A move from a current-year to a rolling forecast allows one risk manager to fine-tune the cash flow hedging program.
A new CFO can mean a little change—or a lot. In the case of one NeuGroup member who manages FX risk, the new CFO drove an initiative to ensure budget forecasts would have a longer horizon and be available earlier.
- Over the course of two years, this has enabled an evolution from a program that only hedged a year out from the budget to a longer-tenored layered program.
The benefits of earlier forecasting. In the previous scenario, treasury would get the forecast for the following fiscal year, say for FY2021, very late in FY2020, and the multiyear forecast well into FY2021.
- To maintain hedge accounting (a key objective), hedging was in effect limited to the budget year, i.e., 12 months out from the budget.
- With a budget now available much earlier in the fiscal year, and the multiyear forecast, too, treasury can hedge further out sooner.
- This has given way to an approach of layering the hedges systematically on an ongoing, quarterly basis up to 24 months out, but now with a minimum of 12 months out, not a maximum.
Strategic framework with flexibility for opportunism. The FX impact is measured in terms of risk contribution to the P&L. Treasury identifies the exposures (currencies) that contribute the most risk to the P&L.
- Then, based on a maximum risk tolerance level (i.e., a maximum dollar amount of downside within a 90% confidence interval), it makes a hedge recommendation according to which currencies and hedge ratios reduce volatility the most and minimize the P&L impact.
- The team will consider hedging exposures that represent more than 10% of exposures or where the risk contribution is over 7.5% from a VaR perspective. “We use cash flow at risk as a guide and a way to keep our focus; we don’t live and die by it,” the member said.
A decision model. The framework will soon include a decision model for variability in hedge ratios to be opportunistic based on certain market factors.
- The CFO “doesn’t want to ever not hedge,” or have business unit leaders try to influence hedge decisions based on their view of favorable or unfavorable conditions, the member said.
- “We want systematic criteria” for making choices on hedge ratios, underpinned by market signals like valuation, carry and momentum, he added.
- Valuation is a long-term hedge signal: assuming currencies tend to mean-revert, is the currency over- or undervalued against measures like purchasing power parity (PPP)?
- Carry: Historically, it’s rare that a currency depreciates as much as indicated by the forward points. Is the carry favorable or punitive?
- Momentum is a short-term hedge signal: Simple measures like 100-day moving averages indicate currency trends that can inform decisions.
Expense side: predictability. For the USD functional company, expenses are concentrated in a few currencies that treasury wants to hedge to a high degree (high hedge ratio) using forwards to create predictability on the operating expenses line.
- Layering smooths out volatility, and for each of the four operating lines, the hedge ratio is raised quarterly as forecast certainty increases to maintain a constant 24-month hedge horizon.
- By contrast, the revenues side stems from license royalties which by their nature (paid in arrears based on sales by licensees) are harder to forecast with the same degree of accuracy and therefore to hedge.
- Hence, the focus on predictability in operating expenses.
Forecast confidence requires close collaboration. An effective hedge program is only as good as the forecasts that feed it. Without close cooperation with the forecasters in the business units, the program fails.
- The finance function at the business units tracks forecast accuracy quarterly and reviews with treasury and accounting to create a feedback loop so that forecast certainty drives decisions on hedge ratios and accuracy improves over time for a virtuous circle of improvement.