By Anne Friberg

Leading FX managers have finalized their best practices for FX programs. But the quest to achieve world-class status is far from over.

World-class corporate foreign exchange management has meant many things to many people. But the financial crisis prompted The NeuGroup’s two FX Managers’ Peer Groups to undertake a project to define exactly what constitutes best practices. The project, its supporters hoped, would help FX managers determine what they could do better, and argue for more resources, if necessary, from management. After a year of exhaustive work by the FX groups, a consensus has emerged. Now implementation is the big challenge.

The Phase 1 benchmarks were distilled and detailed last September (an overview is available in “World-Class FX Management,” IT, October 2009). Over the course of the winter, FX group members designed and completed an extensive survey for the second phase, in which, again, 32 companies participated. At their March meetings, the two FX groups covered risk analysis, performance measurement and efficiency, as well as a self-assessment against the Phase I benchmarks.

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PHASE II WORLD CLASS BENCHMARKS

While corporates struggle to determine if they’re meeting the high bars determined in the first phase of the project, the FX group members devised these additional best practices:

1) Risk analysis. Members agreed that value-at-risk could be considered a world-class metric because it encompasses both the probability of losses occurring and their magnitude. However, while requiring that a world-class FX program incorporate a value-at-risk approach (or its earnings, cash-flow, etc., counterparts) sounds right, it is important that the outcome of any risk analysis (i.e., a risk metric) is “actionable” in relation to the goals and policies of the hedge program.

For example, a “risk taker” might decide to accept a certain level of earnings-at-risk from its combined exposures, beyond which hedging would be triggered to reduce it. A rigorous EaR analysis process could be therefore appropriate, but senior management should understand its meaning and implications. A “risk avoider” whose exposures by policy are 100 percent hedged as soon as they are identified will benefit less from this type of analysis.

Benchmark: A world-class risk analysis process will use sensitivity analysis, stress testing or value-at-risk calculations frequently to quantify risks based on varying levels of spot rates, forward rates, volatilities, and correlations. Risk analysis calculations should align with company objectives and policies.

Risk analysis should be performed in a resource-effective manner, depending on the complexity of the company’s exposures and hedge programs. Management should be informed of risk analysis results frequently so that appropriate actions to minimize the impact of risk can be taken.

2) Performance measurement: As with risk metrics, performance measurement and metrics need to be closely tied to the objectives of the hedge programs. For example, a common goal of FX hedging is to reduce the impact on reported earnings to a narrow band around EPS (e.g., one cent per quarter). The metric needs to reflect whether the goal is achieved, and if not, by how much it was missed.

Benchmark: A World-Class performance measurement process will measure the effectiveness of an FX program frequently. Multiple methods may be needed to adequately measure performance, and they should ideally be simple to understand and quick and efficient to calculate.

Performance measurement should reflect the goals of the FX program, and assist in identifying its value added.

Performance measurement should be performed in a resource-effective manner. Management should be informed of performance measurement results frequently so that changes can be made to improve performance and effectiveness. A World-Class FX program will continually educate all levels of management on the methods and meaning of performance metrics.

3) Efficiency: The survey showed that most companies in the FX groups have very lean teams, and there is not a straight relationship whereby “one unit worth more of systems equals one unit less of people” or vice versa. For example, with the implementation of FireApps, it is possible to view exposures in a way that was never available before; however, without adding more people, there may be little bandwidth for a team to do anything with that knowledge. A team that has already “maxed out” on what its systems can perform may have to give up on certain world-class ambitions until more people can be hired.

Benchmark: A World-Class foreign exchange program will operate as efficiently as possible balancing the allocation of resources (people and systems) against the risk from foreign exchange, in alignment with company objectives and policies.

Exposures should be ranked in order of risk to the company based on notional value and/or risk-adjusted notional value. Resources should be allocated to exposures in accordance with that ranking, which could mean that immaterial or non-volatile exposures receive little attention and may not be hedged at all. Exposures should be periodically reviewed to ensure resources are allocated appropriately.

The cost of implementing systems should be weighed against the frequency and magnitude of errors in manual processes. Manual processes may require more experienced, well-trained staff to mitigate the risk of error. Automated
systems cannot fully replace the value added by a motivated and well-trained FX Team.

World-Class FX: What’s Next? Project members agreed that they should leverage the wealth of survey data collected during Phase I and II and continue to explore ways to move their companies towards world-class status via self-assessment against the benchmarks and case studies on how to “get there.”