Preparing for a board meeting can often be tedious and time-consuming. One of the topics that often receives a lot of attention (or avoidance) is foreign exchange (FX). This is because many consider it complex and “speculative.” As you walk into that next meeting, your challenge is to demystify the concepts and articulate the objectives of your program, but how and why?
Whether you’re hedging currency risk already or not, here’s what you need to know.
What to Expect From Hedging
Hedging is all about protecting, offsetting risk, and exchanging undesirable risk for desirable risk. Implementing a hedging program can help a CFO better understand and see the financials, giving them the confidence they need to do their job more effectively.
But this is only true when the CFO has the right expectations about what an FX hedge program can accomplish.
Many CFOs falsely assume that currency is presented rationally in financial statements. That can lead to false assumptions about exposures and hedges. In reality, your program can only deliver three things:
- Results that reflect the functional currency structure
- Results that reflect the objectives of the program
- Results that reflect the instruments used
CFOs need to influence certain strategic decisions about functional currency, hedge program objectives, and derivative instruments to achieve their desired results.
To make these decisions, know these three simple rules about FX hedging.
1. Don’t Set Generic Objectives
Too many FX risk management policies start with an objective along the lines of “to mitigate the impact of currency changes in my financials.” This is technically a true sentiment, but it’s too generic. What does it mean?
It’s time to think more strategically about currency risk. Your top priority as CFO is to determine what matters most in the financial statements. Do you care about revenue? Operating income? If you could lock in the cost of sales for a year, would you? So, if that’s what you care about, why isn’t that your objective?
A clear objective determines how a company will define the success of the hedging program. Unfortunately, a generic catch-all statement could make any derivative the company uses look successful.
As CFO, you also need to own the hedging program objectives. So when you set FX risk management policy and goals, make sure it’s protecting what you care about — whether that’s predictability in cash or net income or insurance for your margin. You’ll get the results you want to see and be able to confidently explain them because the objective is specific and comes directly from you and your priorities.
2. Know the Program’s Limitations
Remember, your program’s results can only reflect the functional currency structure, objectives, and instruments used. These three elements can limit your choices, even more so if they aren’t set cohesively.
You think economically and rationally: I want to protect the U.S. dollar value of my foreign revenue, so we hedge those foreign revenues, right?
Not so fast.
Your functional currency structure — a decision likely made during the early stages of the company’s growth — will drive what you can and can’t hedge. And you can’t hedge foreign revenues in a local currency functional subsidiary and get favorable accounting treatment for derivatives. It’s a classic limitation. (But don’t give up hope, there may be ways around it through proxy hedging strategies.)
As CFO, your role is to set and understand your company’s philosophy and culture around FX risk management, which also means understanding the accounting structure and framework. For example, you must decide which derivative instruments the company is allowed to use and why. The “cheapest” instruments lock in the USD value, reducing your ability to benefit from currency tailwinds to unhedged exposures.
3. Own the Program’s Controls
FX hedge programs require procedures and controls to ensure they are correctly executed and don’t create more risk than they mitigate. Successful hedge programs have robust controls. Part of the role as CFO is to own these controls, which include:
Accounting. Appropriate controls ensure that qualifying exposures are reflected in the financials at the hedged rate.
Trading. We haven’t seen rogue FX traders in the headlines in a while, but it doesn’t mean they don’t still exist. Solid trading controls separate traders from confirmations with counterparties and from accounting for their own trades.
Reporting. Reporting is where it all comes together — proving the hedge program is meeting the objectives defined in the policy within limits set by the policy.
As CFO, you own your FX hedge program at a strategic level. Therefore, it’s critical to set the key objectives for managing risk, understand what hedging FX risk can and cannot accomplish, and ensure the organization has an appropriate control structure. That will give you the confidence as CFO to address any questions at any time.
Helen Kane founded Hedge Trackers in 2000 as a FAS 133 consulting and outsourcing firm serving Fortune 100 to 1000 companies. She’s grown the firm into a premier provider of hedge program solutions, delivering outsourced derivative accounting, software, consulting, and training services.