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Découvrez les stratégies essentielles de couverture des risques de change et les meilleures pratiques de gestion des devises de nos experts en la matière.
Why You Need an Automated Budget Hedging Program
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:
- The reasons why CFOs and treasury managers may want to protect the budget rate of an individual campaign/budget period;
- The mistakes they often make as they implement the corresponding hedging programs to protect the budget rate.
- The best practices in protecting the FX budget rate, including combinations of hedging programs.
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
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.
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.
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.
The Power of Delay: How to Optimise Your FX Hedging with Conditional Orders
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.
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.
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.
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:
- Flexibility. The passing of time gives the treasury team more time to adjust and update its forecasts
- Forward points optimisation. The cost of hedging is reduced in the event of unfavourable forward points.
- Netting opportunities. Exposure netting opportunities can be uncovered, further reducing costs.
- Collateral management. There is less need to immediately set aside cash for collateral purposes.
- Profiting from favourable market conditions. If FX markets move in a favourable way, better hedge rates can be locked in.
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.
3 Common Misconceptions When Hedging the Budget (and How to Avoid Them)
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:
- Confusing campaign and budget. Campaign periods may overlap budget periods, and that confusion must be avoided by FX risk managers.
- 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.
- 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.
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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