A slightly contrarian view on cash flow forecasting accuracy

Time after time, FX management surveys confirm treasurers’ concerns with the degree of accuracy in their cash flow forecasts. In our own sample measurement, this concern is given more weight than potential episodes of high FX volatility or shifting interest rate differentials between currencies. Worries about cash flow forecast accuracy are easily understood given the current uncertainty in financial markets. As a corporate treasurer, the last thing you need is to be caught off-guard in terms of your company’s funding needs, a point recently made by investor Warren Buffett.No one would seriously challenge that assessment. Yet, when it comes to currency management, the importance of having accurate cash flow forecasts is overstated. Let us see this in more detail.

Cash flow forecasting in hedging programmes

There are three main FX cash flow hedging programs:

• Micro-hedging programs for firm sales/purchase orders
• Layered hedging programs
• Static hedging programs

Here’s our point: the degree of forecasting accuracy is not a pressing concern in any of these programs. This is almost obvious in the case of micro-hedging programs for firm sales/purchase orders, very popular in the Travel industry and others, where companies frequently update their prices. The reason is clear: a firm commitment is a legally binding agreement. Its probability of occurrence is very high. Arguably, it is not even a forecast at all.

Forecasted exposures and FX hedging: layering

Things get more interesting in hedging programs where the FpX exposure is unmistakably in the shape of cash flow forecasts. Layered hedging programs are used by companies that desire to smooth out the hedge rate over time. Consider a linear layered hedging program with 12-month granularity, one of the most used. To achieve the necessary commonality between hedge rates, currency hedges in layers of 8.3% are applied, month after month, to the forecasted cash flows (100%/12 = 8.3%).For example, if a forecasted exposure with a January 2024 value date needs to be 100% hedged at the end of December 2023, by the time we reach the end of August 2023, that particular forecasted exposure will have received 8 layers of hedges. And accuracy will be required for less than 70% of the forecast (8.3% x 8 = 66.6%). This is well within the range of what is considered achievable by most standards.

Forecasted exposures and FX hedging: protecting the budget rate

In companies whose main goal is to protect the FX rate used in pricing during a particular campaign, risk managers may feel tempted to hedge most of the forecasted exposure at the start of the campaign.While this allows them to remove the inherent pricing risk of a ‘catalogue-based’ model, it does require a high degree of forecasting accuracy.The solution is to set a program that guarantees a ‘worst-case scenario’ FX rate equal to the budget rate used in pricing. This rate can be protected with conditional orders that are set, for example, at 1%, 2% and 3% to the budget rate, each for a third of the exposure.The worst-case scenario rate, in turn, is set at a level that includes a buffer to the spot rate. What do we gain from this buffer? Flexibility. As time goes by and no hedges are executed on the back of the budgeted exposure, cash flow forecasts are continuously updated. With an added bonus: managers can leverage the information from incoming firm sales/purchase orders to fine-tune their forecasts.

Automation requirements

The operational complexities of the FX hedging programs outlined above make it impossible to manually execute them without error. Here are some examples of why automation is necessary when it comes to managing FX risk:

• Micro-hedging programs. Dynamic conditional orders are continuously reset as the weighted average exposure rate is re-calculated throughout the program. If many currency pairs are contemplated, human error becomes unavoidable.
• Layered hedging programs. The schedule of hedge executions becomes mission impossible as soon as several currency pairs are involved—to say nothing of the risks of manual data input and formula errors when large spreadsheets are used.
• Static hedging programs. The 24/7 exposure monitoring required by programs to protect the budget rate would considerably tax the resources of the treasury team.

Do you wish to set yourself free from the constraints of super-accurate cash flow forecasts when managing FX risk? Currency Management Automation solutions allow you to do just that, while the treasury team seamlessly executes the entire FX workflow.All the while, the most precious asset of all —time— will be at your disposal to further improve those irksome forecasts.