Taming FX Volatility with Enhanced Currency Risk Management Strategy

The Kyriba Currency Impact Report for Q1 2023 indicated corporate impacts to earnings from FX volatility have continued to decline from the record high losses experienced throughout 2022 with a total reported aggregate headwind of $22.5B – a quarter-over-quarter decrease of 25.5%. For many, this may be a welcome relief. However, the total aggregate headwind is still well above historical average impacts for all of 2021. While the downward trend is substantial, we are by no means out of the woods yet. The currency market remains complicated and volatile, fueled largely by continued inflationary pressures, interest rate moves and a general sense of uncertainty from various geopolitical events.

Our last Currency Impact Report blog highlighted the efforts undertaken by corporate FX risk managers and treasury teams to minimize hedging costs by reducing exposure and leveraging more sophisticated hedging strategies that incorporate Portfolio VaR and Cost of Carry optimization analytics. We have also observed smart treasury teams investing resources to improve the timeliness, completeness and accuracy of exposure aggregation and definition processes.

Treasury teams employ two distinct currency risk management approaches  to improve the quality and accuracy of exposure definitions. These approaches are determined by whether a team relies primarily on actual exposure data collected from ERP systems or relies on forecasts to drive their exposure definition.

Actuals Based Exposure Definitions Processes

There are always exceptions to typical best practices. Most companies relying on actuals do so for their balance sheet exposure management processes focused on dealing with accounting FX rates that are updated daily within their ERP systems. Companies relying on daily FX rates to record payables and receivables in their ERP systems tend to monitor actual exposures on a daily or weekly basis and adjust hedges if the net exposure exceeds a defined notional value threshold. To monitor exposures on a daily or weekly basis, automation of the exposure aggregation and definition process is essential.

However, automation alone does not ensure an accurate exposure definition. Two additional best practices should be implemented: Dynamic Master Data Synchronization and Exposure Data Integrity Management.

Dynamic Master Data Synchronization effectively means that as changes and additions of Entities and General Ledger Accounts occur within a company’s ERP system(s), their exposure management process needs to detect and adapt the changes as changes occur. This requires a certain level of intelligence and exception tracking and management within the treasury team’s exposure management technology. This robust approach is preferred to the legacy approach of depending on and waiting for the accounting team and/or IT department to make changes to the reports the treasury team uses to drive their exposure definition process.

Exposure Data Integrity Management, when done well, can help ensure the treasury and accounting teams can quickly identify posting issues within the ERP system(s) that can render every question FX gain/loss results. Issues, such as phantom balances or intercompany balances that don’t reconcile on a functional and transaction currency basis, can result in very odd FX results. In addition, they can take a significant amount of time and energy to track down the source causing the problem.

Leveraging purpose-built business intelligence (BI) analytics allows treasury and accounting teams to quickly identify problematic General Ledger balances and mitigate the offending transaction balances. This results in more accurate exposure definitions, better hedging results and a cleaner month-end accounting close process.

Forecast-Based Exposure Definition Processes

Exposure forecasting is commonly done for two different scenarios: balance sheet exposure forecasting and  cash flow exposure forecasting.

Balance Sheet Exposure Forecasting is often used when a company sets their balance sheet FX accounting rate at the beginning of the month. As receivables and payables are posted in the ERP system(s) throughout the month, they will use the same FX rate. In this situation, FX teams  forecast the balance sheet position to the end of the month and try to put hedges in place quickly to help reduce the rate risk from when the balance sheet FX accounting rates are set.

Cash Flow Exposure Forecasting is commonly used for companies that want to protect Net Operating Income from currency volatility impacts. In this scenario,  companies forecast expected revenue inflows and/or expense outflows out 12, 18, 24 months or longer, depending on the nature of the business and the targeted cash flows. One thing to consider with cash flow exposure management is this type of hedging is done under the purview of hedge accounting.

With both types of exposure forecasting, companies can utilize a direct or an indirect forecasting method. Through direct forecasting, treasury teams gather forecasts from the local business units through forecast submissions. Treasury teams using the indirect forecasting method commonly leverage an FP&A-provided forecast or budget and use rules and assumption-based logic to transform the forecasts into a balance sheet forecast and/or a forecast of expected transactional cash flows.

The key to success for any type of forecasting method is variance analysis and accountability of the exposure source. Performing monthly and quarterly forecast accuracy analysis is a critical first step in comparing what was forecasted with what was booked. If exceptions are identified and if they fall outside a variance threshold, best practice-based treasury teams will bring the exceptions to the attention of the FX Risk Management Steering committee. Variance causality exception reports are typically required to help identify root causes of the variance to help ensure proper steps are taken to reduce the likelihood of a material forecast misses in the future.

Using this approach will lead to a continuous improvement mindset. It can help  increase currency awareness throughout the organization and improve hedging results and overall corporate financial performance, as well as ensure that hedge accounting effectiveness is maintained.

In summary, 2023 was a wake up call for CFOs, Treasurers and Corporate Risk Managers. Kyriba is here to assist in helping companies modernize and digitize their currency risk management programs. Contact us today!