Foreign Currency Hedge Strategies

One of the questions that a firm has to address before setting FX rates in their budgeting process is to determine their risk appetite. In other words are they:

1. Risk Averse – You are firm that utilizes basic hedging instruments to ensure that you protect your profit margin or manage your input costs.
2. Risk Seeking – You are firm that utilizes more complicated hedging (options) that gives you the ability to participate in the market moving in your favor. There are potential costs in terms of premiums with this type of attitude.

Once you determine the above than you are in a position to determine your “budgeted rates”. The budget rate that you set should be somewhat realistic to the current market. As an example, you might want to utilize a 100 or 200 day moving average as a basis for setting your budget rate or as simple benchmark. Review your past results to determine where you rates should relative to the market. This is something that is overlooked by firms when they are looking to set their ideal budget rate.

“Budgeted rates” should not be the only driver/variable in the hedging strategy. One has to measure the overall exposure involved, the market (economic) and country (political) risk for that particular currency, instruments that are going to be utilized and what is the risk appetite of your firm (as I mentioned earlier). Given the volatility today’s financial markets more and more firms have to consider contingency plans if their budget rates are not met or completely out of the money. Therefore, having rates that work with your business model is critical.

Many firms or individuals sometimes get caught in the game of trying to time the market. This is wrong game if you are corporate treasurer but the right game if you are prop trader at a financial institution. The rates you select have to work with you business in order meet the earnings expectation of your firm. At the end of the day CFOs want predictable cash flows from the goods or services the firm is selling.

To quickly summarize, understand your exposure and risk (risk seeking/averse), set budget rates, create strategy around budge rates, execute and evaluate and monitor your results. I hope I have given you enough general guidelines to allow you to focus on setting your “budget rates”. Without getting to know specific information about a firm it can be difficult to provide a specific solution.

Just a quick add for field - not overall corporate as addressed above.

For our field operations, as we did not give them to tools to manage the F/X exposure, therefore we used a flat F/X rate for the entire year to measure their performance versus budget. This prevented gains/losses by F/X and avoided a load of arguments (on both sides of the table).

We did rely upon the operations to provide adequate information to corporate to allow us to manage the F/X position. We put the compliance and accuracy of the information as a component of the divisional executive incentive plan - the better the data, the more of their bonus was paid. Not surprisingly, we got better information.

Consistent with comment by Mark. Set one rate for the year, however there had to be CONSISTENCY with the assumptions. My business was insurance thus inflation (claim growth) and interest rates (return on assets) were also significant variables. Thus in an environment with 10% inflation we would have to consider certain level of fx depreciation consistent with this inflation level and an interest return on the investment portfolio consistent with the 10% inflation.

We usually started with a research firm projections (back then it was WEFA - Walton Econometrics Forecasting Association). Most of the country managers bought on these assumptions. We had one country which preferred their own forecasting assumptions, and we agreed as long as the different variables were consistent as mentioned in the first paragraph.

We only hedge transactional issues (i.e., sale of a subsidiary or new investments) and did not hedge operational earnings.

Consistent with comment by Mark. Set one rate for the year, however there had to be CONSISTENCY with the assumptions. My business was insurance thus inflation (claim growth) and interest rates (return on assets) were also significant variables. Thus in an environment with 10% inflation we would have to consider certain level of fx depreciation consistent with this inflation level and an interest return on the investment portfolio consistent with the 10% inflation.

We usually started with a research firm projections (back then it was WEFA - Walton Econometrics Forecasting Association). Most of the country managers bought on these assumptions. We had one country which preferred their own forecasting assumptions, and we agreed as long as the different variables were consistent as mentioned in the first paragraph.

We only hedge transactional issues (i.e., sale of a subsidiary or new investments) and did not hedge operational earnings.