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Balancing CFar and EaR in Order to Optimize FX Hedges

By August 14, 2019 January 22nd, 2020 No Comments

Bloomberg launches dynamic FX hedging model tested by Constellation.

After a successful pilot with Constellation Brands, Bloomberg is offering a sophisticated approach to managing foreign-exchange (FX) risk. The new product measures the impact of currency fluctuations on cash flow and earnings and enables a more targeted FX hedging strategy.

“This risk management strategy has dramatically changed the way we speak to executive leadership about risk,” said Sandy Dominach, senior vice president and treasurer at Constellation Brands. “We now have a holistic view of currencies’ impact on earnings and cash flows which can be explained more clearly.”

A producer and marketer of a wide range of alcoholic beverages across North America, Europe, Australia and New Zealand, the Mineola, N.Y.-based company decided a few years ago that its existing FX hedging program was inefficient. Like many other companies today, the treasury team followed a predefined policy to hedge a fixed percentage of the company’s cash flow exposures.

The policy was easily understood by management and the board, but it couldn’t explain the volatility in consolidated earnings when interest rates changed, nor the risk to cash flow and P&L. And explaining to executive leadership why hedging 70% of exposure was a better strategy than 75% or 80% also became problematic.

“Treasury wants to be able to explain to executive leadership what the risk to their cash flow and profit and P&L is, but presenting strategies strictly based on hedge percentage targets does not link these two together,” Ms. Dominach said.

The treasury team considered moving to a value-at-risk (VAR) model but determined it was more appropriate for short-term risks in banking rather than longer-term financial-statement and transaction risk.

Banking partners introduced the Constellation treasury team to the concepts of cash flow at risk (CFaR) and earnings at risk (EaR), respectively measuring the impact of FX rate movements on cash flow and earnings. After backtesting five years of data, the team realized it could optimize its FX management strategy by using both models together.

Alex Shneydman, treasury director at Constellation, explained that not every currency exposure is a cash-flow risk or a P&L risk, so the team needed to clearly distinguish between them to more accurately model those exposures into financial-statement risk. He added that the team could have used historical, parametric or Monte Carlo simulations to do so, but realized Gaussian variables to simulate the risk for EaR and CFaR were more efficient, without losing accuracy.

“We could then calculate the efficient frontier between the two models for hedging, identify an EaR level that treasury and the executive leadership are comfortable with, and manage the CFaR to the optimal target,” Mr. Shneydman said.

The Constellation treasury partnered with Bloomberg to build the new platform because the news, data and analysis company already had the necessary currency data on the forward and spot rates, the volatilities and the correlations related to those instruments. It also had engineers capable of writing the software algorithms to do the analysis and the computing horsepower to run the thousands of scenarios necessary to balance CFaR and EaR and find the optimal point to hedge.

“We’ve been working with Constellation on this and we’re now at the point where it gives any corporate a really cost-effective way to implement a much better hedging program for them and their shareholders,” said Dave Tamburelli, head of Bloomberg workflow specialist sales.

Mr. Tamburelli noted that treasury’s priority for managing cash flow and the risks associated with it can at times conflict with senior corporate executives’ concern about managing earnings.

“Those two things are almost at odds with each other when a company is implementing a hedging program, because minimizing cash-flow risk can create earnings and volatility risk,” Mr. Tamburelli said.

By connecting those concepts, he added, there’s now a way to figure out how to reduce earnings risk while maintaining a level of cash-flow risk the company is comfortable with. “As treasury seeks to get a bigger seat at the table with top executives, now they can have a conversation about how reducing earnings risk can impact cash-flow risk, and if management is comfortable with that,” Mr. Tamburelli said.

The new approach means that rather than layering on hedges as a percentage of the exposure, the team now layers them on to achieve the targeted EaR and CFaR, enabling the company to assign the dollar value of foreign exchange risk to financial results with 95% confidence. Ms. Dominach said the concept of managing risk by targeting a risk number was easily understood by Constellation’s executive leadership. Consequently, treasury was able to move very quickly from the existing percentage hedge target to a targeted EaR and CFaR strategy approach.

“Given this methodology, we are able to provide analytics to our treasurer for better [decision making] on our [percentage of] hedges. We also provide graphical analytics on a monthly basis to our senior management as well as an overview to our audit committee annually,” Mr. Shneydman added.

Wall Street and investors should also be on board.

“The company has had a formal hedging program for over 16 years. We have clearly communicated our hedging program with our investors,” Ms. Dominach said. “Using a methodology of CFaR and EaR is a refinement to our decision-making but not our overall hedging strategy—and we know all investors want to ensure companies are managing risk appropriately.”

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