Cross-Border
Integrating Hedging with FP&A
Integrating Hedging with FP&A:
Are you asking the right questions when you consider hedging your FX exposures?
For businesses exposed to the foreign currency markets, the wisdom of hedging currency risk is sometimes debated.
Some financial professionals believe that FX markets are cyclical, and whether they hedge or not won’t matter. Others feel that the changeable nature of FX markets, and the inherent unpredictability, make hedging too challenging.
Thus when the question of hedging arises, for many financial professionals the first line of debate is ‘to hedge or NOT to hedge’.
My contention—and this is my opinion—is that we might consider asking ourselves different questions. I believe—again, my opinion—that taking a holistic approach to financial planning, including FX analysis, can help inform an organization’s strategy and improve overall treasury management.
Corpay has tools and resources to help support your planning. To learn more, please read on or contact me for a chat.
The wisdom of hedging foreign currency exposures is sometimes debated, even in volatile markets. Some financial professionals believe markets are cyclical and all will turn out right in the end, hedged or not. Others think that the unpredictability of the markets makes hedging too challenging. My own opinion is that we may not be asking ourselves the right questions.
When the concept of FX hedging comes across financial decision makers’ desks, key questions typically include:
Why hedge?
How to hedge?
Where does hedging fit into our organization’s activities?
In short: ‘WHY’ tends to be the most important question. It starts with an assessment of the materiality of FX movements on a business’ bottom-line, considers what line items are impacted by FX, and, above all, how FX factors into the overall operations and goals of the organization.
A holistic approach to financial planning and analysis – including the FX component – can help improve the overall treasury management of an organization.
The chart below shows the Absolute True Range of EURUSD exchange rate variation over the past two decades (2007-2023). While volatility varies, please note that this reflects outsize shocks (2008 Global Financial Crisis; COVID-19 (2020-2022), and the Russian invasion of Ukraine (2022).
You won’t know where you are going until you know where you are
A good first step is to understand the materiality of FX risk to the business. FP&A data is essential to this.
Let’s begin with the budgeted rate and the projections. Do you see divergences from your budgeted rate, and can you identify which are due to FX exposure? Conducting a variance analysis and pinpointing the sources of variance – combined with comparing budgeted to realized FX rates – can give you a sense of the business’ sensitivity to FX market volatility.
Once you have this data, percentages tend to matter more than absolutes. Ratio analysis comparing budget to actual can facilitate a clear view of the implications of FX movements on business performance. For example, the absolute value of a variance due to FX may be immaterial. But if that variance is influencing gross profit margin, particularly in a business with high operating leverage, the downstream impact of FX movements can be much more impactful than the headline numbers suggest.
Following is a sample income statement illustrating the potential impact on margin and income.
The charts above are for illustration only.
Hedging: a general overview of some main approaches
So, assuming the earlier steps established that FX risk is material, and we have an idea of where it sits on our financial statements. The next question in such a case is this: what are some alternatives for responding?
Before selecting a specific hedging product, consider returning to our FP&A framework for a sense of the business’ overall financial goals and how the budget is set and viewed in the first place.
For example, some businesses that use FX hedging find it helpful to employ a layered hedge strategy, executing hedges at varying ratios to the underlying exposure and on varying timelines. These are then topped up and re-executed as time goes on. This strategy can typically tie in best with businesses that use rolling budgets and forecasts and relatively consistent exposures.
The reality is not all businesses can feasibly operate like this. Some may have underlying FX exposures because of project-based planning. Others may have exceptional seasonality within and between budgeting periods, so their approach tends to be fundamentally different.
Ultimately these sorts of decisions, and the framework employed once the decision to hedge is made, are heavily reliant on a business’ FP&A goals and process.
Would you like to discuss this further? Let’s schedule a chat about how we can tailor the analysis to your business!
Please note: Opinions expressed in this article are those of the author. Please contact an independent advisor to ensure that solutions discussed here are right for your business.
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