How to Align Growth, FX Risk Management and Technology Practical Guide for Corporate Treasurers By Amy Su, Senior Solution Consultant at Reval December, 2014 CONTENT Executive Summary Introduction Getting Started: Basic FX Risk Management Get Going: Enterprise FX Risk Management Go for the Max: Holistic FX Risk Management Conclusion
Executive Summary About Reval This year, the Forbes Global 2000 companies, in total, raked in revenues of 38 USD trillion and profits of 3 USD trillion, with assets worth 161 USD trillion and a market value of 44 USD trillion Although it is complicated to imagine these numbers, it is quite easy to read the trend: All of these are higher than a year ago The top companies around the world are continuing to grow And so are many others As company growth and expansion transform treasury operations, it is particularly important to move to more sophisticated approaches in FX exposure management This guide shows how to align growth, FX risk management and technology Introduction The Forbes Global 2000 companies, as many others around the world, grow fast and global In order to finance the daily business and fund future expansion, treasurers have to review their structures, processes, strategies and technology more closely As foreign currencies usually add most of the complexity treasury is struggling with to cash and risk management, treasury transformation often starts with changing the FX risk management approach Basically, there are three level of sophistication in FX risk management: 1 Basic FX Risk Management Reval is a leading, global Software-as-a-Service (SaaS) provider of comprehensive and integrated Treasury and Risk Management (TRM) solutions Our cloud-based software and related offerings enable enterprises to better manage cash, liquidity and financial risk, and includes specialized capabilities to account for and report on complex financial instruments and hedging activities The scope and timeliness of the data and analytics we provide allow chief financial officers, treasurers and finance managers to operate more confidently in an increasingly complex and volatile global business environment Using Reval, companies can optimize treasury and risk management activities across the enterprise for greater operational efficiency, security, control and compliance Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific For more information, visit wwwrevalcom or email info@revalcom Companies with small FX exposure often take a pragmatic approach and leave the handling of cash and FX risk to their subsidiaries 2 Enterprise FX Risk Management Companies with a critical volume of FX exposure tend to manage FX risk centrally, on an enterprise level At this stage, FX netting and economic hedging are popular strategies to mitigate risk and reduce costs 3 Holistic FX Risk Management Companies with large FX exposures take a more sophisticated approach to FX risk management They apply hedge accounting to mitigate P&L volatility Going beyond individual currency exposure, they analyse 2014 Revalcom, Inc All Rights Reserved 2
correlations and often use the Cash Flow at Risk model to optimise their hedging strategies In general, the adoption of more advanced technology runs in parallel to the evolution of the FX approach The examples below demonstrate that even at its earliest stage, FX risk management can achieve a ROI significantly higher than expected leveraging modern treasury technology Getting Started: Basic FX Risk Management Companies with limited FX exposure often have a decentralized treasury structure and take a rather pragmatic approach to FX risk management In a German DIY retailer with subsidiaries in Austria, Denmark and the Czech Republic, for example, each subsidiary manages its own FX exposure and hedges EUR, DKK, CZK and other currencies with external banking counterparts The FX trades are recorded in spreadsheets with each subsidiary pricing the portfolio differently The Austrian and Danish subsidiaries use the fair values they get straight from the banks, while the Czech treasurer has come up with his own valuation model Key issues in this approach are: Inconsistency in the pricing model and valuation results Risk of human error when using spreadsheets Lack of controls to the FX exposure workflow To mitigate FX risk on an enterprise level and improve the underlying process, companies like our DIY retailer should consider automating its manual processes Modern treasury systems should not only gather all cash flows in one place, but also automate and track key treasury and risk workflows This way, treasurers are able to increase efficiency and control at the same time Ideally, the new solution offers a FX pricing model with an integrated market data feed, ensuring all FX trades are priced and reported consistently Companies with a decentralized treasury structure should particularly make sure users in subsidiaries are able to access the system easily, and in best case, in real-time Doing so will ensure all are on the same page, from a timing perspective, to facilitate reporting and decision making But also, treasurers in smaller corporations should think about global access and scalability at an early stage in order to support their company s future growth and expansion plans 2014 Revalcom, Inc All Rights Reserved 3
Get Going: Enterprise FX Risk Management As companies grow, so does FX risk Reaching a critical volume of FX exposure, companies should consider implementing a more rigorous FX risk management approach For example our German DIY retailer should consolidate and net the FX exposures currently handled at the subsidiary level FX exposure netting can be done in three ways: 1 Simple Many-to-one Hedging The treasurer sums up all DKK receipts and uses a single hedge to mitigate the DKK exposure Then, he does the same for receipts in the other currencies as well as for receivables in all currencies 2 Advanced Many-to-one Hedging The treasurer sums up receipts and receivables per currency and executes a single hedge for each currency 3 FX Exposure Netting FX exposure netting considers cross effects Looking at functional currency pairs, short and long exposures of the three subsidiaries can be netted and hedged together, again decreasing costs These economic hedging strategies bring down the number of external FX trades required and increase transaction volumes, thus effectively cutting down hedge costs Go for the Max: Holistic FX Risk Management Companies with considerable FX exposure should also consider adopting and taking advantage of hedge accounting to mitigate P&L volatility For example, a Belgian beverage and brewing company enters into a contract to sell its beers to a US company and expects to receive the payment totalling USD 1 million in six months In order to mitigate the FX risk, the Belgian company enters into a FX forward to fix the FX rate of the expected USD payment With effective hedging, the company will be able to remove the volatility arising from the FX forward s change in fair value in the P&L and park it in the OCI (Other Comprehensive Income) during the designated hedge period As a result, the Belgian company not only benefits from the economic hedge at the end of the six months, but also effectively mitigates volatilities in P&L during that period Seeing the benefits of hedge accounting, treasurers should also be very much aware of the associated compliance challenges: hedge documentation Whilst it is safest to hedge all exposures back-to-back, it is also very costly and hence not necessarily the most effective approach to managing FX risk 2014 Revalcom, Inc All Rights Reserved 4
One way to reduce hedging costs is to look for currencies that are positively correlated, which means that their rate fluctuations tend to move in the same direction For example, the DKK is pegged to EUR or the HKD to USD On the other hand, some currencies are negatively correlated, hence fluctuations tend to move in opposite directions and offset each other Knowing this, companies could start leveraging these correlations to find the right balance between FX risk mitigation and cost efficiency, optimizing their hedging programme The next step towards excellence in FX management would be to apply the cash flow at risk (CFaR) model which measures the potential shortfall of cash flows in the upcoming months or years For example, a US clothing company has a basket of 35 currencies in its portfolio Figure 1 outlines the worst case scenario of cash shortfalls over the next 12 months Without taking any correlation into account, the projected cash shortfall is USD 293 million Currency Mean 5th Percentile 95th Percentile AED 87,995,366-6,611 6,242 ARS 34,360,320-593,306 617,260 BRL 640,607,799-57,223,225 61,570,241 CAD 246,325,355-16,496,327 16,960,227 CHF -1,285,415,569-120,356,127 120,699,033 TWD 871,106-121,967 125,841 UAH 17,084,961-299,852 297,353 USD 88,034,260 0 0 VND 18,050,430-1,091,138 1,122,478 ZAR 31,804,976-3,764,331 4,115,134 Total -76,189,177-292,765,571 299,751,124 Figure 1 Standalone Portfolio without Correlations 2014 Revalcom, Inc All Rights Reserved 5
Using CFaR, the company would be able to consider correlations amongst the currencies in their FX portfolio and naturally hedge those straight away As outlined in Figure 2 the projected cash shortfalls decreased from USD 293 million to USD 116 million, meaning USD 177 million could be saved before even putting any hedges in place Currency Mean 5th Percentile 95th Percentile AED 87,995,366-2,081 5,416 ARS 34,360,320-248,778-346,899 BRL 640,607,799 41,991,027 804,653 CAD 246,325,355-3,594,084 7,183,314 CHF -1,285,415,569-159,573,395 110,725,717 TWD 871,106-32,181-23,298 UAH 17,084,961-112,737 89,004 USD 88,034,260 0 0 VND 18,050,430-162,844-420,395 ZAR 31,804,976 2,358,888-1,985,617 Total -76,189,177-115,514,025 121,353,479 Figure 2 Correlated Portfolio The company can also run a sensitivity analysis to identify the currencies that contribute most to portfolio volatility The sensitivity analysis in Figure 3 indicates that CHF is the biggest contributor to the portfolio volatility and thus should be prioritized 2014 Revalcom, Inc All Rights Reserved 6
Currency Mean Correlation with Portfolio(%) Volatility Sensitivity(%) AED 87,995,36556-1207 000 ARS 34,360,31985 670 002 BRL 640,607,79909 1761-359 CAD 246,325,35478 1363 031 CHF -1,285,415,56888 7945 1366 TWD 871,10611-722 000 UAH 17,084,96147 546 001 USD 88,034,26000 000 000 VND 18,050,42974 417 001 ZAR 31,804,97640 168-020 Figure 3 Sensitivity Analysis Consequently, the company enters, for instance, a CHF/USD forward contract to reduce the effect of CHF volatility to their portfolio As Figure 4 indicates, our US clothing company could reduce its exposure from USD 116 million to USD 77 million by removing a significant portion of tail risk Repeating this process, the number of hedges could be reduced significantly, translating into significant savings in the long run Currency Mean 5th Percentile 95th Percentile AED 87,995,366 817 2,585 ARS 34,360,320-510,583-388,645 BRL 640,607,799-39,427,285 56,243,233 CAD 246,325,355-23,115,716 11,230,746 CHF 0 0 0 TWD 871,106-114,969 1,232 UAH 17,084,961 88,882 504,112 USD -1,206,532,448 0 0 VND 18,050,430-480,784-679,587 ZAR 31,804,976-2,377,600 205,205 Total -85,340,316-76,889,492 85,164,251 Figure 4 Hedged Portfolio 2014 Revalcom, Inc All Rights Reserved 7
As a result, the CFaR methodology enables the company to identify key risk contributors in its portfolio and focus its hedging program on those By not hedging all FX exposures back to back, significant savings can be realized in the long run Conclusion Growing companies that move to a more advanced risk management approach commonly leverage technology to manage treasury and risk holistically They choose software solutions that capture cash flows and FX exposures in a single platform and additionally provide capabilities for hedge accounting, including correlation and scenario analysis, effectiveness tests, hedge documentation, CFaR modelling and compliance reporting Whether you are working in a DIY retailer, a beverage and brewing company, a clothing company or a company in another industry, you will need to reassess your technology and ensure that it enables you to mitigate FX risk as your company continues to grow and expand into new markets Here s how to learn more: Read the blog: Finding FX Exposures in the Enterprise Haystack Listen to the webinar: How to Gain Access and Visibility Into FX Exposure Data Experience a live demo: Request a Demo 2014 Revalcom, Inc All Rights Reserved 8