Don’t worry, be happy — at least when it comes to the degree of forecast accuracy in your FX risk management programs. In this article, we will explain why a high degree of forecast accuracy is not necessary for successful FX risk management.  

Why are forecasts not required in micro-hedging programs?

In our CurrencyCast episode on the FX Risk Map, we mentioned the journey of a typical FX-denominated commercial transaction, travelling back from the settlement in cash to the issuance of the corresponding invoice, then to the firm sales/purchase commitment, and finally to the forecast itself. A forecast is an anticipated transaction that is not legally binding. And it finds itself the farthest away from the cash flow moment.

Read more: How to Map Currency Risk

This definition sets the stage for our first proposition today, namely that a high degree of forecast accuracy is not required when performing micro-hedging programs. A micro-hedging program is especially well suited for a company with an FX-driven price that is frequently updated. Whether the goal of risk managers is to protect the cash flow exposure or the accounting exposure on the transactions, the type of exposure that will need to be hedged is not a forecast. It is a firm commitment for a sales/purchase order in the first case or a balance sheet item such as an account receivable or an account payable in the second case.

So there it is: a high degree of forecast accuracy is not required at all when performing a micro-hedging program. Is that all? Unfortunately not. Such programs require a certain degree of automation, especially if many currency pairs are involved in hundreds or even thousands of transactions. Failure to have these systems in place may lead some companies to apply inadequate programs.

Static hedging

Things are more interesting if we consider static hedging programs that are well suited for firms that keep steady prices during an entire campaign or budget period, and that can ‘reprice’ at the onset of a new campaign, whatever happens in the FX market in between. The challenge here is to create a program that allows treasurers to secure and protect a ‘worst-case scenario budget rate’ while at the same time providing enough flexibility to leverage incoming information to fine-tune and improve forecasts. To achieve that, a buffer is created by setting the budget rate at a distance from the FX reference rate at the start of the campaign. Next, stop-loss orders are placed around the budget rate. In a worst-case scenario where the stop-loss orders are hit, the budget rate would be secured for the campaign as it is forecasted at that moment in time.

Also, profit-taking orders are set above the reference rate to take advantage of favourable moves in currency markets. If market rates trade inside the corridor between profit-taking and stop-loss orders —and that’s precisely the raison d’être of the ‘buffer’—then risk managers have the most precious asset of all at their disposal: time. As the Rollings Stones song puts it:

Time is on my side. Yes it is

You’re searching for good times

But just wait and see

How does the treasury team gain time? By delaying the execution of the hedges. Time brings three different advantages, some more easily measurable than others. In order of ‘measurability’:

• achieving savings on the carry in the event of unfavourable forward points
• ‍setting aside less capital for margin/collateral requirements
• gaining time to improve and fine-tune forecasts

This last point is the most important when discussing forecast accuracy. Time allows the finance team to fine-tune and improve forecasts as business events —such as incoming firm sales/purchase orders— bring more visibility into the latter part of the forecasted exposure, which is the most difficult to estimate. This is how risk managers can mitigate forecast inaccuracy. And, as a bonus, they can be in a position to take advantage of favourable moves in FX markets.

Conclusion

- A high degree of forecast accuracy is not necessary to systematically achieve the goals of your hedging program. In fact, we can have relatively inaccurate forecasts and yet run a successful FX risk management program. - Currency Management Automation solutions, working alongside your existing systems, are needed to:

1. Allow risk managers to execute micro-hedging programs that do not rely on forecasts.
2. Reliably monitor the FX markets in static programs to set all the program’s parameters, including buffers and conditional orders. This would be too challenging to execute manually, especially in companies with different divisions and/ or business lines and currency pairs
3. Free up time for risk managers, so they can concentrate on improving and fine-tuning their forecasts when they run their forecast-based FX programs. Time brings value!