to remove any uncertainty due to currency fluctuation and lock in a sure thing," Neesham notes.

Rather than return to normal, treasury staffs need to rethink their whole approach to currency risk management, argues Wolfgang Koester, CEO of FiREapps, the Scottsdale, Ariz., provider of foreign exchange exposure management services. Decision-makers should consider the potential impact, not the raw exposure, he insists. "A gross exposure might be $300 million--you might be long that much to a particular currency," he illustrates. But depending on the currency, the potential impact on the company's revenue would be far less, perhaps $42 million, he suggests. "Then you consider how much to hedge and what it will cost you, perhaps a cost of $400,000 to reduce the $42 million potential impact to $18 million," Koester continues. "Then you should ask if that is the best way to spend that money, and typically the answer will be 'No.'"

Treasury staffs are trained to look for the largest gross exposures, not the largest actual risks, he says. "It's not unusual for a company to identify its six largest gross exposures and then spend the money hedging them. If they had complete visibility and analytic capability, they might see and address the ones that posed the greatest risk." Technology is now making that possible, Koester argues, and helping treasury staffs to see which hedges are really worth the cost and which ones are not.