Identifying FX Exposures: A Critical Step in Developing an FX Risk Strategy

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In an earlier article, we helped you build a foundation for your FX risk management strategy with a “brick and mortar” analogy… the process of collecting exposure data and executing hedges we described as “bricks,” and risk measurement and analysis using VAR and confidence intervals were described as “mortar.” This article will discuss a crucial step in your foundation-building process: gathering accurate FX exposure data.

Identifying FX Exposures

Your firm has likely identified FX exposures such as:

  • Forecasted foreign denominated transactions (revenue and expenses)

  • Recognized foreign denominated assets and liabilities (cash, trade receivables and payables and loan/debt receivables and payables) 

  • Equity positions or net investments in foreign subsidiaries 

A forecasted transaction, asset, liability, or net investment can be an FX exposure, if it is denominated in a currency other than the functional currency[1] of the entity it belongs to. For example, forecasted United States dollar (USD) denominated sales revenue would be an FX exposure for a euro functional currency entity, but not for a USD functional currency entity. 

Identifying FX exposures that relate to recognized foreign denominated assets, liabilities and net investments is a straight-forward process, because they are readily identifiable by viewing a company’s general ledger. However, accurately forecasting future foreign denominated expenses and revenue is a challenge for most companies. Typically, the financial planning and analysis (FP&A) group is responsible for budgeting, forecasting, and analytical processes. Forecasting techniques range from the simple – such as increasing the previous year’s results by a fixed percentage, to the more complicated, i.e.: using statistical techniques like regression analysis. 

Importance of Accurate FX Exposure Data

Gathering accurate FX exposure data for each entity within a company is critical to formulating, evaluating and executing an FX risk management strategy. In previous articles, we discussed how value-at-risk (VAR) can be used to assess the impact of exchange rate volatility on alternative FX risk strategies, and how budget rates should be set, based on existing hedges and the current forward exchange rate applied to the proportion of unhedged exposures. Both of these tasks utilized forecasted exposure amounts. Variances between actual and forecasted exposure amounts will impact an entity’s ability to deliver budgeted functional currency results. 

Accurately forecasting FX exposures is also important for companies that want their hedges to qualify for cash flow hedge accounting.[2] One of the cash flow hedge accounting eligibility criteria is that the hedged forecasted transaction be probable or likely to occur. If an entity establishes a pattern of over-hedging forecasted transactions, it may be prohibited from using cash flow hedge accounting for future hedges. 

 

Coping with Forecast Uncertainty

It is almost a certainty that a company’s forecasted FX exposures will not be 100% accurate. However, difficulty in forecasting FX exposures should not discourage your company from developing and executing an FX risk management strategy. Examples of different strategies or approaches for coping with forecast uncertainty include:

1.    Restating the forecast as a range to include a high, low and best estimate. FX risk can be measured using each of the three forecasted amounts.  

2.    Layering hedges of forecasted exposures over time so that the percentage hedged (hedge ratio) increases as the time period before the occurrence of the exposure declines. For example, a company could initially hedge 50% of exposures that are expected to occur in twelve-months and then increase this percentage at the start of each subsequent quarter. 

3.    Updating forecasts at least semi-annually or if there is a significant change in the company’s business or the economy in general. 

Hedge Tenor

A topic related to forecast uncertainty is hedge tenor or how far in advance of a forecasted exposure should a company hedge. Typically, companies forecast revenue and expenses only for the following budget year, and consequently, their FX hedging focuses mostly on the same horizon. However, this is not the best strategy if the goal is to reduce year-over-year earnings volatility caused by fluctuating exchange rates. By increasing their maximum hedge tenor to address three years of forecasted exposures, companies can improve year-on-year FX comparisons. Though forecasts beyond one year may be unreliable in-total, it is not important that the company have a high degree of confidence in the precision of the total forecasted amount, but rather, that the hedged portion of the forecasted amount be probable of occurring. For instance, while a company might forecast EUR 10 million of sales for July, 2022, if the company initially hedges 30%, it is only important that the first EUR 3 million of the forecast be probable of occurring. The company can then review its forecast for 2022, during 2020 (with two years remaining) to establish whether it is confident in its forecast such that an additional portion of the exposure can be hedged.

 

Summary

Gathering accurate FX exposure data is a crucial step in the development of any FX risk management strategy.  There are various strategies that companies can employ to cope with the uncertainty of FX exposure forecasts including restating the forecast as a range (high, low, and best estimate) and adjusting the hedge ratio. Additionally, companies should consider extending their hedging horizon in order to reduce year-over-year volatility.  

[1] An entity’s functional currency is normally the currency of the economic environment in which it primarily generates and expends cash. A multi-national corporation could have several entities (subsidiaries), each with a different functional currency. The criterion for selecting an entity’s functional currency is described in Accounting Standards Codification (ASC) Topic 830, Foreign Currency Matters.

[2] The use of cash flow hedge accounting minimizes quarterly earnings volatility by enabling the change in fair value of the derivative to be deferred in other comprehensive income (equity) until the hedged transaction impacts consolidated earnings, rather than immediately recognizing it in earnings.


About the Author

Steven Walter is the Director of Analytics at OANDA Corporation. He is a CPA, a hedge accounting subject matter expert, and he spent 15 years providing risk management and derivative accounting support to derivative marketers and corporate treasury groups. Previously, he was a Director at ABN AMRO Bank, and an Executive Director at Ernst & Young.

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