A Guide to Automation in Layered FX Hedging Programs

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