The question above is frequently asked by treasury professionals who are responsible for protecting their company’s revenues and profits from adverse fluctuations in exchange rates.
Broadly speaking, the goal of a professional FX risk management strategy is to ensure that a company has downside protection in the event that currency markets move against them. When assessing whether a company has implemented “the best” FX hedging strategy, it is worth reviewing the following checklist:
Is the performance measurable?
- It is impossible to say whether an FX hedging strategy is effective without it being measured against key performance indicators (KPIs). These could include the level of risk reduction achieved, overall cost and expected liquidity impact from margin requirements.
- The best FX hedging strategies can demonstrate effectiveness against predetermined KPIs, in all market conditions.
Does it balance hedging policy objectives and constraints?
- When undertaking FX hedging a Treasurer has the ability to set multiple parameters including hedge tenor, hedge ratio and the derivative instrument used.
- There is no perfect combination that will work for every company. The best FX hedging strategy should optimize the expected outcome based on each company’s individual circumstance and predetermined, measurable KPIs.
Is it repeatable?
- A strategic hedging policy and process should be defined and implemented beforehand to create a framework that can deliver consistent results, regardless of future currency market moves
- Whilst a hedging strategy can include some element of opportunism and take tactical input based on market conditions, this should be done within a consistent, repeatable framework.
- Implementing speculative hedging activity based on daily newsflow or sharp market moves is just that, pure speculation.
Does it incur additional risk?
- Treasurers and finance teams should ensure risks are not being repackaged through derivatives to appear elsewhere further down the line.
- There are plenty of examples where derivative solutions sold by transactional FX providers (banks and brokers) result in a client incurring significant unexpected losses (see link).
- Remember that if a specific product seems too good to be true, it probably is!
A final point to make clear is that no-one can consistently and reliably predict the future direction of currency markets. FX hedge funds and other aggressive trading firms like Goldman Sachs often lose large sums of money attempting to profit from this type of speculative activity. It comes as no surprise, therefore, that predictions from FX analysts at Banks and FX brokerage firms often turn out to be wildly incorrect. As a Corporate Treasurer or CFO, why take the risk of making a speculative decision on the timing of your hedges based on an emotional bias or attachment to a “favorable” rate? Getting the timing wrong could well have greater negative consequences than the upside from a correct prediction.
Measurable, repeatable reduction in risk due to successful currency hedging will benefit all stakeholders and increase the chances of long term business success. Adhering to the principles above should enable every business to implement the best possible FX hedging strategy for their unique set of circumstances.
If you feel like your strategy needs improvement, or you’d simply like greater visibility into its performance, get in touch with our team today on 02037438358. We’d be delighted to assist you.