FXSenior Executive

Turn Down the Volume: Cutting Through ‘Noise’ in FX Hedging

By March 24, 2022No Comments

NeuGroup members share their common sources of unexpected volatility in cash flow and balance sheet hedging programs.

One goal of a foreign exchange hedging program, one FX risk manager said at a recent NeuGroup meeting, is to minimize the risk that senior executives will face questions during quarterly earnings calls about the impact of currency on results. But uncertainty sparked by global issues like the war in Ukraine, inflation and fallout from the pandemic means this isn’t always possible.

  • Those issues can be one source of unexpected FX gains or losses, often called “noise” by treasury teams. And noise can highlight hedging challenges and invite questions from senior leaders who seek the source of the noise. “On a month-to-month basis that’s what we have to spend a lot of our time explaining to leadership,” one member said.
  • Members at the meeting, a summit for NeuGroup for Foreign Exchange 1 and 2 sponsored and co-hosted by Chatham Financial, said noise often comes from market volatility, forecasts that aren’t timely or accurate enough, or simple human error.
  • Attributing the noise to a source reveals if it’s an external factor the corporate can’t control, or may help identify errors and process improvements that can be remedied.

Cloudy crystal ball. Cash flow hedging relies on forecasted exposures of foreign revenues and expenses over a company’s planning and hedging horizon. Forecasts that miss the mark are the biggest source of noise, according to a survey at the meeting (see chart below).

  • Increasing uncertainty since the start of the pandemic has caused forecasting to be far less reliable. One member said that even when volatility leads to increased sales, it makes life harder for the FX team.
    • “As we looked at our updated cash flows when Covid first happened and sales were expected to decrease, we started to be over-hedged, so we pushed out positions to make sure we were not,” he said. “In the end, we actually flourished from a sales perspective, but the unknown of Covid led us to be too conservative,” leaving the company under-hedged.
  • FX impact, cited by 22% of those surveyed as the largest source of cash flow hedging noise, stems from movement in exchange rates that hasn’t been hedged or modeled as an acceptable risk. “How do you differentiate between what the market is doing and the things you’re choosing to do from a hedging strategy perspective?” Chatham Financial’s Amanda Breslin asked the group.
    • “Many companies choose to hedge a subset of their exposures based on risk tolerance, cost to hedge, reliance on correlations or forecast visibility. Outcomes that deviate from the assumed degree of residual risk are where we see companies exploring the sources of additional noise.” She added that FX teams need to understand “from a hedge perspective, are they targeting the right ratios, currencies and tenors? It gets quite messy.”

Missing the match. For balance sheet hedging programs, the sources of noise identified by members are a bit broader, which can make solving the issue more complex. The common sources are mismatches in notional value, timing and currency rates (see chart below).

  • Mismatches in notional are similar to deviations from forecasts in cash flow hedging, as they can occur when forecasted exposures are fully hedged but the company’s actual balances are higher or lower than the forecasted amounts, or when currency exposures go unregistered and remain unhedged. Almost half (48%) the members surveyed identified this as their primary issue, which can also be caused by errors in bookkeeping.
    • “We identify errors, which have a huge impact on our balance sheet exposure notional,” one member said. “When we go to the ERP system, often times, [local teams that execute FX transactions] book the balance in a certain FX currency, but actually balance in a functional currency which is not part of the exposure.” Because of this, she said the forecast is often incorrect, resulting in a balance sheet that is either over-hedged or under-hedged.
  • For other members (26%), a mismatch in rates can cause a cacophony. This issue can arise when the spot rate used to revalue derivatives comes from a market rate, while exposures are remeasured using a company balance sheet rate. “If someone is using the wrong exchange rate, we’re creating a lot of noise,” one member said.
  • An equal share of members say the biggest source of unexpected results is a mismatch in timing. “We have data coming in from multiple ERPs and multiple systems,” one member. “I’ve seen a lot of companies, a couple days before the end of the month, start generating some forecast exposures to get an idea of what they think the balance sheet will look like.”
    • He continued that companies often do pre-balance sheet hedging to get the process started and then when the data becomes available, often five or six days into the month, will make additional hedges on top of that. “That presents a lot of issues,” he said. “You’re going to have timing mismatches, you’re going to have notional mismatches, you’re going to get some noise.”

Communication to turn down the volume. One FX head shared a simple approach to track a source of noise and tackle it, going one step further than simply being prepared to explain its origin.

  • “The first step is just having a conversation,” he said. Each month, the member meets with controllers for each currency and has a “kumbaya” moment to break down any noise and where it stems from.
    • “We talk about what the previous exposure was, what the upcoming one is going to be, and try to figure out why there were issues with the prior forecast,” he said.
  • After identifying the reason for the unexpected volatility, the team tracks the source using “reason codes” for recurring causes, creating a historical log that tracks the origins of noise. “Now we can identify whether it was a revenue mismatch, whether there was something wrong on the cost side or something wrong with tax, and these reason codes are specifically tied to the P&L impact of that mismatch,” he said. “It allows us to very quickly look back to see exactly what caused the problem and why, so we know who to talk to.”
  • Another member added that beefing up tracking of these noisemakers can be very valuable when meeting with leadership, which the member ran into when faced with an issue hedging deferred income, which “always comes out at a different rate than the prevailing monthly rate” due to a reliance on forecasting.
    • One senior executive who recently joined the company confronted the member’s team, expressing concerns about an unexpected $9 million loss due to this issue.
    • “But I showed him the data, and I said, ‘A forecast cannot be perfect, and that’s a big driver.’ And after that he said, ‘well, you know what, I’ve never felt so good about losing $9 million,’” the member said. “You just need to be able to translate what is happening in a way the business understands.”
Justin Jones

Author Justin Jones

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