Treasurers and risk managers who’ve been around the block recognize — once they’ve set a budget rate — that fluctuating market rates rapidly affect their ability to capture that rate. Companies forecast financial performance in terms of EPS, revenues, operating margins, etc., by using budget rates to convert foreign currency denominated transactions into their reporting currency. So, setting meaningful budget rates, then executing an FX risk management strategy capable of delivering budget rates with a high degree of certainty is essential for global companies seeking to achieve their performance forecasts.
In our last article, we described the best practice for setting FX budget rates. But when a portion of the exposures are not hedged once the budget rate is set, changes in market rates will cause budget variance — and the chances are 50/50 it will be unfavorable. So, it is imperative to coordinate the determination of budget rates with the execution of the FX strategy.
This article focuses on how you can set budget rates and align your FX strategy to increase confidence that your company will convert its forecast exposures at the budgeted conversion rate.
Reflect Hedging Progress in the Budget Rate
Depending on your company’s FX strategy, the hedged portion of forecast exposures is anywhere between 0 and 100% when budget rates are set. For simplicity, we’ll view an example using a single exposure, hedge, and date.
Company ABC forecasts revenue of EUR 10 million to be recognized on June 15, 2020
Based on its risk management strategy, the company previously executed a forward sale of a portion of the forecast revenue at a rate of 1.1300
The current forward rate to June 15, 2020 is 1.1500
So, depending on the portion of the forecast previously hedged, an appropriate budget rate would be found as follows:
Note, unless ABC’s treasury instantaneously hedges the unhedged portion of the exposure after the budget rate is set, the company is still vulnerable to budget variances on the unhedged portion. And the lower the portion hedged, the more the potential budget variance. As shown by the following graph, the only way to reduce budget variance once the budget rate is set is to hedge a greater portion of the exposure. Increasing the hedged proportion narrows the distribution of conversion rate outcomes the company will incur. But hedging more — or driving hedge execution based solely on the budget rate setting schedule — does not always suit companies’ various objectives.
Putting Confidence in Your Budget Rate
So, how can your company set budget rates in a way that reflects incomplete hedging and market rates while still increasing the probability of achieving conversion at the budget rate? Recall the confidence interval.  If using market forward rates (as in the table above) subjects the company to a 50/50 chance it will achieve conversion of the exposure at its budget rate, then we must change the probabilities to satisfy our need for confidence. For instance, if we want to be 90% confident we will achieve our budget rate, we can use the 90% confidence interval rate (1.0574) in place of our market forward rate (1.1500). Let’s revisit our table above with this amendment.
Using the CI90 rate to reflect unhedged exposures, we can be 90% confident we will convert (or subsequently hedge) unhedged exposures at (or above) that rate. We are already certain of the conversion rate for previously hedged exposures (1.1300, in our example).
The confidence interval-based method shifts (depicted below) our budget rate relative to the distribution of all potential market outcomes such that we can have a stated degree of confidence in our ability to convert exposures at the budget rate (or better).
You can reduce the range of conversion rates around your company’s budget rate by hedging more (graph 1), but unless you hedge 100% of forecast exposures, you cannot be 100% certain of achieving the budget rate. To increase your company’s confidence that its FX strategy will achieve the budget rate, you’ll need to coordinate the execution of the strategy with the budget rate setting process. To reduce the risk of unfavorable budget variances due to unhedged exposures, you must incorporate confidence intervals into the component of budget rates that reflect unhedged exposures.
 See “A Dose of Reality: Rethinking FX Budget Rates,” May 28, 2019.
 See “Put Confidence in Your Strategy,” April 24, 2019.
About the Author
Chuck Brobst is the Managing Director of Analytics and Innovation Strategist at OANDA Corporation. He teaches graduate courses on risk management and banking at DePaul University. Previously, he founded GFM Solutions and spent 15 years in global markets divisions of BAML and ABN-AMRO Bank.
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