Gaining insights into the accuracy of historical forecasts by currency can help determine whether the future forecasts provided are reliable and actionable. This historical trending of forecast variance over time should not be confused with an absolute measure of forecast variance. While forecast variance reports are typically the difference between the most recent forecast and the actual outcome, forecast variance trend analysis is achieved through rules based matching of actual events against all historic forecasts of those events going back in time through each prior forecast cycle. This gives rise to a plot showing the history of variance for each forecast back to when the first forecast was made for a particular event or combination of events. Irrespective of the forecast methodologies adopted to predict the currency flows that are expected to be generated or absorbed across the business, historic trending of forecast variance over time can be the key to deducing the instrument and/or instrument tenor to mitigate the liquidity and FX risks arising. While episodic events can always disrupt future predictions, this approach gives a confidence measure to determine how far out from the event horizon a forecast currency position can be deemed reliable for action to be taken. The benefits of getting this right are clear:

Effective hedging of future earnings without need for multiple "repairs" to offset mistakes.
Greater yields on investments due to their longer tenor without incurring losses through early breakage due to unexpected liquidity shortfalls.

In conclusion, with continued FX volatility expected and with the back drop of interest rate uncertainty and geopolitical tensions, putting in place an effective cash flow forecasting program underpinned by reasonable economic assumptions is key in the implementation of an effective liquidity or FX risk management program. Systemic visibility over future cash flows and currency positions by future date can then enable identification of natural offsets and opportunities for internal hedging and thereby reducing overall external hedging costs. Historical Forecast Variance Trend analysis is the key to determining the correct next action in the market to hedge or invest effectively.

Instant Insights /

The Use of Cash Flow Forecasting as a Risk Management Tool

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