How to Set FX Budget Rates for Forecasting, Variance Analysis, and FX Risk Management
How to Set FX Budget Rates for Forecasting, Variance Analysis, and FX Risk Management
'What doesn't get measured doesn't get managed.'
This is an axiom to live by. It's funny, though: to this day I still encounter businesses that have trouble determining what their FX exposure is or what the impact of foreign exchange rate movements might have on their P&L and other metrics. Without a defined FX budget rate, it can become difficult to quantify currency exposure or understand how FX movements impact financial performance.
A good place to start is to determine a budget for FX rates.
What is an FX Budget Rate?
This is the benchmark exchange rate that grounds the budget and against which FX fluctuations are measured for a given period.
It helps businesses understand their FX exposure: not just in the amount of currency exposure and its impact on the business, but just as important, the business's effectiveness in managing FX risk.
There are many ways to determine FX budget rates, each with advantages and pitfalls.
This piece will outline different approaches for setting budget exchange rates and their pros and cons, with the goal of outlining best practices.
Why FX Budget Rates Matter for FP&A and Treasury Teams
FX budget rates are essential for financial planning, variance analysis, and FX risk management.
Ask my CPA wife, my friends, and my colleagues, and they will tell you they love numbers. After 15 years in finance and accounting, my feelings are more ambivalent. That said, I do see the utility of setting a framework for FX rates in the planning process.
FX budget rates allow you to:
1. Measure FX variance against plan
Analyze and measure performance relative to plan. This metric is key for FP&A and treasury teams. Budget line items can carry multiple sources of variance. Without a budget FX rate, you won't really be able to tell how much of that variance is from FX rate movements.
Setting budget rates can help you isolate variances in performance due to foreign exchange rate movements. This is critical to understanding the real-world implications of FX market movements.
This same process is applied to testing the effectiveness of hedge programs.
2. Quantify FX exposure and support FX risk management
Without a budget rate, it is often difficult to quantify a business’s actual FX exposure.
In many businesses, foreign exchange exposure is indirectly accounted for or not built into cash forecasts. Additionally, budget FX rates provide an essential benchmark for measuring the performance of hedge strategies as well as transaction costs.
Chart Considerations
The graphic above shows the EUR-USD historical spot price and future forecast scenarios
This is a visualization used to represent the uncertainty surrounding future exchange rate movements and the probability distribution
Similar to historical volatility on the last chart, this shows how unpredictable rates and impactful events can be within the currency pair
Managing FX risk can help reduce variability and support margin stability
Source: Corpay Treasury Solutions
How Businesses Set FX Budget Rates
There are multiple ways for businesses to determine a budget rate for FP&A purposes. What is key is to set a rate that is realistic and achievable.
Many businesses fail on this last point, and it’s important to know why and what the implications are.
Common Approaches to Setting FX Budget Rates
Each of the following approaches is used in practice, though their effectiveness varies significantly depending on the business and its hedging strategy.
1. Weighted average rate of existing hedges
Businesses with active hedge programs often use the weighted average exchange rate of those existing hedges to set their budgets/pricing for future periods. It is a key advantage of a continuous rolling or layered hedge strategy.
Achievable and realistic, this can be a good starting point for businesses with an active hedging program.
2. Current spot rates
Achievable? Yes. Realistic? Not really.
Even developed market currencies tend to fluctuate in high single-digit percentage ranges—even in low volatility years. Today’s spot rate is not necessarily achievable or realistic six months from now. And pre-buying all your FX requirements for the year on the spot market is a huge capital commitment.
To get around this, businesses often add a buffer to the existing spot market rate to account for variation. This is better than nothing but might result in one of two problems.
The buffer in their budget is too wide for the pricing of their goods or services, making them less competitive in the marketplace.
The buffer may not be wide enough to accommodate the likely FX movement over the planning period.
The unfortunate reality for businesses is that they may be dealing with both of these problems at once if they have elected not to hedge.
3. Forward rates
This is my personal favourite.
Using the forward rate for the end date of the planning period is considered by many (myself included), the gold standard for setting FX budget rates.
Forward rates are achievable, as they are based on a market rate that is executable at that moment. They also embed the cost of FX hedging in the budget rate determination, making them a reliable foundation for setting FX budget rates.
4. Bank forecasts
Bank forecasts as budget rates? This approach has noteworthy trade-offs.
Aside from the fact that these rates are not realistic or achievable, they also tend to be unreliable for budgeting purposes. I have cited some research by Silicon Valley Bank’s currency team that quantifies how frequently bank FX forecasts are wrong.
In short, some studies suggest accuracy rates below 50% over time.
5. Implied volatility-derived expected range
This ventures into real ‘nerd’ territory, and its complexity should deter all but the most experienced hedgers.
Implied volatility is ‘backed into’ by running option pricing through a mathematical model. Since it is based on live option pricing, it is executable. The advantage of this approach is that it gives you a market pricing-based array of potential outcomes for FX rates that you can use in scenario analysis.
Source: Corpay Currency Research
What Works Best in Practice: Setting FX Budget Rates
What might work for your business? There is beauty in simplicity.
Utilizing forward market rates, plus the weighted average rate on any existing hedges, is the most common approach that I see used by teams with professionalized budget-setting processes.
The end result tends to be easy to understand, executable, with the rigor to support board-level planning/critique.
For onboarded clients of Corpay Cross-Border, Corpay has a free FX budget rate calculation tool that allows you to access a wide range of key data points and build budget rates based on all these approaches.
Additional Resources:
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