Cross-Border

FP&A and Hedging: Integrating scenario analysis

CalendarFebruary 13, 2024
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FP&A and Hedging:

Integrating scenario analysis

The unpredictability of foreign exchange markets can complicate financial planning processes. Since forecasts are often unreliable, it can be challenging to analyse the range of potential impacts FX rate volatility may have in financial modelling.

Sensitivity and scenario analysis in the financial planning process can help businesses assess potential impacts of foreign exchange movement on financial performance. It can help to crystallize risk appetite and inform FX hedging strategies, and it is often the jumping-off-point for foreign exchange hedging discussions.


Introduction to scenario planning and analysis

Unpredictability is universal and with foreign exchange markets it’s a given. This complicates life for financial planning and analysis professionals tasked with constructing forecasts, budgets and analysis for businesses that operate across borders. Since forecasts on FX rates are often unreliable, how can a business determine which approach to take to assess a reasonable range of potential outcomes for FX rates to apply to financial models?

Utilizing sensitivity and scenario analysis in the planning process can be a game changer. Specifically, these analyses can help you:

  • Reveal questionable or faulty assumptions in financial models, shedding light on deficiencies in decision-making frameworks, and

  • Highlight potentially overlooked variables that affect financial performance, increasing clarity about the levers that drive it.

This holds true for businesses that need to assess potential implications of foreign exchange movements on their financial performance. It is also why scenario analysis often plays a key role in many of Corpay’s clients’ FX hedging discussions.

Multiple approaches

There are multiple approaches to scenario and sensitivity analysis that can be utilized to determine these rates, each with pros and cons. Many of Corpay’s hedging clients focus on these two:

Historical Scenario Analysis. This approach looks at notable market events in the past to better understand likely drivers of FX rate movements.

  • A positive (‘pro’) of this approach. Often intuitively understood and easily explained to stakeholders without finance backgrounds. Further, it does not rely on the assumption that market movements are normally distributed and linear.

  • A negative (’con’) of this approach. While history may rhyme, it doesn’t usually repeat in the literal sense. Historical patterns may not hold true (and may not even rhyme) in the future.

Parametric Delta-Normal Analysis. This approach relies heavily on statistical methods to analyze and estimate probabilities of several potential outcomes. For those familiar with Value-at-Risk (VaR), this is the most common way it is determined.

  • A positive (‘pro’) of this approach. The results are forward-looking, and can help give you a sense of potential outcomes at given levels of forecast probabilities.

  • A negative (’con’) of this approach. Quantitative methods like these are difficult to explain and assume a normal distribution of returns; for FX rates, that assumption rarely holds, implying a need to take results with at least a grain of salt.

A starting point

The latter method, Parametric Delta-Normal Analysis, has effectively become a key standard chosen by many of Corpay’s hedging customers for modelling their business’s FX risk.

In large part this is due to its quantifiability, which for finance professionals is very appealing. While a key shortcoming in most presentations of VaR is that it doesn’t translate into implied FX rates for FP&A purposes, the following example can help to address that challenge.

Example

This example uses a hypothetical US-based manufacturer who sources 60% of their costs of goods sold (COGS) in Mexican Peso (MXN). The underlying statistical analysis forms the basis for forecasting highs and lows of the USDMXN at 95% confidence intervals for the next twelve months in this basic scenario analysis.

This example applies the 95% threshold numbers for the high and low forecast of USDMXN to the forecasted monthly income statement for the month of June.

This, in turn, allows us to outline the variances from the spot FX rate at the beginning of the year to help assess financial implications of variations in this line item. As you can see, financial performance impacts caused by FX market volatility can be quite material.

Without conducting sensitivity analyses, businesses often learn this fact the hard way. This is why collaboration between FP&A teams, treasurers, and their FX providers can be helpful for global businesses in their efforts to protect their core business’ profit margins.

What happens next?

Corpay has created a risk modelling protocol and tools that can aid businesses in their scenario planning and analysis.

To see the tools in action, or to chat about your business needs and hedging strategies, please get in touch.

Opinions expressed in this article are those of the author. Please consider contacting an independent advisor of your choosing – an advisor completely independent of Corpay – to help you ensure that solutions discussed here are right for your business’ needs.

The hedging products described in this document can be useful but are also associated with significant added complexity; obtaining a thorough understanding of each such product's trade-offs/pros-and-cons (fully describing these is beyond the scope of this article) is important before choosing to use any of these products.

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Author

Sean Coakley, CFA

Sean Coakley, CFA

Director, Strategic Sales, & Market Strategist

Sean works with mid-market corporates, focusing on FX risk management and international working capital optimization. He blends experience in finance and capital markets with a robust understanding of business performance and capital markets knowledge.

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