In a Deloitte survey of treasury groups, 52 percentof respondents cited foreign exchange (FX) volatility as theirnumber-one strategic challenge. Meanwhile, a Wells Fargo survey reported that 43 percent oftreasury and finance professionals think market volatility,combined with the effects of volatility on hedging decisions andstrategy, forms their greatest FX risk management challenge. Thiscomes as little surprise, given trends in currency markets inrecent years.

Over the past five years, the trading range of the U.S. dollarvs. many other major currencies has swung widely. Consider, forexample, the Brazilian real: BRL220,000 was equivalent toUS$100,000 in 2014, but less than US$53,000 in 2018. So a companythat earned US$100,000 in real-denominated revenue when exchangerates were favorable would have seen the same revenue devalued tobe worth just over US$50,000 when FX rates were at their worst.Businesses with revenues and/or expenses denominated in foreigncurrencies, such as U.S.-based software companies sellingapplications in euros in Europe, or U.S. manufacturers using MXN topay for components they buy in Mexico, are finding it impossible toforecast results or analyze investments with an acceptable level ofaccuracy.

Leading multinationals have long dealt with currency challengesby implementing sophisticated FX risk management strategies. Thesecompanies may be hedging 20 currencies at a time, placing thousandsof derivatives trades each year. Their risk management processesare effective, but they're possible only because of the sheer scaleof the organization. The advanced technologies these organizationsrely on represent a significant investment in terms of both dollarsspent and staff resources required for implementation and ongoingmanagement.

The thousands of small to midsize businesses (SMBs) racingtoward globalization each year do not have access to the same FXrisk management capabilities that multinationals employ. Once theyarrive in the international marketplace, SMBs are confronted by theimpact of foreign currencies on their sales, procurement,investment, and capital-raising activities. They don't requiresolutions that are as complex as a multinational's, but SMBs doneed to address FX risk up front. And there's a lot they can learnfrom the well-established currency programs at largerbusinesses.

Smart SMB treasury groups develop their own, customized versionof multinational FX risk management strategies, incorporatingrelevant best practices on a scale that makes sense for theirorganization. In building their own approach to currency riskmanagement, SMBs should focus on three goals:

• Defining specific, consistent objectives,
• Understanding and prioritizing exposure types, and
• Implementing a common workflow with practices tailored tocorporate objectives.

How to Effectively Define the Program's Objectives

A company's FX risk objectives should be consistent with itsfinancial and competitive objectives. For instance, a technologycompany that is going global might be relatively young, so itsinvestors may be focused primarily on top-line growth. In contrast,a mature company entering its first overseas expansion might beevaluated mostly on operating margins or net income. And a highlyleveraged business or a regulated financial institution is likelymost concerned about how FX impacts its leverage, liquidity, andcapital ratios.

Organizations that are newly launching global operations shouldselect one or two specific desired outcomes for their currency riskmanagement. Then, they should use these desired outcomes to set theobjectives for their currency risk management program and to buildthe foundation on which they develop the program.

The FX objectives that an SMB selects should reflect coredrivers of its organizational well-being. They should also bespecific, practical, relevant, and efficient. Avoid vaguestatements such as “We seek to mitigate the impact of FX on ourfinancial results.” Generality causes confusion and allows room fordisagreement about whether an objective is met. For example, theboard may take a dim view of a 5 cent-per-share FX loss, whiletreasury views that outcome as a success because the hedgingstrategy mitigated what would otherwise have been a loss of 9 centsper share. To avoid this type of situation, the objectives of an FXrisk management program need to clearly state what stakeholdersexpect.

Here's one example of an effective objective: “An unfavorable FXimpact is a deterioration in earnings-per-share contribution ofrecurring foreign-currency revenues and expenses as a result of FXmovement. We aim to contain unfavorable FX impact on earnings toUS$0.02 per share year-on-year. We will execute our strategy todeliver this result 95 percent of the time.” Obviously, this is anambitious goal. However, the statement itself is specific andeasily understood.

Setting clear, measurable objectives enables the treasurydepartment to:

• Articulate the processes, activities, and support required toachieve each objective;
• Rationalize the value of objectives against the investmentrequired to achieve them; and
• Build performance reports that identify success—or failure—andtherefore any necessary modifications to policies orprocesses.

Although initial objectives might be clear and achievable, theycan easily unravel with flawed performance benchmarks. Inparticular, take care not to introduce bad tactical objectives togood strategic objectives—for example, setting FX rates in thebudget that are unobtainable given current market conditions andexisting hedge rates.

Companies use budget rates to convert forecast amounts to theirreporting currency. Suppose Company X has a sales forecast of EUR1million that it converts to US$1.2 million in its corporatefinancial plans based on a budget rate of EUR-USD1.20. Perhaps thecompany used its bank forecasts to set the budget rate, which is apoor practice but quite common. If Company X has not executed anyhedges at 1.20 or better, and the market rate for hedgeing forecastexposures is lower than 1.20, risk managers face an irreconcilableproblem that leaves them helpless to deliver a predictable outcomeat a rate that achieves the budgeted performance in their reportingcurrency.

How to Understand and Prioritize Exposure Types

Companies view FX risk through the lens of their functionalcurrency. So, an organization that uses the euro for financialreporting takes on FX risk anytime it engages in revenue- orexpense-generating activities denominated in a currency other thanthe euro.

To optimize their FX strategy, organizations that docross-border business need to identify which exposure types havethe greatest impact on their specific financial objectives. Thenthey should limit their strategy's scope in order to control theimpact of those exposures. Strategies typically congregate aroundthese prominent sources of exposure:

• Transaction—forecast exposure. FXswings can reduce the functional-currency value of forecastedforeign-currency revenues or increase the value of anticipatedcosts for transactions that will be conducted outside of theorganization's functional currency but that are not currentlyreflected on corporate financial statements.
• Transaction—balance-sheet exposure.Exchange rate volatility can also lead to losses on the corporatebalance sheet related to monetary assets or liabilities denominatedin a foreign currency, when the value of those assets orliabilities is converted back to the functional currency.
• Translation—net equity (investment)exposure. Companies that own foreign subsidiariescould face financial losses on their equity balance caused byexchange rate movements.
• Translation—net income exposure. Manyglobal organizations face potential losses due to FX fluctuationsas they convert earnings denominated in foreign currencies into theparent company's functional currency.

Figure 1 indicates the impact each type of exposure could haveon a company's financial objectives, by clarifying the corporateperformance metrics that might be affected. For instance,objectives such as net income, cash flow, and liquidity areimpacted by balance sheet transaction exposures (as highlighted inblue). Corporate treasury teams can use this information totranslate their FX program's objectives into priorities forspecific risk-mitigation activities.

Some of these areas are impacted by FX across multiple exposuretypes. It's worth noting that the impact of the different exposuresvaries in magnitude. When prioritizing, the treasury team needs todetermine not only which exposure types could affect organizationalobjectives, but also by how much. The source of currency risk thatis most top-of-mind, even for treasury, is not necessarily theexposure that poses the largest risk to the company's objectives.Figure 2, below, provides an example.

For Company X's finance team, the most obvious FX exposure isthe portfolio of accounts receivable (A/R) that is denominated ineuros. Because Company X is a U.S.-based business, this A/Rbalance—along with all other monetary assets that areforeign-currency–denominated—must be re-measured in U.S. dollarsfor financial reporting purposes. In a year where the EUR-USDexchange rate declines from 1.20 to 1.10, the value of the EUR1million A/R portfolio declines by US$100,000[1], and the company must record this amount as anFX loss.

But analysis by Company X's treasury team reveals that thisisn't the greatest FX risk to the company's economic value. Supposethat the company's average customer payment cycle is one month. TheA/R balance of EUR1 million per month implies that the company hasEUR1 million in monthly sales. Thus, the company budget anticipateseuro-denominated sales of EUR1 million, which rolls up to theUSD-denominated corporate budget as US$1.2 million in monthlyrevenue using the EUR-USD budget rate of 1.20. The decline in theexchange rate to 1.10 would reduce the value of this sales revenueby US$600,000 over the course of the year.[2]

How to Establish an FX Workflow

Whatever the scale or complexity of an FX risk managementprogram, success requires that the program feature a robustworkflow of activities that act as universal building blocks. (SeeFigure 3, below.) The workflow must encompass five core steps:

1. Exposure aggregation. Good exposureaggregation requires ready access to the most current data andenables useful analysis for decision support by answering thesequestions:

• Which currencies are causing exposures?
• How does each exposure impact our financial objectives?
• Which entity is exposed?
• When will each exposure impact corporate financialresults?

By aggregating exposure data using this information, companiescan analyze the potential magnitude and timing of risk, based onthe type of exposure and currency involved.

The starting point and key focus for data aggregation is theexposure type. That's because each exposure type has a uniqueimpact on the company's financial performance, as well as its ownunique hedging strategies.

Each exposure type indicates the appropriate data source forthat exposure. Understanding where data exists within the companyis the first step to successful, accurateaggregation. Some balance-sheet exposures can be found inthe enterprise resource planning (ERP) system, treasury managementsystem, or company banking platforms. Other exposures, such asnon–functional-currency forecast revenues and expenses, aren'tavailable in most ERP systems, so the treasury team may have toconduct a global survey using spreadsheets, databases, or email togather forecasts. For organizations with the budget, there aretechnologies that facilitate a streamlined process in whichbusiness units can submit their own dynamic forecast updates whenthey need to amend data they've submitted.

2. Exposure analysis. There areseveral ways to produce exposure analyses; the most commonapproaches include net notional exposure, simulation, andsensitivity analysis. Corporate treasury and finance professionalsshould be familiar with each of these methods. Other possibleapproaches include “earnings at risk” or “expected shortfall,” bothof which are more complex to compute but provide additionalinformation that treasury staff can use to assess the severity andthe probability of losses.

Whichever approach a treasury team chooses, the analysis shouldbreak down risks by exposure type, with the goal of pinpointingwhich exposure types and currencies pose the greatest risk to theorganization's objectives. If, for example, the company isprimarily concerned with year-on-year variability in earnings pershare (EPS) that may result from FX movement, then aggregating andanalyzing by exposure type can reveal whether EPS is impacted moreby balance-sheet or forecast transactions.

This information, in turn, enables the treasury group toprioritize their hedging strategy. If the analysis shows thatforecast exposures have the greatest impact, treasury can net andanalyze forecast exposures by currency pair to prioritize whichcurrencies they hedge. Note that whatever approach the companyadopts, every analysis must consider net amounts. If the companyforecasts EUR1 million in revenue and EUR600,000 in expenses forJune 2020, the net FX impact must be calculated based on the netEUR400,000 the business expects to receive that month.

Exposure calculations must also consider the timing of when thetransaction—either revenue or expense—will be recorded on thecompany's financial statements. Timing is crucial in determiningthe net exposure in each period. Getting the timing right helpsensure that hedges associated with a specific item on the forecastwill “settle” (mature) in the same month that the associatedrevenues or expenses are reported.

The end result of the processes of aggregating and analyzingexposure data should be to generate a side-by-side analysis bycurrency for each exposure type. As an example, Figure 4 shows thenet forecast exposures of Company Z, broken out by the differentcurrencies in which the company does business.

It's worth noting that a heat-map analysis can also identify thecurrencies that present the most significant total exposure for acompany. However, heat maps do not indicate how or when theorganization will be exposed. Instead, they simply draw attentionto those currencies that might have the largest overall impact oncompany value.

3. Hedge execution. Financial marketsare complex, sometimes counterintuitive, and opaque. The bestapproach for executing FX hedge transactions is to keep itsimple.

One key to effective execution is to measure everything twice.When implementing a hedging strategy, execution errors—such asusing the wrong amount, direction, or currency—can be very costly.Treasury teams can help mitigate this risk by following theseprotocols:

• Check and recheck the amount, currencies, and exposuredirection (receiving or paying) prior to executing atransaction.
• If possible, create a trade authorization process that requirestwo individuals to review each transaction and confirm that thecorrect instruments will be executed.
• Most companies don't hedge 100 percent of an exposure,particularly if it is subject to forecasting uncertainty.

Another important policy is to ensure that all hedging decisionsare highly disciplined. Many companies make the mistake of tryingto predict currency fluctuations. A disciplined, periodicapproach—such as hedging a consistent, predetermined portion of thecompany's exposure each month or quarter—is far more likely toprotect against currency-related losses in the long term. Such asystematic FX risk management program helps protect companiesagainst the risk of locking themselves into unfavorable forwardrates.

Finally, the treasury team needs to monitor the suitability oftheir hedges on an ongoing basis. Execution should be continuous,not episodic, and plans should be flexible when exposures change.For instance, forecasts might need to be amended if expectationsfor organizational performance change—at which point the companywill need to re-evaluate its existing hedges.

4. Financial reporting. The financial reporting requirements for hedgeaccounting were recently simplified by the Financial AccountingStandards Board (FASB), but they still require interpretation,rigor, and administration. To manage the complexity of financialreporting for hedges, treasury teams need to simplify their hedgingactivities. Prioritizing which exposure types and currencies mustbe hedged to achieve the company's objectives is an important stepin that direction. Adopting a robust technology platform thatautomates and standardizes reporting requirements can also greatlyhelp the goal of simplification.

Treasury and finance teams that need help managing the financialreporting of hedges can seek guidance from a subject matter experton financial reporting to establish an accurate and concise processfor accounting for each type of hedge (i.e., the hedge associatedwith each FX risk management objective) the company uses.

5. Performance evaluation. The two keyelements of evaluating the effectiveness of an FX risk managementprogram are compliance and results. The treasury team shouldconduct compliance reporting at least monthly to determine whetherthe strategy is being executed as intended. For example, theyshould check to ensure that the portion of exposures being hedgedfalls into the range required by corporate FX risk managementpolicy. (Violations might occur because hedges were poorly executedor misallocated against exposures at the wrong entity, or becauseexposure forecasts changed causing hedge ratios to fall out ofcompliance.) They may also need to check compliance with policiesaround counterparty risk, hedge tenor, instruments utilized, andauthorizations. Ideally, the treasury team will be able to seecompliance reports in real time so that it's immediately clearwhether aggregated exposures are up to date, hedges have beenexecuted in accordance with the company's strategy, and activitiesare being completed as intended.

It's also important for treasury to report at least quarterly onthe results of the hedging program, to identify whether thestrategy and execution are meeting the FX risk management program'soverall objectives.

When compliance reporting shows that hedges aren't following FXrisk management policy, or when results reporting shows that hedgesare underperforming in terms of effectiveness at mitigatingexposures, treasury can take corrective actions. Compliance reportsare most valuable as an alert to oversights, which FX risk managerscan easily correct. Results shortcomings might indicate a moreserious misalignment between FX objectives and risk managementactivities.

The Art and Science of FX Risk Management

Establishing a best-practice strategy for FX risk management isboth an art and a science. The art lies in matching the right riskmanagement objectives with robust practices that support thecompany's currency strategy. The science lies in executing thoseactivities reliably and efficiently so that the currency strategysupports overall corporate financial objectives.

Supporting a good strategy with good technology can improveresults by increasing efficiency, accuracy, and communication.Companies that adopt appropriate tools are able to do more withless by expanding their risk management activities to address moreexposures and currencies, while increasing accuracy and reducingthe amount of employee time that FX risk management consumes. Theadoption of risk management technology has the added benefit ofcentralizing and institutionalizing knowledge of the FX riskprogram. In short, it can reduce the risk of execution errors orinformation gaps caused by staffing changes.

Chuck Brobst is managing director of theanalytics division at OANDA Global Corporation. He is also anadjunct professor of finance at DePaul University in Chicago, wherehe teaches graduate courses on enterprise risk management andcommercial banking. Prior to joining OANDA, Brobst launched astartup in the financial technology space, having previously servedas an executive in the global markets divisions of Bank of AmericaMerrill Lynch and ABN AMRO Bank for 15 years.

[1] A/R beginningbalance of EUR1 million x budget rate 1.20 = US$1.2 million. A/Rending balance of EUR1 million x actual exchange rate of 1.10 =US$1.1 million. The change is recorded as an FX loss during theyear—US$100,000 for the year, US$8,333.33 per month.

[2] The total exposurefor the year is EUR12 million in sales. Meanwhile, the averagedepreciation of euros over the year is US$0.05 per euro—thebeginning EUR-USD rate is 1.20, and the average rate over the yearis 1.15 [(1.20 + 1.10)/2]. Therefore, the average loss to forecastsales will be EUR12 million x US$0.05, or US$600,000.