What’s the value of saving your CFO from having to explain to analysts why a foreign exchange setback caused the company to miss its earnings numbers?
Addressing that question can go a long way toward helping treasury leaders succeed in the corporate beauty contests that determine whether, and how much, funding their hedging programs receive.
When making their case to fund hedging program improvements, treasury leaders “have it a little tougher because financial risk management is a zero-sum game if you go out long enough,” acknowledges Atlas Risk Advisory CFO Scott Bilter. “That said, there is value to reducing the volatility of your earnings.” While precise determinations of that value may require some subjective assessments, treasury leaders should keep in mind that CFOs prefer a stable amount of predictable quarterly earnings over time, as opposed to achieving the same total with wild fluctuations.
Strategic Treasurer managing partner Craig Jeffery says that quantifying the value of financial risk management programs yields several benefits, including bringing exposures into alignment with the company’s risk appetite and its corporate directives.
Quantifying and communicating the program’s value also helps prevent internal business units and functions from viewing hedging as a speculative endeavor. Colleagues outside of the treasury group, “including some finance people, may work against a risk program by indicating ‘If we hadn’t hedged, we would have had better financial performance,’” Jeffery notes. “The process of communicating the risk management activities and quantifying the results provides a refresher to executives. The purpose of hedging is akin to having insurance.”
Treasury leaders should communicate the value of their financial risk management program to all levels of the organization. “Financial risks should be understood and agreed upon by both first and second lines of defense, and align with the broader company strategy,” notes Ernst & Young LLP principal Peter Marshall.
Value calculations can also set the stage for making process- and automation-related improvements to hedging programs, says Bilter, who stresses that the primary benefit relates to reducing negative earnings per share (EPS) impacts. “Probably the biggest piece of the value determination is the calculation of potential impacts to earnings based on volatility reduction,” Bilter says. “If you can show EPS improvements with a better risk management program, that should be very valuable to the company and investors who can’t do anything about that risk on their own.”
Finally, it is important to avoid common mistakes when calculating and communicating the value of financial risk management to the rest of the organization.
One potential misstep is to assume that getting senior leadership teams up to speed on hedging programs automatically translates into their ongoing understanding and support of these activities. “The core points of financial risk management must be covered repeatedly, for their benefit and for your protection,” Jeffery asserts. “Those who don’t live in financial risk management tend to forget key elements of it quickly if this learning is not reinforced.”
Bilter warns that forward-points costs are ripe for misunderstanding when assessing the costs and benefits of hedging activities. In balance sheet hedging, forward-points costs or benefits are part of the hedge, while there is no offset on the remeasurement side. This is purely a function of the interest-rate differential between the currencies being hedged, Bilter notes, reflecting the difference between the spot rate and the relevant forward rate to the hedged date. “This may be a cost or a benefit to the company,” he adds, “depending on whether the company is a seller or buyer of the higher–interest-rate currency to a future date.”
When it comes to quantifying a hedging program’s value, it pays to calculate carefully and communicate continually.
- October 2022 Special Report
- To Hedge or Not to Hedge?
- Getting Back to Natural Hedges
- 3 Quick Fixes for Hedging Efficiencies
Eric Krell’s work has appeared previously in Treasury & Risk, as well as Consulting Magazine. He is based in Austin, Texas.