Optimizing FX risk management: From strategy to seamless execution

Effective foreign exchange (FX) risk management requires tailored strategies for booked, contracted, and planned exposures. Learn how to navigate these distinct categories and how to execute the process with the aid of Treasury Management Systems and trading platforms.

In today’s global economy, FX risk is a constant presence, impacting businesses of all sizes. Having a robust FX risk management strategy is crucial to protecting profits and ensuring financial stability. It is important to note that FX risk management is not about profiting from market developments, but primarily about establishing planning security.

What is FX exposure?

Generally, there are three different categories of FX exposure:

• Booked exposure represents the confirmed and recorded financial commitments.
• Contracted exposure refers to future obligations that have been agreed upon but not yet recorded.
• Planned exposure is an estimation of the potential future exposure (PFE) based on anticipated transactions.

To manage FX risk ideally, these three distinct exposure categories should follow different hedging policies based on their nature, timing, and the company’s risk tolerance. The company’s risk tolerance and risk management strategy should be the guidance for setting target hedge ratios and thresholds to trigger hedges.

Setting the target hedge ratio

Due to the certainty of occurrence and short-term nature, the target hedge ratio for booked exposures can be set at a high level. Setting thresholds is not inherently necessary, due to the obligation to the transactions.

Target hedge ratios for contracted exposures can vary based on the degree of flexibility in the contracts. Higher target hedge ratios may be applied to fixed-date, fixed-amount contracts, while lower ratios can be used for more flexible contracts. It can be useful to set up thresholds for these exposures, but keep them flexible based on changing contract terms.

Given the relatively uncertain nature of planned exposures, companies can apply moderate layered target hedge ratios with ratios decreasing relative to how far in the future they mature. Setting thresholds can also help keep hedging costs low.

Using a TMS to manage FX risk

The best way to execute a company’s FX risk management strategy is through a Treasury Management System (TMS), which usually allows for a seamless straight-through process.

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Planned and contracted exposure should already be available in the liquidity planning tool of the TMS since liquidity plans are the natural source of FX exposure. Booked exposures could be imported from ERP systems to be processed further in the TMS.

Since the holding company often manages FX risk centrally, and not all entities are eligible for executing FX trades, the settlement entities must also be defined in the TMS. Executing trades via only a few entities also opens up the possibility to net transactions and reducing hedging costs.

After collecting all exposures from the group’s different entities in the TMS, a netting of all exposures should automatically occur for each entity. This is done by offsetting payables and receivables to reduce the overall exposure for each currency and entity.

Applying hedging policies to FX risk management software

The hedging policies must then be applied to the exposures to determine the hedge recommendations for each currency pair and maturity date. Hedge recommendations should only be generated if the defined thresholds are exceeded. Before the trades are executed via trading platforms, it should be possible to net the hedge recommendations for each currency pair, maturity date, and settlement entity. This can be done if the applied accounting standards allow for netting between different entities. Most trades executed are spots, forwards, and swaps.

Typically, a TMS connects to external FX trading platforms via data integration, and users can initiate the trade execution directly in the TMS. If it is a bi-directional interface, the resulting trades can be imported directly into the TMS and are available for further processing. These processes can include settlement, valuation, posting, risk assessment, and more.

Also, if the original exposure belongs to a different entity to the settlement entity, IC trades should be generated automatically to fulfill in-house banking requirements. If compliant with the company’s policies, IC margins could be applied to the rates of the IC trades to cover in-house bank administration costs.

If hedge accounting is applied, the original exposure can be linked with the resulting FX trades, generating hedge relations and evaluating them according to the applied accounting standards.

The cash flows from the resulting FX trades should also be transferred to the liquidity plans of the entities where they can be compared to the original exposures to determine the actual hedge ratio and assess risk key figures such as VaR or CfaR. These can be compared to risk limits to decide if further hedging requirements are necessary.