Digitally Enabling Risk Management Objectives: Accelerating to Smart Treasury

FX Risk Management Solutions Quarterly | Issue 127 | July 2020 | Trending 5 Case Study: Realizing risk management policy objectives Existing policy may not be meeting company risk management objectives. In this case study, we find that through both benign and turbulent markets over the past 25 years, applying optionality would have significantly improved a corporate’s hedging program compared to policy-stipulated forwards in terms of both average rate achieved and standard deviation (volatility). This finding also argues the case for the need to systematically assess the appropriate hedging tools to be applied to ensure company risk management policy objectives are met. Corporate case study includes… 1. Back-testing EUR/USD forecasted cash flows (long USD/short EUR) over a 25 year period with a 3-month hedging frequency, 1-year hedging tenor and forecasting error of +/- 30%. 2. Benchmarking alternative hedging strategies against existing risk management policies and objectives. 3. Recommendations in order to meet risk management objectives Table 1: Existing (pre-study) corporate risk management policy and objectives Risk management objective Hedging tools and practices Best achieved rate and minimise period-on-period volatility Rolling forwards, layered forwards, based on forecasting accuracy. Tenor: 12 months. In our validation process, we test a number of different hedging strategies, including the company’s current approach. As stated in table 1, the company’s permitted hedging tools are both rolling and/or layered forwards, applied quarterly (3-month) and with a 1-year tenor. The risk management objective has two components: attain the best achieved FX rate and limit period-on-period quarterly FX volatility. EUR/USD case study results Based on the results in table 2, the company’s two risk management policy objectives, namely attaining the best FX rate and reducing period-on-period FX volatility, have clearly not been met. When applying rolling forwards the average quarterly rate achieved over the back-testing period is 1.2235, which has underperformed against all examined strategies with the exception of unhedged. In addition, the rolling forward strategy exhibits the highest risk with a quarterly standard deviation of 4.9% against all examined strategies except unhedged. The layered forward, although with the lowest standard deviation, has also underperformed in terms of average quarterly rate achieved (1.2204) against several of the alternative strategies examined. Table 2: EUR/USD 1-year hedging program results, highlighting rolling forward current policy and an alternative hedging solution suggesting rolling options Unhedged Rolling forward Layered forward Rolling option Layered option Rolling collar Layered collar Rolling forward + FE (option) Layered forward + FE (option) Effective rate 1.2123 1.2235 1.2204 1.2097 1.2115 1.2233 1.2188 1.2194 1.2177 Standard deviation 4.9% 4.9% 2.6% 4.2% 3.3% 4.2% 3.0% 4.1% 2.3% Risk management policy objectives: recommended adjustments. For treasury to meet its risk management policy objectives, it will need to adopt a program that incorporates optionality against its forecasted cashflows (table 3). More specifically, this is achieved by adopting the rolling option or layered option program, where the average quarterly rate attained over the past 25 years is 1.2097 and 1.2115, compared to rolling forwards (1.2235) or layered forwards (1.2204), respectively. In addition, both option hedging solutions lead to lower volatility than the rolling forward approach. Table 3: Risk management policy validation: recommended adjustments Current: Risk management objective Current: Hedging tools and practices Recommended: Risk management policy adjustments Best achieved rate and minimise period-on-period volatility Rolling forwards, layered forwards, based on forecasting accuracy. Tenor: 12 months. Move from 12m rolling and/or layered forwards to 12m rolling or layered options In conclusion, this study demonstrates that even when examining one of the most commonly applied risk management policies and currency pairs by corporates today, existing risk management practices may not be meeting company policy objectives. Although we do recognize this is only one specific example, nonetheless, it does support our argument for the need to more frequently systematically assess the appropriate hedging tools applied in order to ensure company risk management policy objectives are met. It may be then appropriate to tackle any of the infrastructural and/or organizational obstacles that currently impede the use of optionality in hedging programs.