A Dose of Reality: Rethinking FX Budget Rates

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We all daydream of winning the Publishers Clearing House Sweepstakes. A cushion of $25,000 per month would go a long way to pay bills, save money for rainy days, and build a retirement nest egg. Alas, the probability of such a stroke of luck is miniscule. Instead, we rely on realistic expectations and disciplined actions to meet our personal financial objectives. Many companies do not apply such concepts when determining how to convert budgeted FX exposures to their reporting currency. Similar to assuming you’ll win the sweepstakes to pay your bills, many companies set targets in a manner that relies on random luck to achieve their FX budget rates. 

This series of blog articles describes how companies can formulate FX risk management strategies and be confident in the results they’ll achieve. For global companies doing business across borders, a lynchpin of the FP&A budgeting process is the FX budget rate: the rate at which companies assume they can convert foreign currency denominated transactions into their reporting currency. 

Setting realistic budget rates is vital to create a reliable forecast of a company’s upcoming performance. Connecting the budget rate setting process to the FX risk management process is essential for companies seeking to minimize budget variances due to FX. This article explains how to set budget rates that align with the FX risk management process. 

 

Off-Target FX Budget Rates

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One of the most prevalent mistakes companies make in their FX risk management strategy is to set budget rates that are unrelated to the risk management process itself. An astounding 47% of companies set budget rates that are unrelated to 1) market rates, and 2) existing hedge rates.[1] That’s right, almost half of companies use consensus forecast rates to set expectations of their company’s budgeted performance. This approach relies on sheer happenstance – not risk management – for companies to achieve their budget forecasts. 

Using consensus forecast rates as budget rates creates an irreconcilable disconnection between a company’s hedging efforts and its performance forecast. Companies can only increase certainty of meeting their budget rate by hedging at market rates, they cannot execute hedges with contract rates that are based on market strategists’ forecasts. If budget rates are not based on market rates, hedging will create budget differentials. Locking in budget differentials often begs the question, “is hedging worthwhile?” But, the problem is not hedging, nor is it the hedge rate, it’s the senseless use of forecast rates as budget rates. 

We all know two wrongs don’t make a right, so why would combining 30 wrong forecasts make the consensus any more correct? Using fictitious rates such as consensus forecasts is not a benign practice. Disconnected, meaningless practices obstruct treasury’s ability to create reliable risk management strategies.

 

Ready, Set (Meaningful Budget Rates), Go!

 

How should you set budget rates so that:

  • they are connected to your FX risk management efforts, and

  • you can construct your FX strategy to minimize actual/budget variance? 

Companies should set budget rates for anticipated exposures based on:

  • the weighted-average rate of (previously executed) hedges of exposures for the budget year

  • current market forward rates to the expected dates of the exposures (as of the budget rate setting date), which we will call “opportunity rates.” [2]

Here is a simple, single exposure / single date example of how to set budget rates.

  • Company ABC forecasts revenue of EUR 10 million to be recognized on May 15, 2020

  • Based on its risk management strategy, the company previously executed a forward sale of EUR 5 million at a rate of 1.1650

  • The current forward rate to May 15, 2020 is 1.1530

  • So, the company should establish 1.1590 as its budget rate, as follows:

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Summary

Forecasts in our operating budgets use our best estimates of operating components to create visibility and challenge employees to deliver great results. A company’s ability to deliver budgeted results could depend as heavily on effective FX risk management as its ability to generate forecast sales growth. Companies seeking to deliver on forecast results must coordinate the budgeting process with their FX risk management efforts to set realistic budget rates and execute a strategy that has a high expected success rate. 

In our next article, we will explain how to increase confidence in your FX strategy’s ability to deliver the conversion rates that meet our budget’s expectation. 

[1] 2018 Risk Management Practices Survey, Wells Fargo Foreign Exchange

[2] We have the “opportunity” to hedge incremental amounts at these rates at the time we set the budget rate. 


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