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The previous blogs of this series clarified some of the most important points treasury teams need to consider when they implement a layered FX hedging program. These elements include:

• Pricing. Layered hedging is best suited for companies that need continuity on pricing, i.e., keeping prices as steady as possible 

• Misconceptions. While treasury teams might face constraints, there is more to layered hedging than just ‘rolling’ the hedges

• Commonality. Best practices in layered hedging are centred around the notion of commonality between average hedge rates

In this final blog, we present the automation requirements of a well-run layered FX hedging designed to systematically achieve a ‘smooth hedge rate’ over time. This is the only way management can keep steady prices over many periods—without hurting budgeted profit margins in the face of adverse developments in currency markets. 

Layered FX hedging: the automation imperative

Picture yourself as the treasurer of streaming giant Netflix. You have more than 40 currencies to manage—and unhedged exposures can make or break the firm’s financial performance, as 60% of total revenue comes from foreign sales.

In one of the pricing segments, the finance team has just been given a seemingly impossible task. Whatever happens in currency markets, the team needs to protect the firm’s profit margins while allowing management to keep steady prices—not just during one budget period, but as long as possible.

This mission involves a good dozen FX-layered hedging programs. To achieve commonality between hedge rates in each of these programs, a precise schedule of hedges must be established and executed. The more granular the program, the more effective it will be. 

Different value dates will reflect different degrees of forecast accuracy. Also, each currency pair will display a different scenario in terms of forward points. For example, USD trades at a 5.5% forward premium to BRL, but at a 3.8% forward discount to CHF. Series sold in Brazil will have to be hedged differently than the EUR forecasted revenue. 

This means that the treasury team needs to calibrate each program to optimise forward points, taking advantage of favourable setups, while delaying hedge execution when facing unfavourable forward points. This, in turn, requires treasurers to adjust the length of the program and/or to set conditional orders to delay hedge execution. 

And it’s not over. When combining a layered FX hedging program with a micro-hedging program for firm commitments —by far the most effective way to achieve the goals of the program—, two additional elements require API-enabled automation:

• ‍24/7 markets monitoring‍
• ‍End-to-end traceability

24/7 markets monitoring

As we saw in the previous blog, the combination of a layered hedging program and a micro-hedging program for firm sales/purchase allows treasurers to work around constraints they might face regarding their degree of forecast accuracy:  

• ‍Initial hedging is based on forecasts. As firm orders take some time to accumulate, hedging is at first carried out according to the layering schedule chosen by the treasury team. ‍
• Accumulated firm orders take over. As soon as accumulated orders surpass pre-determined hedge ratios, hedging is automatically done on the back of firm commitments.

Achieving this combination is easier said than done. On the one hand, the budgeted part of the exposure is based on forecasts that often sit on Excel spreadsheets. On the other hand, firm sales orders may originate from the company’s CRM or other system.

This involves at least two different sources of exposure information, with different ‘owners’ within the firm. With system-agnostic API connectivity, treasurers can ‘feed’ their layered hedging program with all the exposure data they require. 

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To visualise this complexity at work, consider the chart above. The orange area shows hedged positions of a given value date. As the corresponding sales or purchase orders are received, their accumulated amount is initially below the hedge ratio set by the layered program.

To avoid over-hedging, these positions are not hedged. However, as soon as their level surpasses the indicated hedge ratio, the program is automatically ‘switched’, executing hedges only based on firm exposures.

Note that the illustration displays only one value date and one currency pair. The treasury team need only to multiply this setup by all required value dates, and then by all currency pairs, to realise the impossibility of manual execution.

Traceability: automation requirements

Further automation is required to track the hedged sales/purchase orders to the corresponding forecasted exposure. This makes it possible for finance teams to apply Hedge Accounting under IFRS 9 and US GAAP. 

Hedge Accounting can be a time-consuming task that, when manually executed, requires skills in accounting and the valuation of financial assets. Companies sometimes shy away from applying Hedge Accounting —and even from currency hedging altogether— due to the perceived costs in terms of documentation and compliance.

API-enabled traceability allows finance teams to easily perform all the work involved in compiling the required documentation. The same can be said for the task of using FX swaps to adjust the firm’s hedging position to the settlement of its underlying commercial exposure. 

Given the role of traceability in accounting and swap execution, it comes as no surprise that a recent EACT Treasury Survey reveals treasurers’ preference —when it comes to treasury technology— for Data Analytics and APIs.

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Layered hedging meets technology

The practice of achieving a ‘smooth’ hedge rate over time is being redefined as we speak. It is no longer enough for treasury teams to take a more or less random series of hedges and set arbitrary hedge ratios in the hope that their forecast accuracy will save the day.

We can go one step further, as we saw in the previous blog. Technology makes it possible for finance teams to fine tune their layered hedging program to take advantage of favourable moves in exchange rates: 

• Maturity flexibility. If the spot FX rate moves in a favourable direction, the finance team can increase the length of the layered hedging program.

• Hedge ratio flexibility. If the spot FX rate is more favourable in the current period than in the previous period, the hedge ratio can be increased for nearer-term exposures. 

This is accomplished by applying different ‘partitions’ to the hedging program, allowing the software solution to monitor FX Markets 24/7 to automatically increase hedge duration or hedge ratios whenever currency markets move in a favourable direction.

Thanks to Currency Management Automation solutions, the inherent complexity of such programs is no longer the daunting challenge it used to be. By allowing firms to protect their competitive position while reducing cash flow variability, treasurers make it possible for business managers to confidently use more currencies in their operations

A hedging program can be a powerful tool for businesses seeking to maintain stable pricing in the face of fluctuating currency markets. By strategically layering hedges over time, companies can mitigate the impact of adverse FX movements on their bottom line.

However, to fully harness the potential of layered hedging, it's crucial to avoid common misconceptions and pitfalls that can hinder its effectiveness.

In the introductory blog of this series, we asked ourselves the question: What are the pricing characteristics of companies that need layered FX hedging programs? We saw that firms that require continuity in pricing are best suited for these types of hedging programs.

This is because layered hedging makes it possible for managers to keep prices as steady as possible, for as long as possible, without hurting budgeted profit margins—even in the face of adverse movements in currency markets. 

Before tackling the nuts and bolts of an effective FX layered hedging program in our next blog, we need to clarify some of the most common misconceptions and/or suboptimal practices that hinder the effectiveness of these programs. These include: 

• Confusing layered hedging and rolling hedging

• Disregarding constraints faced by treasurers

• Lacking the necessary flexibility to react to FX markets

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Layered hedging and rolling hedging

Companies that desire to keep prices steady for as long as possible will naturally use some form of continual or rolling budget. This allows them to project the FX-denominated budgeted revenues and/or expenditures that make up the firm’s exposure to currency risk.

At this point, a couple of clarifications are in order. As we will see in more detail in our next blog, layered hedging works by ‘building’ the FX rate in advance as successive layers of hedges are applied to forecasted exposures.

As layers of hedges are executed, different value dates mechanically share some trade dates (and spot rates) in common. This commonality allows treasurers to ‘smooth out’ the hedge rate over time, making it possible for the firm to keep prices as steady as possible.

Why do we emphasise this point? Because we are keen to make a distinction between this mechanical smoothing and what we call ‘fake smoothing’ and ‘statistical smoothing’. Fake smoothing describes the improbable situation of a treasury team that executes, right at the start of the program, an FX hedge with a very long maturity.

Quite apart from the fact that this ignores the weight of constraints —in particular, the degree of forecast accuracy and the possibility of executing forward contracts with a very long maturity—, the treasury team would find itself at the mercy of FX markets as soon as the hedge matures. In other words: there is no smoothing effect at all.

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‘Rolling hedging’ programs are more common. Here, several periods are hedged at different trade dates. Depending on how markets move, these trade dates may or may not share a similar spot rate. In other words: commonality between hedge rates can be obtained, but this would be on a statistical —as opposed to systematic— basis.  

Constraints

In real life, treasury teams have to face a number of practical constraints. Inevitably, these limitations contribute to the final shape of the FX hedging program that is adopted—and this can lead to discrepancies between desires and reality. The two major constraints include: 

• The degree of forecast accuracy

• The maximum trade length authorised by banks

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The degree of forecast accuracy depends, quite naturally, on each business model. German sportswear company adidas, for example, has long-term contracts with its manufacturing partners. Some of these contracts have a tenure of more than 20 years. This makes it relatively easy to project the firm’s long-term exposure to currency markets.

Changes in business models can affect forecasting accuracy. Take aquaculture. Citing an FAO study, the Financial Times notes that "the amount of fish farmed globally just surpassed the wild catch. In 2022, 94.4m tonnes of fish were farmed in pens and ponds, vs 91.0m tonnes in open water." Clearly, some of the companies involved will gain a lot in terms of forecast accuracy.

And that’s not all. In corporate forecasting, advances in AI and AI-generated ‘nowcasting’ techniques are making strides. While some of these are quite spectacular [see], the reality is forecast accuracy will inevitably constrain the capacity of the finance team to come up with perfectly reliable long-term projections for FX-denominated future cash flows. 

Finally, the implementation of a layered hedging program has to contend with the fact that a firm’s banking partners may set a maximum trading length, presumably per currency pair. This consideration may clash with the treasury team’s ability to set up its layered hedging program and must be taken into account. 

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Insufficient flexibility in the face of FX markets opportunities

As we will discuss in detail in our next blog, layered FX hedging programs are ‘time-driven’. The schedule of hedges is known in advance and has to be executed according to a predetermined calendar of trades. But ‘market-driven’ elements can be introduced to reduce costs and/or to profit from favourable moves in currency markets.

One example is the automatic monitoring of FX markets for individual layers, using conditional orders to reduce the financial impact of unfavourable forward points. We can go one step further. Technology makes it possible for finance teams to fine tune their layered hedging program to take advantage of favourable moves in exchange rates by altering the length of the program or the desired hedge ratio by currency pair:

This is accomplished by applying different ‘partitions’ to the hedging program, allowing the appropriate software solution to monitor FX Markets 24/7 to automatically increase hedge duration or hedge ratios whenever currency markets move in a favourable direction. 

While highly valued by corporate customers, this flexibility is lacking in most layered hedging programs. And here’s precisely where Currency Management Automation comes to the rescue. 

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In late 2023, the finance team at streaming giant Netflix made a startling announcement: faced with profit margin pressure from the strong U.S. dollar, the company told shareholders that the treasury team would start “layering in [FX] hedges”. Why was this decision taken?

The first thing to note is the increasing weight of FX in terms of Netflix’s business. By late 2023, the company’s non-US dollar revenue had grown to 60% of total companywide revenue. Clearly, this proportion was “likely to increase over time”. That’s the first point.

Now consider the firm’s pricing strategy. 

The Los Gatos firm is not shy about bumping up pricing in its 10 largest markets —especially in the standard and premium segments. The basic segment displays a different pattern. There, Netflix keeps prices as steady as possible, for as long as possible [see]. For example, no price changes were seen in Germany and South Korea between 2016 and 2022.

And that’s precisely where layered FX hedging comes into play.

In this post, the first in a series devoted to layered hedging, we start by answering a simple, yet often disregarded question: What type of company should apply layered hedging programs? 

We will also learn about:

• The differences in pricing parameters between companies that apply static FX hedging programs and those that need layered hedging. 

• The notion of the ‘cliff’, both in terms of FX markets and the impact of sharp currency moves on companies' profit margins. 

• The type of cash flow exposure that needs to be collected and managed in layered hedging programs.

Characteristics of companies that need layered hedging

First things first: keep steady prices

At Kantox, we are keen to emphasise the importance of the pricing characteristics of each firm. This is the key to understanding what type of FX hedging programs companies need to apply as they seek to protect themselves from fluctuations in currency markets.

• Pricing parameter 1: catalogue-based pricing. We exclude from the analysis companies that can pass onto their customers the impact of large adverse FX market fluctuations—for example, firms with catalogue-based pricing, where prices are periodically adjusted. In this particular case, static budget hedging is the right approach as we explained in recent blogs.  

• Pricing parameter 2: continuity in pricing. FX layered hedging programs are best suited for companies that need or desire continuity in pricing, period after period. Companies in this category include:
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  1. ‍FX-driven firms. Firms that use an FX rate in pricing while facing a competitive landscape may need to keep prices as steady as possible. Example: a South Korean exporter of commodity-type chemicals.
  2. Non FX-driven firms. For commercial reasons, some companies desire to display the same prices to their customers, period after period. Example: Netflix has recently announced a layered FX hedging program.

It goes without saying that, in the face of adverse fluctuations in currency markets, keeping prices steady is not possible without accepting a corresponding degree of profit margin erosion. This is where the ‘cliff’ enters the picture. 

Mind the cliff

The concept of the ‘cliff’ is used to assess the effectiveness of layered hedging programs. In its simplest form, the cliff denotes a sharp move in currency markets. Such episodes occur frequently in currency markets.

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At the level of a company, we define the ‘cliff’ as a measure of how much profit margins are impacted if selling prices are not changed in the face of adverse FX fluctuations. As we will see in coming blogs, a key objective of layered hedging programs is to reduce the average cliff between hedge rates.

For now, it is sufficient to stress the following point: the only way for companies to keep prices as steady as possible in the face of adverse moves in currency markets is to apply FX hedging programs that reduce or remove such FX-induced ‘margin cliffs’.

Studies on pricing parameters and currency ‘cliffs’

There is no shortage of studies regarding firms’ pricing parameters and the impact of currency fluctuations. Central banks are keen to study such episodes as they frame monetary policy. Here are some examples: 

• ‍Sweden. The Sveriges riksbank finds little in the way of price changes in the event of a USD-SEK ‘cliff’. Sustained USD appreciation reflects 'flight-to-safety' episodes that signal less economic dynamism ahead. As a consequence, "firms choose to not pass on the increased costs, as demand is low."‍
• Switzerland. Firms in a tight financial position refrain from decreasing prices to maintain profits—even at the expense of future market share. Here, time is the striking element. The large pass-through elasticity rate of 41% only materialises about a year after the FX shock [see].‍
• United Kingdom. Following the GBP-USD 'cliff' after Brexit, UK exports have been partly dollarised. USD-invoicing surged from 1/3 to nearly 55%, while the share of non-EU exports invoiced in GBP declined from 55% in 2015 to 35% in 2022 [see].

Type of exposure

Before discussing what many companies get wrong as they implement layered hedging programs —and how Currency Management Automation can come to their rescue—, we need to say something about the type of exposure that is relevant in layered hedging.

Layered hedging programs are cash flow hedging programs. The exposure is in the shape of rolling forecasts for budgeted, FX-denominated revenues and expenditures over a number of campaign or budget periods linked together. This rules out purely transactional hedging where the exposure is in the form of firm sales/purchase orders or invoices.

Note however, that layered hedging programs can be effectively combined with micro-hedging programs for firm orders or invoices.

Why do we stress the importance of several campaign or budget periods? Because, unlike in static hedging programs for businesses that keep prices fixed for only one period, firms that apply layered hedging take a longer-term approach as they seek to keep prices steady for as long as possible. 

This ‘timing’ aspect of the exposure is also relevant as treasury teams consider possible constraints to their layered hedging programs. For example, their banking partners may not allow them to trade FX forward contracts beyond a certain maturity.

Wrapping up

In coming blogs we will discuss layered hedging programs in more detail. In particular, we will endeavour to show what many companies get wrong, partly as a result of a confusion between layered hedging and simple rolling hedging programs.

We will then dig deeper into the concept of commonality between hedge rates that lies at the core of layered hedging programs. Finally we will show how automation is the way forward for firms that deal with many currency pairs. 

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For example, a company with EUR as its functional currency may wish to protect its Hedging the budget: the automation imperative

The previous blogs on hedging the budget were devoted to:

1. The reasons why CFOs and treasury managers may want to protect the budget rate of an individual campaign/budget period;

2. The mistakes they often make as they implement the corresponding hedging programs to protect the budget rate.

3. The best practices in protecting the FX budget rate, including combinations of hedging programs. 

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In this final blog of the series, we want to present the automation requirements of a well-run combination of hedging programs designed to systematically protect the budget rate from FX market fluctuations. 

Hedging the budget: nowcasting and traceability

At first glance, a program to protect the FX budget rate used in pricing would not seem to require a high degree of automation. This perception can be misleading.

Time and again, experience shows that manual execution is a resource-intensive process that carries operational risks—especially when several currency pairs are involved, each with its particular degree of volatility and situation in terms of interest rate differentials.

When combining a static FX hedging program with a micro-hedging program for firm commitments —by far the most effective way to protect the budget rate—, three elements require an advanced degree of API-enabled automation:

. Nowcasting of FX exposure

. 24/7 markets monitoring

. End-to-end traceability

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Nowcasting the FX exposure: automation requirements

As we saw in the previous blog, the combination of a static hedging program and a micro-hedging program for firm sales/purchase orders sets in motion a process of ‘nowcasting’. This occurs as the FX exposure is automatically adjusted when hedges are executed.

Achieving this, however, is easier said than done. On the one hand, the ‘static’ part of the program relies on forecasts that often sit on Excel spreadsheets. On the other hand, firm sales orders may originate from the company’s CRM or other system. This involves at least two different sources of exposure information, with different ‘owners’ within the firm.

These types of exposure are created with different frequencies. Most likely, they also involve a different level of granularity. In addition, care must be devoted to ensuring that, while new forecasts for revenues and expenditures override previously existing ones, firm orders accumulate as time passes by. 

As the reader will surely realise, this calls for what we call, at Kantox, “system-agnostic” API connectivity.

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24/7 market monitoring: automation requirements

Programs to protect the FX budget rate are market-driven, an important difference with time-driven layered hedging programs. The latter works ‘like a clock’ because the schedule of hedges is known in advance and has to be executed according to a predetermined calendar of trades.

The distinction between time-driven and market-driven FX hedging programs has implications in terms of the technology and automation requirements. While the stop-loss (SL) and take-profit (TP) orders that protect a worse-case-scenario FX rate can be manually set, the exposure should be managed in different partitions with a well-defined hierarchy.

campaign/budget rate on its GBP-denominated sales. With a EUR-GBP 0.8540 spot rate at budget definition, the treasury team sets the worst-case scenario used in pricing at 0.8796, a 3% markup.

Protecting this FX rate can be achieved by setting three different SL orders, each covering ⅓ of the forecasted exposure. To give the finance team some flexibility, these orders can be set at EUR-GBP 0.8884, 0.9796 and 0.8708, so that their average matches the worst-case scenario rate to protect.

More work is required in terms of the monitoring of firm commitments. As individual pieces of exposure accumulate into the positions that are likely to be hedged, the Weighted Average Exposure Rate (WAER) must be recalculated 24/7, with each piece coming in at a different currency rate. Clearly, this sort of task is ripe for automation.

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Traceability: automation requirements

Further automation is required to track firm sales/purchase orders (hedged items) to the corresponding forecasted exposure that is hedged (hedging instruments). This makes it possible for finance teams to apply Hedge Accounting under IFRS 9 and US GAAP. 

Hedge Accounting can be a time-consuming task that, when manually executed, requires skills in accounting and in the valuation of financial assets. Companies sometimes shy away from applying Hedge Accounting —and even from currency hedging altogether— due to the perceived costs in terms of documentation and compliance.

API-enabled traceability allows finance teams to easily perform all the work involved in compiling the required documentation. The same can be said for the task of using FX swaps to adjust the firm’s hedging position to the settlement of its underlying commercial exposure. 

Given the role of traceability in accounting and swap execution, it comes as no surprise that a recent EACT Treasury Survey reveals treasurers’ preference —when it comes to treasury technology— for Data Analytics and APIs.

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Hedging the budget meets technology

The practice of protecting the FX rate embedded in the pricing of a campaign/budget period is being redefined as we speak. It is no longer enough for companies to take a big hedge at the onset of a budget period and hope that their forecast accuracy will save the day—and the budget.

In terms of FX hedging programs, this requires treasury teams to: 

• Effectively integrate static and micro-hedging FX hedging programs 

• Use market-driven programs with 24/7 monitoring and perfect traceability

• Leverage the power of delaying hedge execution

Thanks to Currency Management Automation solutions, protecting the budget rate from FX fluctuation helps CFOs and treasurers systematically achieve their KPIs. This can be achieved independently of their degree of forecast accuracy—and of what happens in currency markets during the campaign.

In our previous blogs, we discussed the pricing parameters that should guide a company’s choice of FX hedging program, and we highlighted the most common mistakes treasury teams make as they hedge company budgets. 

This third blog describes best practices in terms of FX hedging programs, including:

(a) Combinations of programs. The combination of static hedging and micro-hedging programs is the most powerful tool when hedging the budget. 

(b) Nowcasting the FX exposure. Treasury teams can adjust forecasts in real time, effectively ‘nowcasting’ the firm’s exposure to currency risk.

(c) The power of delay. Using conditional orders to delay hedge execution provides a number of financial and business benefits.  

Combinations of hedging programs

To understand what combinations of hedging programs can help you achieve as you protect your company’s budget from currency risk, it is best to take a step-by-step approach and start with the simplest of all programs. We’ll then add more and more elements. 

A big hedge at the start: serious drawbacks

The simplest approach is to take a big initial hedge. At the onset of the period, the finance team hedges the full amount of the forecasted exposure. As we saw in the previous blog, care should be taken to use a slightly worse FX rate for pricing purposes—a markup.

Thanks to the markup, the hedge rate is better than the pricing rate. This simple and widely used setup suffers from two serious drawbacks: (a) it relies on super-accurate cash flow forecasts, an unrealistic assumption; (b) it is not well-suited for situations of unfavourable forward points. 

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Using conditional orders: nowcasting the exposure

To tackle these drawbacks, conditional stop-loss (SL) and take-profit (TP) orders are used. While stop-loss orders protect a worst-case scenario rate that is used for pricing purposes, take-profit orders allow the finance team to take advantage of favourable moves in currency markets.

The illustration below shows the power of conditional orders. As a take-profit level is hit (see the green dotted line below), a portion of the forecasted exposure is automatically hedged. That portion is determined by the treasury team in accordance with its own tolerance for risk, its degree of forecast accuracy, and the situation of the business in terms of forward points. 

Note that there is a ‘nowcasting’ effect at play. This is because the program automatically adjusts the remaining exposure as soon as hedges are executed. The passing of time not only reduces the cost of hedging in the event of unfavourable forward points—it also creates flexibility to fine-tune forecasted revenues and expenditures.

This flexibility is all the more valuable to the finance team as forecast accuracy is especially relevant in regard to the latter part of a budget period, when visibility is relatively scarce.

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Combinations of programs: adding precision

An even more robust approach must now be considered. It combines the static FX hedging program outlined above and micro-hedging for incoming firm sales/purchase orders. With this combination, the finance team achieves extreme precision in currency hedging. 

The source of this precision is easy to explain. Hedging is not only executed on the back of forecasted exposures—it is also applied to firm sales/purchase orders, a type of exposure that has a higher degree of certainty. To see how this setup works in practice, consider the illustration below, where a hypothetical combination of programs is at work.

Initially, incoming firm orders are hedged, no matter the number of pieces of exposure and their size. As a take-profit level is hit for 50% of the forecasted exposure (the green dotted line), a large hedge is executed. Firm orders are still automatically tracked —but not hedged— as they continue to accumulate.

The exposure is actively managed throughout. As soon as accumulated orders go beyond the hedge ratio set with the initial SL/TP orders, they are once again hedged. And if stop-loss orders are hit, as shown in our example by the red dotted line in the middle part of the diagram, the solution reverts to tracking firm commitments without hedging them, since all the forecasted exposure is by now protected. 

And it is not over. In our illustration, accumulated firm orders grow beyond the total budgeted exposure, as realised revenues/expenditures surpass budgeted estimations. But there is no risk of ending up under-hedged, since the program has once again —and automatically— reverted to hedging them. 

And voilà. This is how the treasury team avoids ending up under or over-hedged while systematically protecting the campaign/budget rate. And if that wasn’t enough, it can take advantage of the benefits of delayed hedge execution. 

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The power of delay

As the campaign/budget rate is systematically protected, the use of conditional orders and the initial markup allow the finance team to benefit from delaying hedge execution. These benefits comprise: 

1. Flexibility. The passing of time gives the treasury team more time to adjust and update its forecasts

2. Forward points optimisation. The cost of hedging is reduced in the event of unfavourable forward points. 

3. Netting opportunities. Exposure netting opportunities can be uncovered, further reducing costs.

4. Collateral management. There is less need to immediately set aside cash for collateral purposes.

5. Profiting from favourable market conditions. If FX markets move in a favourable way, better hedge rates can be locked in. 

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Case study: Italian petrochemical company with USD exposure

An Italian petrochemical firm that resets its prices at the onset of each annual budget has exposure to USD on the contracting side. We proposed a static hedging program combined with a micro-hedging program for firm orders.

As the company defines its pricing at the onset of the budget period, it sets a markup to arrive at a worst-case-scenario FX rate (WCS). For example, if the spot EUR-USD rate is 1.1000 and the markup is set at 2.75%, then conditional stop loss (SL) orders are set at three levels from the spot reference rate: 1.75%, 2.75% and 3.75%. 

The average of the S/L orders thus matches the 1.06975 WCS rate to protect. In addition, a micro-hedging program for USD-denominated purchase orders is added, with hedges being executed on the back of firm commitments. During each period of the backtest period (2019-2023), the budget rate is outperformed.

This is because firm commitments are hedged at a rate that is by definition better than the SL orders. Outperformance reached 11.82% in 2021, generating gains of €1.98 vs. the budget rate on a €260m annual exposure. The lowest outperformance (0.87%) occurs in 2022 as stop-loss orders are hit in the second semester of that year.

As the micro-hedging program is executed, the residual exposure is automatically adjusted, which diminishes the finance team’s concerns about the degree of forecasting accuracy. 

In our previous blog, we discussed the type of pricing parameters that should guide a company’s choice of FX hedging program (you can read it 👉 here). We saw that protecting the budget rate, one period at a time should be prioritised by firms that use a ‘catalogue-based’ pricing model.

This second blog delves into the most common mistakes treasury teams make as they attempt to hedge company budgets. These misconceptions include:

1. ‍Confusing campaign and budget. Campaign periods may overlap budget periods, and that confusion must be avoided by FX risk managers.‍
2. Setting an inadequate budget rate. The choice of the budget rate may fall short in terms of attainability and stability —we show how this can be improved.‍
3. Hedging right away. This classical approach puts companies at the mercy of forecast accuracy. It may also yield a subpar financial performance.  

Campaign or budget? A classical misconception

The confusion between the campaign and budget period is a frequent one. Consider the example of a company that sets its 2024 and 2025 budgets by projecting a forecasted income statement, as shown in the illustration below.

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Campaign and budget periods may or may not overlap. There is no reason why a yearly budget should precisely match the forecasted revenues and expenditures of an individual campaign. In fact, the two are unlikely to overlap each other, as is common in fashion firms that display different collections during the same year.

The questions for the treasury team are: What is the exposure that needs to be hedged? And when is the corresponding settlement to be expected? In our example, hedging the expected AR from the start to the end of the year would reflect a double confusion:

. Confusion about the exposure. Only €200 million would be hedged instead of €300 million of the campaign. What needs to be ‘protected’ is the budget FX rate of the campaign, rather than the FX rate for the annual budget.

. Confusion about value dates. In our example, settlement is expected both in 2024 and 2025. This is the ‘cash flow moment’ that informs the treasury team about the hedging horizon, i.e. the value-dates of the corresponding derivatives instruments.

The correct solution is to hedge the forecasted exposure for a campaign until the expected settlement date of the corresponding commercial transactions. This policy allows the company to effectively protect the firm’s economic exposure to FX risk—but all of this needs to be effectively communicated to the C-suite to avoid confusion. 

Let’s talk about the budget rate

There are several possibilities to create an FX budget rate, the exchange rate that is used in pricing during an individual campaign or budget period. The following table, taken from Bloomberg, provides some examples of common practices regarding the choice of the budget rate:

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As we can see from the table, relevant questions about the budget rate include: (a) is it attainable? (b) is it achievable? (c) is it stable? Let us take an example. If the treasury team uses the spot rate that prevails at the time the budget is being created, the question of whether it is attainable relies largely on the cost of carry.

The cost of carry, in turn, is determined by the interest rate difference between currencies. Needless to say, this issue has gained in importance since 2021, when central banks began raising interest rates —each at its own pace— to fight inflation and inflation expectations.

FX markups: the case for an off-market exchange rate

Setting an off-market FX rate is a widely accepted practice when calculating the FX rate that is going to be embedded in pricing.

An example allows us to see how it may be constructed. A Europe-based company with EUR as its functional currency buys furniture in Asia, paying in USD. The firm sells in Europe during a campaign period, at a fixed ‘calendar price’ in EUR.

To arrive at the FX budget rate that is embedded in pricing, the treasury team takes —as a reference— the spot EUR-USD rate at the time the budget is created. It then ‘deflects’ that rate by, say, 3%. This less favourable rate constitutes a markup.

As such, it yields a higher profit margin than the prevailing spot rate. In the next blog we will see how treasurers can use conditional stop-loss orders to effectively ‘protect’ that FX rate during the entire budget period.

For now, let us note the tradeoff faced by the treasury team: the higher the markup, the more stable and achievable the budget rate—but the greater the detriment in terms of the firm’s competitive position.

This is why, in the event of favourable forward points —for example, when buying in a currency that trades at a forward discount, or when selling in forward premium currency—, such markups could prove unnecessarily costly.

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ILLUSTRATION. An off-market FX rate: Budget rate with markup

(A Europe-based firm with USD contracting costs)‍

Hedging right away? Don’t be so sure

When discussing how to hedge the budget, most textbooks —and many advisors— lazily limit themselves to a disarmingly simple, ready-to-use one-size-fits-all solution: just take a hedge right at the onset of the budget period. And do it for the entire amount of the budgeted exposure.

As readers of this blog know, such an approach does not take sufficient account of the variety of real-life situations. Immediately hedging the full forecasted exposure should only be considered in the event of: (a) close to perfect forecast accuracy; (b) favourable forward points.

When facing unfavourable forward points, or when less-than-stellar forecast accuracy is the norm, this may not be the best way for the finance team ro reach its objectives. Hedging right away exposes the firm to the dangers of under- or over-hedging—and to suboptimal financial performance. 

As we will see in the next blog, FX automation solutions allow finance teams to tackle these threats by taking advantage of what we call the benefits of delay. Delaying hedge execution yields quantifiable benefits in terms of financial optimisation and collateral management.

Importantly, it allows treasury teams to leverage the information coming from different company systems, and thus to reduce lingering concerns about forecast accuracy. This is the topic of our next blog.

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We are starting a series on the budget hedging topic to help you prepare for budgeting season and understand the importance of FX in the budgeting process. First you will need to understand the value of budget hedging for your business.

Budgets set out short-term plans to help managers run the business. They provide the means to assess whether actual performance was as planned and, if not, the reasons for this. They are an integral part of a planning framework adopted by well-run businesses. 

How do budgets help managers run the business? Four key reasons are commonly cited: 

1. Budgets promote forward thinking
2. Budgets help to coordinate the various sections of the business
3. Budgets can motivate managers to better performance
4. Budgets provide a system of control

Businesses of all sizes undertake budgeting and forecasting. The intricacies involved in the process are illustrated by the profusion of terms like periodic budget, rolling budget, master budget, zero-based budgeting, cash budget, revenue budget and many more. But what is the importance of foreign exchange in the budgeting process?

What pricing characteristics you have to consider in budget hedging?

Beyond the complexity that underlies budgeting in the business world, the single most important element from the FX point of view is the pricing characteristics/parameters of the business.

The key distinction to bear in mind is whether a business:

• Updates prices frequently

• Keeps prices steady during individual campaigns

• Keeps prices steady across several periods linked together‍

Frequently updated prices

When prices are frequently updated, FX hedging is conducted on the back of firm sales/purchase orders. In the lifetime of a typical commercial transaction, these orders reflect a contractual exposure to currency risk, as opposed to the forecasted or budgeted exposure. For this reason, we will not discuss this setup in this blog series. 

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Steady prices across budget periods.

When prices are kept as steady across several periods linked together, the exposure is in the shape of a rolling forecast of cash flows encompassing several periods linked together. The corresponding FX hedging programs —known as layered hedging— will be analysed in detail in another series of blogs.‍

Steady prices in individual campaign/budget periods.

Finally, many firms keep prices steady during a particular campaign or budget period and, as the following campaign or budget period unfolds, they simply reset their prices. This business model is sometimes referred to as ‘catalogue-based pricing’. 

When risk managers refer to budget hedging or to ‘protect the budget rate’, it is this catalogue-based pricing setup that they typically have in mind. And it is to this model that our attention is directed in this series of blogs. 

Understand the catalogue-based pricing model

The salient feature of catalogue-based pricing is that an item that is purchased at the start of the year can be purchased at the same price in the latter part of the catalogue period. When analysing this pricing model from the FX point of view, two key elements need to be considered: 

1. the ‘FX cliff
2. the notion of pricing risk

Borrowed from geography, the term ‘cliff’ plays a determining role in budget-based FX risk management. An FX cliff denotes a sharp movement in the exchange occurring between two budget periods. Recent examples of such cliffs include GBP-USD (September 2022) and USD-MXN (June 2024): 

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For a company with a high proportion of foreign sales, a sharp appreciation of its functional currency between budget periods is akin to an ‘FX cliff’. This is the case of Swiss watchmaker Swatch, a firm that suffered a CHF 500 million drag on revenue on account of the strong CHF in 2023 [see]. 

The same could be said for a company with exposure on the contracting side when its functional currency depreciates between budget periods. 

Accepting the cliff

Can the company pass on the impact of such currency market moves to its customers at the onset of a new budget campaign/period?

In other words: do its customers ‘accept’ the cliff? If they do, then the firm needs to protect the FX rate that it uses in pricing during each particular campaign/budget period. 

This is the case, among many others, of French luxury company Hermès. The firm hiked prices by an average 7% in 2023 in response to the weakness of some Asian currencies vis-à-vis the euro. Price increases were in the double digits in Japan on account of the 23% appreciation of EUR against JPY in 2024 and 2022.

Pricing risk: an under-appreciated ingredient in budget hedging

Pricing risk is defined as the risk of an adverse FX rate fluctuation between the moment a price is set and the moment a firm sale/purchase order is signed. Consider the catalogue-based pricing model. For transactions that occur in the early part of the budget period, this time lapse is very short.

Pricing risk, however, has more of an impact towards the end of the budget period, as a large and unfavourable FX fluctuation may take place while the firm maintains prices unchanged. Such fluctuations can easily wipe out profit margins.

When management infrequently adjusts prices —for example, at the onset of a new campaign— it needs other tools, such as an FX hedging program, to protect its profit margins. This is precisely the topic of this series of blogs. 

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Goals of FX hedging programs for individual campaign/budget periods

As it considers embarking on an FX hedging program, currency managers need to thoroughly assess the pricing characteristics/parameters of the business. This is why at Kantox we lay such emphasis on this matter. 

In upcoming blogs, we will describe in detail:

• What companies get wrong as they hedge their budgeted exposure during individual periods
• What best practices indicate in terms of setting and protecting the budget FX rate
• The automation requirements of such programs.

Before deep diving into these topics, however, it is important to state the primary and secondary objectives —and possible constraints— of an FX hedging program designed for individual campaign/budget periods: 

• Principal objective. Protect the FX rate used in pricing 

• Secondary objectives. Optimise forward points, address forecast accuracy, set appropriate risk tolerance levels

• Possible constraints. Degree of forecast accuracy, maximum trade length authorised by banks

In the previous blogs of this series, we discussed three reasons why CFOs and treasury managers may want to remove the accounting impact of FX gains and losses, and the mistakes they often make as they implement the corresponding balance sheet hedging programs. 

It is time now to pull up our sleeves and show how it’s actually done according to best practices in currency management. The preferred solution takes the middle of the road between two programs discussed earlier: (a) hedging every single balance sheet item individually; (b) hedging accumulated balance sheet items at a set date.

Best practices: the role of conditional FX orders

To hedge accumulated exposures while removing FX gains and losses is best achieved by setting conditional stop-loss (SL) and take-profit (TP) orders. This allows for small pieces of exposure known as entries to accumulate into larger positions.

These positions are then hedged as soon as SL or PT levels are hit. A few things need to be said about conditional orders: 

• Risk tolerance. The corridor created by the distance between SL and TP should reflect the risk tolerance level set by the finance team. 

• Automatic recalculation. As new entries accumulate, SL and TP levels must be reset on the Weighted Average Exposure Rate (WAER) that results from new entries.
• ‍Traceability. Each element along the transaction journey —from entry to position to conditional order to operation to payment— should have a unique reference number.

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Market-driven vs time-driven FX hedging programs 

The approach outlined here is market-driven. This means that hedges are executed only as currency markets hit the constantly changing SL and/or TP levels. In this sense, market-driven balance sheet hedging programs differ from types of FX hedging programs.

Take, by comparison, a layered FX hedging program. Whereas balance sheet hedging aims at removing the impact of FX gains and losses, layered hedging is concerned with creating a smooth hedge rate over time. The table summarises some of the differences: 

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‍Secondary objectives: some valuable advantages 

Finance teams at different companies may have different objectives regardingin regard to their FX risk management policies. As we saw in the first blog of this series, Merck applies the full gamut of FX hedging programs, including balance sheet hedging to remove FX gains and losses.

It is worthwhile to note that, alongside the main objectives of a well-planned FX hedging program, finance teams also have a set of secondary goals in mind. And while the nature of these goals may differ according to the hedging program, it is a fair assumption that treasurers will require their hedging programs to perform in the following areas:

• Forward points optimisation. Reduce the cost of hedging in the face of unfavourable forward points while taking advantage of favourable forward points.

• Exposure netting. Take advantage of exposure netting opportunities to reduce unnecessary FX trading.

• Collateral management. In an area of shifting interest rates, reduce the amount of cash that is set aside in terms of collateral requirements. 

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Removing FX gains and losses: the power of delay

The market-based approach to remove the impact of FX gains and losses outlined here is especially well suited to reach these objectives. Here, again, we see the importance of conditional orders to delay hedge execution. 

Delaying hedge execution with conditional orders allows finance teams to reduce the cost of hedging in the event of unfavourable forward points and to uncover exposure netting opportunities. It is also a way to optimise collateral management. 

Let us see this in more detail.

The fact that currencies trade against each other at various degrees of forward premium / discount plays a major role in FX risk management. There are two key rules of thumb for optimising forward points in currency hedging: 

• With favourable forward points. Anticipate hedge execution as much as possible. The hedge rate captures the positive impact of interest rate differentials. 

• With unfavourable forward points. Delay edge execution as much as possible with conditional FX orders. The hedge rate improves as hedging is postponed.

Note that, while delaying hedge execution with conditional FX orders, the underlying currency risk remains fully under active management as conditional stop-loss and take-profit orders must be monitored 24/7.

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Looming large: the automation imperative

We started this blog by describing best practices in balance sheet hedging to remove FX gains and losses as a middle-of-the-road approach between: (a) hedging accumulated exposures at arbitrarily set dates; (b) hedging each individual balance sheet item. 

We discussed the role played by conditional stop-loss and take-profit orders in allowing treasury teams to reach their principal objective —effectively removing the impact of FX gains and losses from the P/L— in accordance with their risk tolerance levels.

We then showed how delayed hedge execution plays an important role in terms of the firms’ secondary goals, including forward points optimisation, exposure netting and collateral management.

We’ve come a long way. But we’re not done yet. The next blog describes in detail what we call the automation imperative.

In the context of the firm’s commercial exposure, FX gains and losses reflect fluctuations in exchange rates during the time lapse between the moment an FX-denominated transaction is recognised as receivable or payable in the firm’s balance sheet, and the settlement of the corresponding transaction.

To remove the impact of FX gains and losses from the P/L, firms can implement balance sheet hedging programs. The most common setups include:

1. Standalone programs: They are run by firms whose principal FX goal is to reduce/remove the impact of FX and losses on the P/L. These are firms with solid profit margins and/or reduced weight of foreign currencies in their operations, i.e., firms with low FX sensitivity. 

2. Combinations of programs: For firms with higher FX sensitivity that hedge forecasted revenues and expenditures, balance sheet hedging programs are mostly deployed as a complement to existing cash flow hedging programs. 

In this and in the following blog, we provide an answer to the following questions: How do firms run their standalone balance sheet FX hedging programs? Do they follow a time-based approach, or do they attempt to hedge every single piece of exposure?

Finally: Is there a more convenient, middle-ground approach that makes a better use of FX automation solutions?

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The ECB exchange rate

When a firm recognises an FX-denominated transaction as a balance sheet item, the basic accounting principle is clear: the receivable/payable must be booked at the spot rate of the day. For European companies, this often means the ‘reference rate’, also known as ‘ECB reference rate’.

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What is the ECB reference rate?

The reference rate is published daily by the European Central Bank (ECB) on its website at around 16:00 CET. Its levels are set after consultation between central banks across Europe, reflecting market conditions around 14:10 on weekdays. As the ECB is careful to remark, reference rates are for information purposes only, i.e., not for transaction purposes. 

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‍How to remove FX gains and losses‍

When we consider the FX risk map in the context of balance sheet exposure, the ‘pricing moment’ and the ‘firm commitment moment’ are already in the past. What matters is the exposure that arises from the recognition of the balance sheet item until the settlement of the corresponding transaction. 

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To manage this exposure, firms usually hedge with forward contracts. Some companies may choose to partially or completely hedge that exposure. We know, for example, that the German global health care company Merck hedges balance sheet items in full, a practice that started in the 1990s as the firm sought a way to lower the cost of equity capital. 

As balance sheet items are revalued alongside the hedging instrument, changes in opposite directions offset each other. If the currency of a receivable appreciates against the firm’s functional currency —displaying an FX gain—, the reverse happens to the forward contract, as the foreign currency was sold, by definition, at a less favourable rate.

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Removing FX gains and losses: things to consider

• Reduction/removal of FX gains and losses: Balance sheet hedging removes the variability of the FX gains and losses line on the P/L

• Standalone or combined programs: Balance sheet programs are either ‘standalone’ type, or combined with a cash flow hedging program.

• No need for Hedge Accounting: As the FX impact is mutually offset, there is no need to apply Hedge Accounting under IFRS9.

• Cash flows are still at risk: When ‘standalone’ balance sheet hedging programs are implemented, cash flows may remain unprotected from FX risk.

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Pitfalls of removing FX gains and losses: hedging at set dates

The most common method used by companies as they seek to remove the impact of FX gains and losses is to take currency hedges at a given, arbitrarily set date. This method consists in pulling, out of the ERP, accumulated pieces of exposure —i.e., FX-denominated balance sheet items— and then taking the corresponding hedge with a forward contract.

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The process is then repeated at one point in the month, usually at the end of the month. The main pitfall of this procedure is easy enough to figure out: there is still a time lapse between the moment the exposure is captured and the corresponding risk mitigation exercise. This results in FX gains and losses, undermining the main goal of the program.

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                                                                                                                             Balance sheet hedging:  Hedging at set dates

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‍We often see that, if the balance sheet item has a maturity of 90 days until settlement, then probably about 75 days are effectively hedged, which leaves —on average— two weeks with open FX risk. In some currencies, this can represent a material P/L impact — Antonio Rami, Kantox Chief Growth Officer

Pitfalls of removing FX gains and losses: basic micro-hedging

Some companies use a different method altogether. Instead of hedging accumulated positions at fixed dates, they attempt to hedge every single FX-denominated balance sheet item. Needless to say, this is quite a resource-intensive activity.

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Members of the finance team are constantly collecting and hedging the exposure. The cumbersome nature of this technique is a shortcoming because it may force the finance team to neglect some currency pairs. These could well turn out to create a P/L headache for the finance team.

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In the event, the goal of removing FX gains and losses would not be achieved. This approach also fails to reduce the cost of hedging in the presence of unfavourable forward points. A EUR-based or USD-based firm that immediately hedges a receivable in the Brazilian currency will leave a good deal of money on the table. 

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This is because BRL trades at a 6% one-year forward discount to EUR on account of the gap between BRL and EUR interest rates. As we will see in our next blogs, there are better ways to deal with such forward discounts/premiums. 

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Towards a market-based approach to removing FX gains and losses

The two traditional approaches to removing the impact of FX gains and losses on the P/L present flaws. For different reasons, both of these approaches ultimately may fail to achieve the goals set by finance teams.

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On the one hand, hedging at arbitrarily set dates does not completely remove FX gains and losses due to the time lapse between the moment the exposure materialises and the risk mitigation exercise.

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On the other hand, attempting to hedge every single item in isolation is a resource-intensive activity that is only adapted to a situation of favourable interest rate differentials between currencies. 

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Our next blogs explore a way out of these intricacies.

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Most practitioners in the field of corporate finance agree that, when making investment, financing and dividend decisions, the ultimate objective of the finance team is to maximise the value of the business. But what is the role of currency management in this process?

One way to enhance the value of the business with currency management is to remove FX gains and losses from financial statements. In this blog, we will walk you through the basics of FX gains and losses and give you 3 reasons to remove them from your financials.

What are FX Gains and Losses?

In the context of a firm’s transactional accounting exposure, FX gains and losses reflect changes in exchange rates during the time lapse between the moment a foreign currency-denominated account receivable or payable is recognised in the firm’s balance sheet, and the settlement of the corresponding transaction. 

Finance teams can implement balance sheet hedging to achieve a clean, zero-line in terms of removing the impact of FX gains and losses. As we will see in this series of blogs, achieving this is easier said than done. Before discussing these hedging programs, however, it may be worthwhile to ask ourselves:

Why is it so important to achieve a clean, zero-line in terms of FX gains and losses?

And most importantly, how does that relate to the value of the firm? CFOs and treasurers can point to a number of reasons, the most important being: 

1. Reducing net income variability to lower the cost of equity capital

2. Smoothing out earnings when higher earnings are taxed at higher rates

3. Allowing the firm to grow by using more currencies in business operations

Let us consider these reasons in more detail. 

1. Reducing net income variability: Merck's success

In 1990, Merck CFO Judy Lewent made history as she co-authored a paper detailing the firm’s approach to FX risk management. Back then, the finance team reasoned that equity market participants failed to differentiate between earnings drops that could be attributed to the managers of the firm, and earnings drops that were the result of currency fluctuations.

A decline in earnings caused by an adverse exchange rate movement would cause the stock price to fall, impairing Merck’s ability to invest in R&D and grow its drug pipeline. This observation provided the rationale for balance sheet hedging programs to remove the accounting impact of FX gains and losses, a practice which continues till this day.

As we can infer from the Management of financial risks guidelines, Merck hedges FX-denominated "receivables from and liabilities to third parties". Balance sheet items are "hedged in full" in order to remove the accounting impact of FX gains and losses.

As the company tells investors, this practice is carried out in a systematic way, strictly eschewing any type of speculation regarding the path of exchange rates. 

The hidden benefits of balance sheet hedging: stock prices

Lower earnings variability resulting from balance sheet hedging can bring down the discount rate and boost the stock price—ultimately enhancing the company’s ability to invest. Merck now boasts of a market capitalisation north of  $330 billion—a fitting testimony to the success of a currency management policy envisaged more than 30 years ago.

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Merck’s stock price

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2. Smoothing out earnings

Another reason to tame earnings variability is often made in the context of corporate taxation. To the extent that higher levels of corporate income are taxed at higher rates (convex tax rates), there will be tax savings over time to firms that use currency hedging to effectively remove FX gains and losses.

The hidden benefits of balance sheet hedging: taxation

Here’s a hypothetical example from Prof. Aswath Damodaran. Consider a tax schedule where income below €1 billion is taxed at 30%, while income beyond the €1bn level is taxed at 50%. Since removing FX gains and losses smooths out earnings, it is possible for a firm with volatile income to pay less in taxes over time, as shown in Tables 1 and 2. 

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Comparing the two situations, it appears that hedging to remove FX gains and losses can help reduce the taxes paid over 4 years by €140 million. In other words: the firm can afford to spend up to €140 million to manage currency risk and still come out with a value increase. 

3. Using more currencies in the business

The rationale for removing the impact of FX gains and losses may vary from firm to firm. Listed companies with robust profit margins are more likely than not to implement balance sheet hedging.

Companies that operate on thin profit margins may have other primary objectives, including:

• Protecting profit margins on every transaction

• Protecting a budget rate during a particular campaign/budget

• Achieving a smooth hedge rate over time

Some companies, including Merck, use the full gamut of hedging programs at their disposal. They hedge the FX exposure from both “forecast transactions and transactions recognized in the balance sheet” [see]. They can do so with the help of combinations of hedging programs. 

Whatever the goal of your hedging program, here’s the important thing to keep in mind: removing currency risk not only reduces the variability of performance — it also allows the business to use more currencies in its commercial operations. With FX risk out of the way, companies can confidently buy and sell in the currencies of their suppliers and clients.

They are in a position to scale their operations by tackling new markets. And while they do so, they can reduce contracting costs and lower the credit risk in their accounts receivables. This is the third key reason for achieving a clear, zero-line in terms of FX gains and losses. 

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