In the last 18 months, the COVID-19 pandemic has underscored the need for companies to focus on liquidity risk. As the situation improves, treasuries are reviewing their FX risk management policy to consider exposures more holistically. To enable this, treasurers are assessing how technology can support this shift in focus and optimize their FX risk management processes. Let’s review how you can use technology to transition from a reactive to proactive approach, and finally an advanced approach for FX risk management.
Prerequisites for FX risk management
There are a couple of things you need to do before you can start managing risks with a treasury management system (TMS).
- Define treasury policies that determine the risks you are aiming to mitigate.
- Capture exposures from your forecasts, ERP systems, AP systems, third party systems, etc.
- Capture hedges including hedge exposures and hedging instruments in your portfolio, such as swaps, forwards, options, etc.
- Import relevant market data.
- Analyze financial risks to know your position and the impact of market trends.
- Implement standard reporting for hedge accounting, IFRS, and other corporate mandates and policies.
Technology for FX risk management
Risk management is performed at different levels of sophistication. First, there are treasuries that are reactive, and the risk policy dictates a standard model. Second, there are treasuries that take a more proactive approach and increasingly leverage technology to automate day-to-day operations. Third, there are treasuries that have implemented advanced risk management and use the most advanced functionality in their TMS for it. Let’s take a closer look at the different stages:
1) Reactive FX risk management
When getting up and running with FX risk management, less advanced treasuries only cover the basics. They want to get to grips with FX risk, comply with their risk policies, and use basic TMS functionality instead of spreadsheets. Still, technology helps them in many ways:
- System of record
They use their TMS for trade capture, inventory reporting, alerts, and warnings. They also use audit trails and workflow to make sure trades are approved and recorded in a timely and accurate manner.
The treasury system also helps risk managers with capturing their treasury policy, reporting on compliance, and short-to long-term views on risk.
- Platform integration
Connectivity is important to execute, track, and account for trades efficiently. A TMS supports standard interfaces (for example, FXall or 360T), two-way interfacing, end-to-end audits, bid capture, and confirmation matching.
For reactive users, a TMS offers basic capabilities such as statement accounting, information on realized PnL and un-realized PnL, and hedge accounting.
2) Proactive FX risk management
As treasuries have locked down the fundamentals and are becoming more proactive in FX risk management, they start looking at more sophisticated analysis and reporting. They really want to understand their exposures, improve hedging decisions, and protect their companies from market volatility and uncertainty. Technology helps them to answer fundamental questions. Here are some examples:
- What-if analysis
What would be the impact of a certain batch of trades?
What would be the impact of trades at a certain price?
- Stressing market curves
What is the impact on my portfolio if certain market rates change?
What is the impact on my portfolio if some market rates change at the same time?
- Simulating macro events
Based on what happened during COVID, what if there is another wave?
Based on what happened in 2008, what happens if markets become turbulent?
3) Advanced FX risk management
You find advanced treasuries in large global corporates with many different exposures, in different currencies, spread across the world. Their Treasury teams really need to manage exposures not on a one-by-one basis, but rather by looking for natural hedges within their portfolio and using advanced analytics such as Cashflow-at-Risk (CFaR) to reduce risk and cost at the same time.
CFaR is a powerful tool using Monte Carlo simulations that allow FX risk managers to understand the potential shortcomings of their hedge programs. Here are some examples:
- With advanced analytics, you can compare portfolios. You can analyze the Cashflow-at-Risk before and after laying over a hedge portfolio. These analyses can be done with what-if simulation or an actual derivative portfolio.
- With optimized analysis of your foreign exchange portfolio, you can look at different asset groups across different currencies around the world. The report will give you an optimized order of what to hedge first, second, third, and so on. You can reduce the number of transactions. Less transactions not only means less bank fees, but also less work for the treasury team on a day-to-day basis.
Across ION’s customer base, we see all types of FX risk management. Our portfolio of treasury management solutions supports them, wherever they are in their transition from reactive to advanced risk management.
FX risk management: How to evolve your risk strategy
Treasuries handle FX risk management at different levels of sophistication. ION Treasury shows you in this 30-minute webcast how you can improve automation and control in your risk management approach.