A recent report from Greenwich Associates found that 60% of corporate treasury professionals felt it was not possible to establish best practices for FX. Yet only one in five of the large companies surveyed employ the variance at risk (VaR) framework – such as earnings at risk or cash flows at risk – despite its suitability for precision hedging strategies.
Cash flow at risk and earnings at risk take into account the relative volatilities and correlations of individual currencies when designing hedging strategies and incorporate cash flow and earnings implications in addition to payments.
“However, the methodology requires relatively good information management and access to sophisticated tools and datasets,” says Ken Monahan, senior analyst in Greenwich Associates’ market structure group and author of the report. “Many firms do not pursue the latter because they do not believe they can achieve the former.”
One of the reasons put forward for the low level of VaR usage was that companies have little confidence in the quality of their own data.
“The first step in a financial risk-management framework should be to identify the underlying exposures,” says Sander de Vries, senior manager at Netherlands-based treasury consultancy Zanders. “If the underlying data is poor quality, the outcome of the risk quantification will not be reliable. In addition to standardization and centralization of processes, we also see that companies are taking initiatives to invest in technologies related to big data and artificial intelligence to improve data quality.”
He agrees that many corporates might not implement at risk calculations in their financial risk management framework because they are more difficult to make, and the outcome is more difficult to interpret.
“We feel it is best practice to use this quantification technique,” says de Vries. “However, it should be complementary to other methodologies which are more closely aligned to current hedging practice.”
Firms do not hedge to get a return but as an instrument of FX risk management at the corporate level. Having a 95% confidence interval for protecting your margins is something many corporates do not necessarily feel comfortable with since their goal is to be FX neutral under any market situation.
That is the view of Antonio Rami, chief growth officer at Kantox, who recommends that companies design processes and adopt systems that allow them to capture different types of data exposure such as forecasts, firm commitments and balance-sheet items.
Antonio Rami, Kantox
“This is especially relevant for forecast data, since there is often less trust about its quality and timing,” he says. “The solution here is to break the ‘silos’ between commercial and treasury teams by improving communication and designing joint processes.”
An FX management solution should also be implemented in order to capture different types of exposure in real time, as well as their evolution from forecasts to firm commitments to balance-sheet items.
“This is crucial in terms of having full exposure visibility and defining an optimal hedging policy,” adds Rami.
Lack of reliable data and the complexity of the task at hand often leave companies dependent on FX dealers, with treasurers asking their dealer counterparties to conduct VaR analysis on their behalf.
“The tools used to generate these estimates and strategies are more commonly used by banks than corporates, so it might be cheaper depending on the frequency with which the company hedges according to these principles,” says Monahan.
Treasurers asking dealer counterparties to run VaR is a way of estimating downside risk for the positions the company carries with each individual counterparty, but that still may not provide the desired consolidated risk assessment picture, according to treasury consultant Fabio Marcos.
“So this is in fact a partial substitute for a more robust risk-management practice,” he says. “One way of addressing the issue of insufficient reliable data or not having access to reliable data in a timely manner is centralization through automation and integration of different sources, such as accounts receivables and accounts payable.”
It does not change the perception of VaR as a tool that is more suitable for active asset managers seeking a rate of return than for corporate risk managers worried about reducing the impact of FX
– Antonio Rami, Kantox
“Treasurers should be able to calculate risks, but they have to separate short-term risks from long-term risks,” observes Richard Cornielje, director corporate customers at risk management technology company KYOS, adding that lack of knowledge and limited internal communication often hold back best practice.
Rami acknowledges that conducting proper VaR analysis requires market data availability and analytical capabilities that are far more common with dealer counterparties.
“However, this does not solve the underlying problem of exposure data quality and it does not change the perception of VaR as a tool that is more suitable for active asset managers seeking a rate of return than for corporate risk managers who are more worried about reducing the impact of FX in terms of margins and reporting,” he concludes.