Charity Finance Directors Group. Managing FX Risk. Andrew Derry Treasurer, Save the Children International. November 2011

Transcription

1 Charity Finance Directors Group Managing FX Risk Andrew Derry Treasurer, Save the Children International November 2011

2 Managing FX Risk Overview A. Design procedures and reports that enable FX risks to be identified B. Focus on those risks that are most likely to be realised C. Distinguish Financial from Outcome risks D. Investigate feasibility of hedging and/or other risk management techniques

3 A. Identifying FX Risks All budgets, and related reports, should clearly identify different currencies Base or home currencies should NOT be introduced (other than for consolidation purposes)

4 A. Identifying FX Risks (2) For example, a Euro grant in Nepal: Income currency = EUR Expenditure currency = NPR Reporting to Donors: Convert NPR expenditure into EUR using executed rate (wherever possible) Budgeting future activity: Set a budget rate for NPR v EUR (with reference to any hedging policy) to establish over/under funding

5 A. Identifying FX Risks (3) Note: NO reference to base/home currency (GBP for UK-based INGO, USD for US INGO, etc) Donors are not interested in base currency of INGO Any funding gap is fundamentally in expenditure currency (e.g. not enough NPR to fund programs, using budget NPR v EUR rate) Funding gaps can be consolidated into an INGO s base currency using snapshot (e.g. month-end) exchange rates

6 A. Identifying FX Risks (4) Be careful to ensure that deferred grant liabilities are correctly recorded, denominated in donor currency E.G. EUR cash paid in advance Balance sheet entries: Asset = EUR cash Liability = Deferred expenditure in EUR Mis-recording the currency of deferred grant expenditure can generate report FX gains/losses that are not real.

7 A. Identifying FX Risks (5) An interesting side-effect Country Office budgets can NOT sensibly be fixed in an INGO s base currency (unless all grants are in that base currency) For the Nepal Country Office in the example: The budget will be set in expenditure currency (NPR) The funding gap will be determined with reference to the donor currency (EUR) Budgets and funding gaps reported in base currency (GBP/USD) will change monthly with exchange rates

8 B. Prioritising FX Risks Not all exchange rate risks have the same financial impact It is important to set procedures that prioritise the management of risks that are likely to have a real financial impact

9 B. Prioritising FX Risks (2) Example a On 1 st Oct, INGO sells EUR 100,000 to purchase NPR 10million (i.e. FX rate = 100) NGO spends NPR 10million in October on programming activity, as budgeted On 31 st Oct, INGO reports activity to donor using month-end exchange rate at 110

10 B. Prioritising FX Risks (3) Example a (Cont d) Reported expenditure = NPR 100million / 110 = EUR 90,909 Reported underspend (and potential reclaim by donor) of EUR 9,091 INGO has used EUR 100,000, but can only report expenditure of EUR 90,909

11 B. Prioritising FX Risks (4) Example b On 30 th Sep, INGO has NPR 10million bank account balance snapshot in Kathmandu, valued at EUR 100,000 (FX rate = 100) On 31 st Oct, INGO again has NPR 10million in bank account, converted at the month-end rate of 110 this is valued at EUR 90,909

12 B. Prioritising FX Risks (5) Example b (Cont d) Balance sheet (reported in EUR) is reduced by EUR 9,091 QUESTION Are both losses equally important??

13 B. Prioritising FX Risks (6) Example a: This is a real loss, especially if the donor requires repayment of reported underspend. The INGO s unrestricted funds and/or reserves are at risk Example b: This is a revaluation loss, but will only be realised if the NPR is ever sold back into EUR highly unlikely if the INGO continues with business as usual, so the value in EUR of this in-country liquidity snapshot is largely irrelevant

14 C. Financial Risks versus Outcome Risks So far we have considered only financial risks from exchange rate movements Exchange rate volatility can impact on programming activity without any financial implications This occurs when the purchasing power of a donor currency changes with respect to the expenditure currency

15 C. Financial Risks versus Outcome Risks (2) For example, suppose an intervention in Nepal costs NPR 10,000 At a budget rate of NPR 100 = EUR 1, each intervention is expected to cost EUR 100 A grant of EUR 100,000 is therefore expected to pay for 1,000 interventions

16 C. Financial Risks versus Outcome Risks (3) Between budget rate being set, EUR funds being received and NPR purchased: If exchange rate moves to NPR 110 = EUR 1, then EUR 100,000 purchases 1,100 interventions everyone is happy If exchange rate moves to NPR 90 = EUR 1, then EUR 100,000 purchases 900 interventions not so happy

17 C. Financial Risks versus Outcome Risks (4) The INGO has borne no financial risk, since it can report the same EUR income and expenditure But the INGO bears reputational risk, since it might not deliver on its commitments Currency risk is being passed to those who ultimately are least well positioned to bear it: local partner NGOs, who have to manage with variable income denominated in own currency the intended recipients of the 100 interventions that are not delivered

18 D. Hedging and other FX risk management techniques A. Set up reports to clearly identify where foreign exchange rate risk lies B. Implement procedures to minimise the major financial risks associated with exchange rate volatility C. Decide how much purchasing power volatility is to be borne by donors/ingos, and how much by varying country office budgets and therefore outcomes

19 D. Hedging, etc (2) Whenever a grant is denominated in a currency other than a project s expenditure currency, foreign exchange volatility presents a risk to outcomes If it is decided that country office budgets (and so outcomes) are going to bear all this risk, then nothing more to do Conversely, if the INGO chooses to bear some or all of the FX risk centrally (and so cushion the impact of exchange rate volatility on country offices), then decisions need to be taken about hedging that risk

20 D. Hedging, etc (3) There are two options for an INGO to bear some or all of the purchasing power risk: i. Use financial market products to hedge risks, or ii. Underwrite the risk that exchange rates deviate from budget rates i.e. committing unrestricted funds and/or reserves as insurance

21 D. Hedging, etc (4) Hedging can mean: a) Purchase full committed amounts of expenditure currencies (potentially offshore ) when grant agreed Enables country offices and local partner NGOs to budget based on certain nominal local currency income Requires advanced funding from donors (or large amounts of unrestricted funds) Might generate notional balance sheet volatility, as cash asset and matching commitment to spend liability get revalued as expenditure currency revalues versus INGO s base currency (INGO will otherwise have to bear risk of donor currency revaluing versus base currency)

22 D. Hedging, etc (5) Hedging can mean: b) Contracting with the donor to denominate grant in expenditure currency Enables country offices and local partner NGOs to budget based on certain nominal local currency income Passes purchasing power exchange rate risk to the donor, often the actor best placed to bear it (though not always willing) If the expenditure currency is restricted then might require alternative arrangements to pass funds from donor into country office bank accounts

23 D. Hedging, etc (6) Hedging can mean: c) Using forward foreign exchange contracts (i.e. agreeing to sell donor currency to purchase expenditure currency at a date, or dates, in the future) Enables country offices and local partner NGOs to budget based on certain nominal local currency income Passes purchasing power exchange rate risk to the financial markets Perfect deliverable hedges often not available, and sometimes non-deliverable forward contracts also not available.

24 D. Hedging, etc (7) Hedging is a particularly important consideration for contracts : E.g: A fixed amount of donor currency (EUR) committed to build a school in Nepal (NPR) We are not going to build a school without a roof Reducing outcomes is therefore no longer an option

25 D. Hedging, etc (8) A postscript on FX options: FX options are sometimes proposed as a tool to hedge an INGO s risks Purchasing an option means the INGO retains the upside if a donor currency appreciates, but is protected against adverse movements Such options cost money e.g. an INGO pays 4% or EUR 4,000 on a EUR 100,000 payment due in one year, to protect it against devaluation of the EUR They are therefore a blend of a hedge and an investment (or speculation)

26 Managing FX Risk SUMMARY A. Design procedures and reports that enable FX risks to be clearly and readily identified B. Focus on those risks that are most likely to be realised C. Distinguish Financial from Outcome risks D. Investigate feasibility of hedging to cushion local NGOs and program recipients from the impact of exchange rate volatility

27 QUESTIONS

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