Managing FX risk in a strong U.S. dollar environment

If your organization is concerned about FX risk, you likely fall into one of three categories. Below, we define the three most common categories companies find themselves in, along with recommendations for proceeding in today’s environment.

1. Considering a new hedging program

If you don’t currently manage your foreign currency exposures, the financial headwinds created by today’s dollar strength may have prompted you to consider a new FX hedging program. Rather than executing hedges as a knee-jerk reaction, use this wake-up call as an opportunity to develop a robust, thoughtful program that can benefit your organization long term. Consider fundamental questions, such as "Should we be hedging?", “How should we be hedging?”, and “Where does hedging fit in our organizational activities?” A thoughtful approach to answering these questions leads to a more resilient and effective program that you can adapt as your organization continues to evolve.

2. Adding a cash-flow FX hedging program

If you currently maintain a balance-sheet hedging program, you may be considering adding a cash-flow hedging program to address fundamental mismatches between revenues and expenses brought on by currency fluctuations. These impacts can be especially painful because they are reported under gross margin, which appears higher in the income statement than other income and expense. Because it can be difficult to forecast costs and revenue, especially in a foreign currency, implementing these programs can be challenging. However, a well-constructed program can deliver significant benefits, such as adding certainty to your forecasted revenue and expense and avoiding wide swings in earnings.

3. Reassessing existing FX hedging programs

Even if you have maintained an FX hedging program for years, today’s market may make you wonder whether your program is still functioning as intended. Perhaps underlying business changes, such as M&A or spin-offs, have altered your risk profile and challenged the assumptions on which your program is based. Objectives can also shift based on external factors, such as the competitive landscape, changes to your global risk footprint, or risk tolerance levels. Internal factors may also play a role, including changes in key personnel, initiatives to drive automation, or cost management. In this case, performing a holistic review of your FX hedging program can help you determine whether making strategic or tactical changes will improve program performance or reduce your cost of hedging.

Consider the cost of your hedge instruments

After weathering massive, unexpected changes to foreign currency exposures, many treasury and accounting teams are evaluating whether their programs still manage risk effectively and cost-efficiently.

For FX hedging, it often makes sense to reassess which currencies represent the highest risk to your organization and prioritize them for hedging. This can significantly reduce your risk profile without hedging every currency you’re exposed to. Understanding that you don’t need to reduce every risk to zero but rather narrow your band of outcomes to a manageable level, can provide both adequate risk protection and meaningful cost savings. With various financial instruments to choose from, including forward contracts, traditional options, and knock-ins/knock-outs, the volatile market can also change the cost — and therefore the value — of one instrument over another. For example, if your organization has euro exposure, option volatility, which drives option pricing, is at its highest point in five years on the EUR/USD. While this may make sense if you need to protect against a worst-case scenario, such as a cross-border acquisition that doesn’t close, it may be less attractive if you aim to create predictability for future earnings.

Reviewing and adjusting the tenor and horizon of your hedges can also enable you to adjust for a changing market environment and improve the cost-benefit equation. Additionally, your organization’s investments in people, systems, and work hours can represent a substantial portion of your program’s overall costs. Doing the work to quantify and manage these operational costs is a critical area for every treasury and accounting team to address.

Monitor your FX exposure

No matter which category your organization falls into, you can take steps to better manage FX risk. Once all stakeholders are aligned on the program’s goals and objectives, focus on quantifying your FX exposure and defining your risk tolerance levels and priorities. For exposure gathering purposes, integrating ERP systems and treasury platforms allows your treasury team to gather and consolidate balance sheet and cash flow exposures from ERPs at the local business level and streamline decentralized data gathering through system integrations. The automatic feed of exposure data from ERP systems enables your organization to make appropriate hedging decisions aligned with your objectives.

Adopt a reporting rhythm

The current market volatility has shone the spotlight on many companies’ FX exposure, leaving corporate treasurers to face tough questions from stakeholders both internal and external. To facilitate the process of informing those stakeholders in a concise and consistent manner, many companies are adopting automated reporting dashboards to provide periodic summaries. Such reports — often linked to internal data sources — can provide insight into hedge efficacy, counterparty exposure, hedge costs, MTM values, etc. These reports can also serve to streamline other post-trade processes such as hedge accounting.

A sound practice in any market, reviewing your FX hedging program to ensure it still meets its objectives is critical in today's strong-dollar environment. Talk to your relationship manager or complete the form below to learn how Chatham can support you in conducting an FX risk management program review.