Glossaire

The deliberate difference or margin applied between the spot foreign exchange rate at the time of budget creation and the actual rate used for pricing during the campaign period.

For example, if a EUR-based company purchases inputs in PLN and the spot EUR-PLN rate is 4.3113 at budget creation, using a budget rate of 4.1820 for pricing represents a 3% markup. This markup serves as a buffer against adverse currency movements and helps maintain profitability.

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FX policy is the process by which companies capture the growth opportunities that result from buying and selling in multiple currencies. A firm’s FX policy is therefore of strategic value; it comprises the entire FX workflow: the pre-trade phase (including the firm’s pricing policy), the trade phase (hedging) and the post-trade phase (cash management and accounting). By pricing and selling in the client’s currency, firms ‘speak the language’ of their customers, allowing commercial teams to add promising new markets to the portfolio. Buying in suppliers’ currency allows companies to widen the range of potential suppliers and to bypass supplier markups, thus leading to higher profit margins. An effective FX policy presupposes effective FX hedging. Depending on a company’s specific parameters, many types of hedging programs can be designed to protect a company from FX risk. The implementation and management of these FX hedging programs may be quite burdensome for treasury teams that rely on manual execution and spreadsheets. However, Currency Management Automation solutions allows firms to run them smoothly, on a fully automated basis.

FX policy guidelines are a set of procedures that spell out a firm’s methodology and tools in terms of managing currency risk. Drawn by the finance team, FX policy guidelines are based on the business specifics of each company, including its pricing parameters, the location of its competitors, the weight of FX in the business, and the situation in terms of forward points. FX policy guidelines should be clearly communicated across the enterprise, in as much detail as possible. This is especially true in the case of firms with high ‘FX sensitivity’, i.e. firms with low profit margins and/or a high weight of foreign currencies in their business. In such firms, FX-related matters are of strategic importance. Therefore, FX policy guidelines should be clearly communicated and explained by the finance team to all relevant stakeholders within the enterprise. They should be well understood and assimilated by top-level managers, including the CEO and the Board.

A company’s FX policy mandate is the document that sets out: (a) management’s strategic objectives in terms of currency management; (b) the goals of the firm’s FX hedging program. Given the FX policy mandate, the finance team spells out the practical steps needed to execute the firm’s hedging program. For example, a firm in the industrial machinery space that expands into emerging markets can include, in its FX policy mandate, the instruction to price in local currencies, and the goal of hedging the corresponding FX risk in a way that creates savings in terms of the cost of carry.

An FX Policy Template is a document that sets out a firm’s strategic objectives in terms of currency management, as well as the goals of its hedging program or combination of programs. The FX Policy Template also enumerates the resources allocated to the finance team in order to execute FX hedging. In firms that automate part or most of their FX hedging, the FX Policy Template should provide a detailed ‘FX Workflow’ framework, a step-by-step description of the procedures involved in the pre-trade, trade and post-trade phases of the FX hedging execution.

Foreign exchange rate alerts (FX alerts) are programmed email or message notifications of a pre-established exchange rate level. Set by currency risk managers, foreign exchange rate alerts cut out the time and commitment required to follow exchange rate movements and reduce the risk of missing a desired rate. By triggering the execution of forward hedges, Currency Management Automation solutions go a step beyond simple Foreign Exchange alerts. In effect, these are turned into ‘take profit’ and ‘stop loss’ orders that are automatically executed at the predetermined levels.

FX transaction costs or ‘foreign exchange transaction costs’ represent the expenses incurred by buying and selling and foreign currencies from a foreign exchange broker/dealer. In currency markets, transaction costs comprise commissions charged by foreign exchange brokers and ‘spreads’ charged by both brokers and foreign exchange dealers. While operational costs are easily identifiable by customers, the spread is often hidden in the exchange rate. To properly evaluate FX transaction costs, a firm should examine the mid-market rate at the exact time when the transaction was concluded, and compare it with the rate applied by the bank or FX dealer. The difference in the exchange rate plus the operational costs (commission) gives a clearer view of the effective FX transaction costs.

Hedge accounting allows companies to recognise gains and losses on hedging instruments and the exposure they are intended to hedge, with both being registered in the same accounting period. This procedure reduces income statement volatility that would otherwise arise if both elements were accounted for separately.The financial instruments standard that deals with the accounting of FX hedges is called IFRS 9. Issued by the International Accounting Standards Board (IASB), IFRS 9 requires firms that implement hedge accounting to provide detailed documentation on their risk management objectives, hedging instrument, hedged item and the nature of the risk hedged, as well as the results of tests that determine the effectiveness of the hedging relationship and the sources of ineffectiveness.

Hedge effectiveness is the extent to which changes in the value of a given exposure (the hedged item) are offset by an opposing change in the value of the financial derivative (the hedging instrument). Under hedge accounting, hedge effectiveness is measured with three criteria: Economic relationship. There must be an inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument. Credit risk. Changes in the credit risk of the hedging instrument or hedged item should not be large enough as to dominate the value changes associated with the economic relationship. Hedge ratio. The appropriate hedge ratio should be maintained throughout the life of the hedge.

The hedge effectiveness ratio —in a typical cash flow hedge of a forecast transaction— measures the accuracy of a hedge by comparing, at each reporting date, the fair value of the forecasted transaction and the fair value of the hedging item. For example if, three months after inception, the fair value of the forecast transaction increased by 100 and the fair value of the hedging instrument decreased by 110, hedge ineffectiveness was the fair value change of the forward was 10 because the fair value change of the forward was higher (by 10) than the fair value change of the forecast sale.