In this time of extreme currency market volatility, it’s especially important for treasury to show that its FX risk management program adds value to the organization. And nowhere is that more critical than in cash flow hedging. Balance sheet hedges are designed to eliminate fluctuations in the FX gain/loss line of the P&L. That’s pretty easy to measure. But it’s a lot harder to tell whether a hedging program of anticipated exposure is beneficial, particularly because it will sometimes generate losses, if the currency takes a move in the wrong direction and the company is locked into a less advantageous rate.
Finding ways to measure the success of cash flow hedging programs has always been elusive. That’s partly that’s because the effects of the program show up in things like COGS or margins. Some companies take the easy way out and measure against a zero or 100 percent hedge. Others go with the middle, i.e., a 50 percent hedge. Still others provide a constant-currency analysis, i.e., what the business performance would have been had the currency rate stayed constant since the same period a year ago. But none of these approaches takes into account the objective of the program, particularly when it comes to layering programs that hedge a larger ratio of near-term exposure and less of long-term risks. That objective is mainly to reduce the impact of currency rate volatility on financial results.
Scott Bilter, partner at Atlas Risk Advisory suggests that treasury should examine ways to measure cash flow hedging programs and communicate their effectiveness to investors and management. It all starts with the cash flow program itself.
While providing constant currency guidance is better than providing nothing at all to investors, it still fails to reduce the volatility of the actual results, which could have been smoothed out with an effective cash flow hedging program, according to Bilter. “Even if you make the zero-sum-game argument that FX impacts on cash flows over the long term will be a wash, the volatility of those cash flows matters as well,” he explained. “Higher earnings volatility increases the beta of any given stock, and the higher risk level depresses the stock price, all else being equal.”
Work closely with FP&A. The best way to smooth out that volatility is with a layered hedging approach, i.e., hedging a large share of near-term exposure and less of the following quarters’. Treasury needs to work on this hand-in-hand with financial planning and analysis (FP&A), according to Bilter. It’s not enough for risk managers to provide only the FX gain or loss, outside the context of the overall plan. “They must also provide the analytic details that build the bridge back to the plan that their business partners understand and for which they are accountable,” he said. The differences may be volume or rate driven:
- Volume drivers are not just because of forecast deviation, but also from fact that most companies hedge less than 100 percent of their expected revenue. Everyone therefore must understand both the accuracy of the forecasts and the impact of the unhedged forecast (which is the difference between the planning rates and the eventual accounting rates, multiplied by the percentage not hedged per policy).
- On the rate side, “the hedges don’t perfectly offset the difference between the planning rates and the eventual accounting rates at maturity if the hedges are not executed at the planning rates,” Bilter explained. That variance can be reduced but not necessarily eliminated by updating the planning rates. Below is an example of a dashboard that incorporates these drivers.
Use a dashboard. According to Bilter, Green-yellow-red dashboards are particularly helpful in improving forecasts over time. Of course, no one wants to have a color other than green associated with a forecast for which they have responsibility. Converting the total impact on the income statement to a pennies-per-share (or fraction thereof) metric can be helpful in the preparation for a quarterly earnings call in the cases where FX impacts are material enough to be discussed on these calls.
“As with any other type of performance, when it comes to that of cash flow hedging programs, you get what you measure,” noted Bilter. “Without proper metrics in place, those in charge of cash flow hedging might do a poor job of mitigating FX risk for their companies.” It’s not treasury’s job to bet on the direction of the currency, but to buy companies time to adjust to changing rates by mitigating the impact of FX rate volatility on the company’s bottom line.
According to Bilter, a good cash flow hedging strategy is one that minimizes the amount of pain across widespread currency strengthening or weakening scenarios, buying enough time to react to competitive shifts while smoothing out the impacts on the income statement. “This strategy must be well understood by all stakeholders and well-integrated into the company’s planning cycles, with frequent feedback provided by treasury on what might be causing unnecessary volatility,” he explained. At the end of the day, it’s treasury’s job to understand and follow any changes to the business models or strategies so they’re aligned with the hedging program going forward.