Author: Anita Hawser

FX EXPOSURE MANAGEMENT

Currency volatility is increasing, and companies are finding that more than ever they need to have an effective FX hedging strategy in place.


By Anita Hawser

Frank Pirozzi is the assistant treasurer at Red Hat, a Raleigh, North Carolina–based company that sells open-source technology solutions to customers worldwide. It derives roughly 40% of its revenues from outside the US and has exposure to 40 different FX currency pairs, the bulk of it being in the top currency pairs, such as US dollar/euro, US dollar/yen and US dollar/sterling. Although its accounting currency in Europe is the euro, Red Hat also has non-euro-based expenses in other currencies, such as the Czech koruna. Until fairly recently, getting a grip on Red Hat’s total global FX exposure was a multiday process for Pirozzi that entailed manually trawling through the company’s enterprise resource planning system and keying figures into a spreadsheet. “With our ERP system there are some limitations in terms of drilling down into the weeds of our FX exposure,” Pirozzi admits.

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The impact of FX risk on businesses has been growing recently. A survey of FX exposure and risk practices conducted recently by treasury software vendor SunGard AvantGard found that across a broad range of industries, revenue categories and regions, FX gains or losses had had a material impact on approximately 60% of organizations, compared with a similar study conducted two years earlier, where just 40% of companies reported a material FX gain/loss. According to Wolfgang Koester, CEO of Arizona-based FX solutions provider FiREapps, volatility in the FX markets is at an all-time high, leaving those companies that do not adequately measure and manage their FX exposures in a particularly vulnerable position. “While in the past the average FX volatility was 10%, it is now 12% to 13% in the G10 currencies,” he says.

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Koester: “CEOs and CFOs need to better understand their exposure”

Giacomo Orlandi, CFO at Ilapak, a Switzerland-based manufacturer of industrial wrapping machinery for primary packaging, says in the past 24 months there has been a lot more volatility, especially in the euro/dollar rate, which went from 1.30 to 1.61, then reverted to 1.20. “That’s a massive shift,” he says pointing to the detrimental effect FX volatility can have on a company’s competitive edge and efficiency if it is not managed properly. For those companies that do the bulk of their business outside of their home market, FX volatility can have a negative impact on their balance sheet and, ultimately, their earnings-per-share. Koester says he is still surprised at the large number of supposedly sophisticated companies that still use manual processes, namely spreadsheets, to manage their FX exposures, and he cites examples of companies that have lost a third of their revenues due to FX volatility. “FX risk has one of the largest financial impacts on companies, and often they don’t understand that impact until it is too late,” he explains. “CEOs and CFOs need to better understand their exposure and determine what is an acceptable level.”

At Ilapak, Orlandi has put a framework in place that enables his company to manage its FX exposure within a maximum loss limit of 10% to 20% of forecasted net profit. “Once we have defined this amount, we set up a system of stop losses that acts as a system of triggers,” he explains. Orlandi says most companies should have a framework for managing their FX exposure. When it comes to hedging their exposure, the percentage they hedge, whether it is 10%, 20% or 80%, depends on how much risk a company is willing to take. “You need to hedge something,” says Orlandi, “allowing for minimum hedging of 30% or 40%. But if you only hedge the minimum, you should have a system for limiting losses.” In order to diversify its currency base, Ilapak also went a step further and changed its production and value chain from being European-centric to incorporating two plants in the US and one in China. So although the company’s value chain is still in dollar-based countries, if the dollar declines against its accounting currency, the euro, Orlandi is able to recover some of that money, as goods exported from its Chinese plant may be cheaper.


Companies Risk Under-hedging

Kevin Grant, CEO, IT2 Treasury Solutions, says FX hedging is tried and tested and is a systemic part of FX operations. “I haven’t sold a treasury management system without there being an FX component,” he says, “but just because there are tools available doesn’t mean they are being used.” While companies may mitigate their FX risk through hedging, according to Koester of FiREapps, companies only hedge those currencies that represent the bulk of their exposures and don’t factor in the volatility of other currencies in their portfolio, leaving them with significant unmanaged risk. Some companies also appear to be struggling with accessing high-quality data in order to quantify their FX exposures. In the SunGard AvantGard study of FX risk practices, the top three FX management challenges were difficulty in quantifying FX exposure, lack of confidence in data, and obtaining timely access to data. By ignoring certain sources of currency risk and under-hedging others, Koester says it is typical for companies that actively mitigate FX risk to—consciously or unconsciously—leave approximately 10% of their FX VaR (Value at Risk) unmanaged.

Most of the data for understanding a company’s FX exposure resides in ERP and accounting systems. Yet some companies can have 50–100 different ERP systems, making the task of collating all the data needed even more challenging. Instead of relying on different people within the organization to send in data on spreadsheets, FiREapps’ software allows companies to pull in data from multiple systems and then provides workflow tools for defining the way a company wants to look at its exposures. Pirozzi says that using FiREapps, he is able to access FX exposure data across Red Hat’s global business in an easy-to-read format, from which he can gather detailed information on currency exposure and type of account (accounts payable or accounts receivable).

“I can pool all my balances at the end of July and compare them with the previous month’s balances, and sometimes that can show me an FX exposure I didn’t know about,” Pirozzi says, adding that he typically does this before he closes the books to make sure any FX hedges he has put in place to cover his exposures are correct. If his FX exposure is less or more than he anticipated, he then adjusts the hedges accordingly to ensure that he is not over- or under-hedged. “I can’t imagine going back to the Stone Age now and having to pull everything out manually,” Pirozzi says. “It is easy for spreadsheets to get corrupted or updated incorrectly.”

Koester says more companies are starting to understand how currency movements affect their business, probably as a result of the sovereign debt crisis in Europe and recent volatility in the FX markets. “Those companies that are managing their FX exposures well don’t have the negative impacts any more,” he adds. However, for some companies hedging may be deemed time-consuming and costly, and some believe that if they don’t hedge, over time they will end up in the same position they started with anyway. But as a publicly quoted company listed on the NYSE, Red Hat is cognizant of how it is perceived by industry analysts, and by proactively managing its FX exposures, Pirozzi says, it is unlikely to create any confusion for analysts. “Any type of … curve ball you throw analysts, positive or negative, is bad,” he explains. “They don’t want to have to worry about what FX is going to do to your earnings-per-share.”