Cash flow hedge programs are generally longer term in nature. Positions due to mature were locked months or years ago, and new positions may not impact the P&L for months or years down the road. Despite the longer time horizons, there are still opportunities to make your hedge program more effective when volatility strikes.
Cash Flow Program Action
- Focus on Forecasting Improvements
Missing hedge targets restricts the program from achieving stated objectives and targeted effectiveness, even if positions are underhedged and not at risk of losing hedge accounting treatment. Forecast inaccuracy does not directly show in FX Gain/Loss like with balance sheet hedging, but that does not mean it should be overlooked. Treat forecasting with the same rigor as balance sheet hedging. Track variances and work to perfect forecasting. Improve forecasting processes and standards, so that hedge targets are more consistently achieved. The hedge program was established to provide economic protection in a specific way, and this benefit cannot be delivered with poor forecasting.
- Revisit OCI Timing and Allocation Assumptions
The high-level objective of all cash flow hedge programs is to align hedge results with the same P&L timing and GL geography as the underlying exposure. Many practical expedients are made to ease the administration of this. During less volatile times, a company can live with looser assumptions, but these mismatches can get amplified in volatile markets.Release and allocate hedge results more precisely by analyzing data monthly rather than quarterly or annually. Hedge results will then more effectively align with the intended protection of the documented hedged item and assist all business segments. This will improve hitting hedge program objectives.
- Develop Robust and Clear KPIs
Improving a hedge program requires analysis to pinpoint the areas that command the most attention. Consistently meeting hedge program objectives requires establishing performance reporting metrics.Create an objective-based performance reporting package every month and quarter. There are not one size fits all reports. Whether the objective is locking into budget, protecting margin, fixing project expenses, or smoothing rates, there are ways to report hedge results. Once established create feedback channels to make improvements.
- Incorporate VaR and Cost of Hedging
Efficient frontier concepts can be used effectively for balance sheet hedging as a short-term portfolio decision making tool. Cash flow hedging is more nuanced due to the objectives and the P&L timing variances between different transaction types. Analysis suited for nimble repositioning is not always a fit for long term cash flow hedging. But when cost of hedging is high, it can be a good time to use quantitative analysis as a guide to adjust layering strategies. Conduct VaR and Cost of Carry analysis on cash flow forecasts. A thorough analysis helps make intelligent, rather than emotional, decisions outside of the normal routine policy. If cost of hedging certain currencies is unusually high and analysis shows those currencies have natural economic offsets, there could be an opportunity to temporarily shift policy while not exposing the company to exurbanite economic risk.
- React to Metrics, not Emotions
Nobody can predict with certainty where the market is heading. Today may not look like the best time to lock into EUR revenue hedges, but what if you shutter the hedge program doors completely and EUR goes well below parity? It may be time to add flexibility to hedge targets based on quantitative analysis, but overreactions could derail a hedge program and lead to poor long-term decisions.Treasury can steer discussions back to objectives and reduce the emotional or knee jerk reactions that senior management may have in volatile markets. Proactively prepare analysis to support ideas that prudently adjust to market conditions. This prevents the c-suite from making short sighted decisions based entirely on “taking a view” on the markets. In lieu of analysis and thought leadership from Treasury, temporary emotions from the top will completely hijack the program.
Kyriba’s FX Advisory team helps multi-national companies optimize hedge programs and evaluate FX risk holistically to complement a full end to end FX Risk Management solution. Reach out today to our FX Advisory team to learn more. Also, visit https://www.kyriba.com/products/risk-management/ to view more on our FX Risk Products or schedule a demo with the team.