Financial analyst

CORE PRINCIPLES FOR MANAGING CURRENCY RISK

So far we have examined currency risk, how to manage and quantify it. Before we go on from theory into practice, it may well be useful to establish a framework, a reference for corporate Treasury of core principles of managing currency risk. There have been several notable efforts along these lines, most notably of course the “Core Principles of Managing Currency Risk” set out by the Group of 31 (US multinational corporations) and Greenwich Treasury Advisors.
Clearly, there is a danger in attempting anything even approaching best practice for corporate Treasury as corporations vary so significantly in terms of their exposures, requirements and focus. Such concerns notwithstanding, the importance of the issue equally requires that the attempt be made to create a reference from which individual corporations can perhaps take what might be appropriate to them. Thus, what follows is my own tentative suggestion of what any such list of core principles of managing currency risk should contain:
1. Determine the types of currency risk to which the corporation is exposed — Break these down into transaction, translation and economic risk, making specific reference to what currencies are related to each type of currency risk.
2. Establish a strategic currency risk management policy — Once currency risk types have been agreed on, corporate Treasury should establish and document a strategic currency risk management policy to deal with these types of risks. This policy should include the corporation’s general approach to currency risk, whether it wants to hedge or trade that risk and its core hedging objectives.
3. Create a mission statement for Treasury — It is crucial to create a set of values and principles which embody the specific approach taken by the Treasury towards managing currency risk, agreed upon by senior management at the time of establishing and documenting the risk management policy.
4. Detail currency hedging approach — Having established the overall currency risk management policy, the corporation should detail how that policy is to be executed in practice, including the types of financial instruments that could be used for hedging, the process by which currency hedging would be executed and monitored and procedures for monitoring and reviewing existing currency hedges.
5. Centralizing Treasury operations as a single centre of excellence — Treasury operations can be more effectively and efficiently managed if they are centralized. This makes it easier to ensure all personnel are clear about the Treasury’s mission statement and hedging approach. Thus, the Treasury can be run as a single centre of excellence within the corporation, ensuring the quality of individual members. Large multinational corporations should consider creating a position of chief dealer to manage the dealing team, as the demands of a Treasurer often exceed the ability to manage all positions and exposures on a real-time basis. The currency dealing team must have the same level of expertise as their counterparty banks.
6. Adopt uniform standards for accounting for currency risk — In line with the centralizing of Treasury operations, uniform accounting procedures with regard to currency risk should be adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the performance of currency hedging.
7. Have in-house modelling and forecasting capacity — Currency forecasting is as important as execution. While Treasury may rely on its core banks for forecasting exchange rates relative to its needs, it should also have its own forecasting ability, linked in with its operational observations which are frequently more real time than any bank is capable of. Treasury should also be able to model all its hedging positions using VaR and other sophisticated modelling systems.
8. Create a risk oversight committee — In addition to the safeguard of a chief dealer position for larger multinational corporations, a risk oversight committee should be established to approve position taking above established thresholds and review the risk management policy on a regular basis.
Clearly, this list of core principles of managing currency risk is aimed at the larger multinational corporations that have the means and the business requirements for such a sophisticated Treasury operation. That said, such a list can also be used as a benchmark for those who, while they cannot or do not need to comply with all elements, can still find some useful. Corporations of whatever size and sophistication must balance the real cost of implementing such an approach to managing currency risk against the possible cost of not doing so. The first cost is tangible, the second intangible — but by the time the second becomes tangible it is too late! That is precisely what we are trying to avoid.
It may be useful for a corporation to split currency risk management into two parts — the first part focusing on the overall approach towards managing of currency risk, the second dealing with the actual execution of currency risk management. Many corporations have this kind of division of labour, whether or not they formalize it. However rigorous a currency risk management policy is, it still runs the risk of being bypassed by events, technology and innovation. Thus, it is very important to have a regular review process to ensure the currency risk management policy remains up-to-date and in line with the corporation’s needs. In this review process, important questions to be raised may include:
Do the currency risk management policy and the Treasury’s mission statement still represent the corporation’s business needs? Should the corporation maintain or change its approach towards managing currency risk?
How has currency hedging performed relative to the established benchmarks? How can the costs of currency hedging be reduced?
Are VaR or credit limits, or the financial instruments relating to currency risk management, still appropriate?