Alankar Karol, Managing Director, EMEA, GTreasury

FX risk management has supplanted cash visibility as the number one priority for increasing numbers of UK corporate treasurers. This is a consequence of today’s complex political and economic environment, in which FX volatility has become a major threat to the protection of profits, earnings and investments. Cash visibility has conceded first place for the first time since the global financial crisis struck ten years ago, according to specialist

finance consultants and other commentators.  However, most corporate treasurers are presently falling short of best practice in managing FX risk, according to last year’s Deloitte report: ‘75% of respondents are not actively monitoring key risks using “at risk” measures, despite FX volatility being flagged as the biggest challenge faced by treasurers. This creates a major opportunity for Treasurers to invest in technology to deliver more sophisticated real time analytics.’

Treasurers are responsible for planning and delivering an FX hedging program to ensure that results are achieved with confidence, and which generates reporting that describes the current and projected future position accurately and clearly to management. These key objectives are most effectively achieved using analysis based on Cash Flow at Risk (CFaR). Essentially, corporate treasurers need a dependable and practical answer to the key question: How bad can things get because of our FX exposures?This is what CFaR provides. The models, simulations and algorithms which produce the required real time reports and analytics are powerful and sophisticated – and they can be delivered through a technology solution that takes care of the required processing. From the treasurer’s perspective, results are presented in graphical and numerical summaries, so that they are straightforward to understand and act on. The CFaR analytics form the basis for comprehending the present exposure situation, for quantifying the worst case risk, for setting up or modifying the portfolio to achieve the most effective hedging strategy, and for reporting promptly and clearly to management. The strategy adopted should be compliant with the organisation’s risk policy and appetite.

CFaR projects a company’s multi-currency operating cash flows over a predefined future time horizon, based on current, observable information, including FX forward rates and volatilities. The insights provided enable the treasury team to make informed decisions about the present risk profile and can hedge as necessary to rectify the situation.

Additionally, GTreasury uses the innovative metric of Target@Risk to provide a practical analysis in line with corporate treasurers’ operational realities. Target@Risk reveals the probability distribution of treasury achieving a tangible target, which may be a specific FX rate or cash flow value.  In combination with CFaR, Target@Risk provides treasury with a clear picture of how likely specific forecast, budgetary or plan projections are to be met in practice. This significantly enhances Treasury’s ability to see the probability of the realisation of its quantitative goals, and therefore opens the opportunity to initiate timely remedial actions to reduce or eliminate the revealed risks.

The combined powers of CFaR and Target@Risk enable corporate treasurers to look forward with confidence, rather than observing the impact of imperfect FX risk management operations in the rear-view mirror.

The use of advanced risk management tools such as CFaR and Target@Risk was once the preserve of multinational energy companies, airlines and the largest corporations.  Today, the scope has expanded to many more types and to smaller sizes of corporation, to include those whose import/export operations, trade patterns and investments mean that their revenues and profitability are significantly subject to the vagaries of seemingly endless FX market volatility.

The FX market is continually shifting, sometimes sharply, as expectations and realities change, with surprises always likely to generate new volatility. And all these unknowns must be offset against the technical, fundamental and psychological factors which influence exchange rate changes – both for the UK and its many trading partners. Corporations with effective risk management tools such as CFaR and Target@Risk in their armoury will be better able to measure and manage their FX exposures, and therefore achieve their financial targets more certainly. Flying blind can be reduced or eliminated, as investment in the necessary technology is easily justified against the quantifiable impact of numerous, all too real risks and uncertainties.

Today’s FX risk analytics enable corporate treasurers to predict and mitigate potential shortfalls versus agreed treasury targets. Similarly, they reveal probable overshoots, which many companies may wish to manage proactively. Significant unexpected and unplanned revenue may be unwelcome, as it could lead to unrealistic market expectations of future performance, and produce undesirable consequences, such as an equity value bubble. Most corporate treasurers want to report minimal deviations between the plan, budget or forecast and the actual performance which will be reported and published.  ‘At Risk’ technology realistically reveals both upside and downside potential, including definable but reasonable possible extremes.

Long term corporate hedging portfolios may include a combination of positions in instruments including FX forwards, options, collars and zero cost structures, reflecting corporate finance policy.  CFaR and Target@Risk analysis allow the treasury team to measure and project hedge performance versus an unhedged position. It enables the team to compare different strategies objectively, in the light of seeing the possible worst-case result, to identify the best fit against finance policy compliance demands and corporate risk appetite. In this way, better informed and therefore more effective decisions are possible.

Additionally, FX hedging should be analysed in the light of observed currency pair correlations, as well as market volatility. CFaR and Target@Risk allow the natural offsets in a corporate’s set of currency pair exposures to be highlighted – and this analysis can reveal that the organisation is in fact over-hedged. So, the hedge portfolio can be reduced so that it is simply managing the true net risk, and this can result in a significant (and welcome) reduction in treasury’s costs. This analysis is based on the correlation between various relevant risk factors. BHP Billiton cancelled a significant part of its hedging portfolio in view of the offsets shown by CFaR analysis.

Today’s “At Risk” tools enable proactive corporate treasury teams to achieve best practice, cost effective FX exposure management. They can make a vital contribution to achieving financial targets, securing corporate results, and building competitive advantage.

Dr Alankar Karol is Managing Director, EMEA at GTreasury, where he consults widely with leading global companies and financial institutions on Treasury, Complex Risk and Analytics, Asset and Liability Management, Valuation, Hedge Accounting and Compliance. He has over 15 years of treasury experience, including his most recent post as head of the Quantitative Services desk at Visual Risk. He holds a PhD in Applied Mathematics and a Masters of Finance, and works extensively in Artificial Intelligence and Robotics.