How to formulate an FX hedging policy for a corporation?
Sometimes we just have to stop and go back to basics. For those who have a deep hand in the FX risk management making and those who get on the cart: what are the five most important things to do and make sure they exist as a prerequisite for effective FX risk management policy for corporate?
My top 5:
- Define an FX hedging policy
- Set budget rates or other reference rates
- Create cash flow exposure forecast
- Manage a high-quality book of executed derivatives
- Consolidated management reports and charts
1. Define an FX hedging policy
The fact that you are reading these lines while still holding your day job means you do not know where an exchange rate is going. Don’t feel bad about yourself because no one knows.
What is hedging policy meaning, and why do you need one?
So everyone will be on the same page as you and understand why you do what you do. And if anyone has something to say, speak now or forever, hold your peace. The policy-making process can turn into exhausting conversations and drag down to inapplicable philosophy thrown into the air. So you all try to transcend yourself and do not try to reinvent the wheel.
Foreign exchange hedging policy example
What is the best practice?
Almost all currency risk management policies have two common denominators: Hedging time horizon and hedging percentages for each time horizon range.
For example:
In this corporate hedging policy example, the hedging time horizons are one year at all times, and the hedging percentages decrease over time. Many corporations feel comfortable with hedging percentages decreasing over time because a long-term exposure forecast is less certain (someone heard of Covid-19?) and many other reasons.
Or
A fixed hedging percentage. If the corporate has a high degree of certainty regarding the exposure forecast, a fixed hedging percentage can also do the work.
This hedging program is a one-dimensional decision. That is, a hedging percentage is only a function of time.
Two-dimension FX hedging policy:
In this type of FX hedging policy, the hedging percentage is a function of two variables — for example, time and the spot rate at the moment of hedging transaction execution.
Foreign exchange risk management policy template
Currency hedging policy for corporate who exposed to the depreciation of the EUR against the USD
Here is an FX hedging policy template to predefine the required hedging percentages for each possible future spot scenario and for each time segment.
2. FX budget rate ≠ wishful thinking rate
Yes, Excel can bear every rate you put in. But don’t go there.
Do not rely on analysts and other “celebs”. The fact that they are well-worded and well-dressed does not mean that they know where an exchange rate is going. No one knows!
What to do? Simple! Set a budget rate that was defensible once you set it.
What is a defensible rate? The rate you could theoretically lock-in if you were executing a series of forward transactions based on the predicted exposures. That is the starting point.
There may be technical adjustments as a result of hedging transactions already in place for the exposure period. In such a case, you will simply set the budget rate as a weighted average that considers the hedging rate of existing hedging transactions, on the one hand, and the forward rate concerning the unhedged exposure.
For conservative reasons, some companies take a slightly “worse” forward rate, to this calculations, than the rate that the market shows when setting the budget rate. I, personally, for it.
3. Exposed cash flow
Producing a currency exposure forecast is not an outsourced task. The natural thing is that the people in the company’s finance department are the ones who will make this forecast.
Some highlights to keep in mind when preparing your forecast:
- The target “bottom line” is the net exposure forecast.
- Exposures “in disguise” must be taken into account. For example, payment made in currency X, but it’s actually linked to foreign currency Y. that is, the exposure is to Y. Make sure you don’t miss it.
- Sometimes a company can roll over its exposure on customers after a few months. That should affect the hedging horizon.
4. Derivatives book
Here you will save all the transactions you have made.
Chances are you will use an Excel sheet or Google Sheets. The more time you devote to planning and building this “book”, the easier it will be for you later on.
Some highlights to keep in mind:
- Make extensive use of “Data validation” (drop-down list, tick box, etc.), conditional formatting that will alert you for non-logical input.
- Minimize the use of free text.
- Think about the reports you would like to receive in the future, and build the database that will allow this right now.
- Decide which fields are mandatory and which are not.
One step beyond that (complex application) would be to prevent users from directly accessing data. Instead, allow access only through forms. That is to create and edit records via forms, add timestamps, etc.
5. Consolidated reports and charts
Put your Excel / Google sheet skill to the test by creating tools to monitor the policy’s actual implementation. Create consolidate and premade reports and charts that will contain all the four sections above into one view (Policy + Budget rate + Exposure + Hedging transactions).
Get inspired by watching👉 this example
What didn’t get into my top 5 list?
FX Derivatives pricer
An important tool, but not necessarily a basic tool, is an FX Derivatives pricer. This tool will allow you to plan and analyze hedging alternatives before execution and get a real price benchmark. The FX pricer can also use for financial reporting if using the appropriate market data for the balance sheet date.
Shopping skills:
If you request a quote from X liquidity providers in the OTC market, you will receive X different quotes. Never work with only one liquidity provider. If he knew that, he would be ruthless. Even for the most straightforward deal, it is essential to compare prices with at least two liquidity providers. This section is not included in my top 5 list because it is a general life skill and not necessarily related to currency risk management.
How to get started? FX Risk Management System for Corporates
Daniel Eran, FX Risk Management for Corporates