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Mapping cashflows and FX needs to better visualize risk and exposure

CalendarJanuary 29, 2024
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Mapping cashflows and FX needs to better visualize risk and exposure

Island-hopping in the Pacific with General Douglas MacArthur

In our last blog post we described the value of consensus on risk management goals, the strategy and objectives that would achieve those goals, and on implementing the agreed strategy.

In this post, we outline how using an array of tools, including sensitivity analysis (examining how levels of uncertainty might affect outcomes), scenario planning (to test different hypotheses), and visualization can help identify potential risks and opportunities so businesses can better plan and implement their risk management strategies. We’ll also address how members of a team can contribute their own expertise to the strategy and execution of a plan.

For illustration, we’ll look at General Douglas MacArthur’s innovative Island-Hopping strategy during the Second World War in the Asia-Pacific theatre, and how it was key to the decisive battle of Okinawa, after which the tide turned in favor of the US-led Allies against Imperial Japan.

Background and strategy

After the First World War (1914-1918), General MacArthur held a number of civilian and military roles before being assigned to the Philippines in 1935. After the Japanese attacked Pearl Harbor in December 1941, the Japanese launched air raids on the Philippines, swiftly conquering the territory and destroying half of the US Air Force on the ground. General MacArthur was recalled to active duty, evacuated to Australia, and was appointed Supreme Commander of the Southwest Pacific.

MacArthur and his Navy counterpart, Admiral Chester Nimitz (Commander of the South Pacific), along with Admiral William Halsey (Air Fleet Commander) devised a strategy they called “triphibious warfare”, or island-hopping, which they implemented after the Battle of Midway in 1942. The air, sea and ground forces targeted the less well-defended islands to develop landing areas and keep supply lines open. Leapfrogging across the Pacific allowed the establishment of a second approach, through the central Pacific, another major blow to the Japanese forces.

The “island-hoppers” knew their ultimate objective and devised a step-by-step tactical approach to achieve it. They studied the terrain and deployed all the tools at their disposal (air, sea, and ground forces), leveraging the strengths of each. The tactical approach allowed for flexibility and agility: they could change direction if circumstances warranted. (It helped that they had the Japanese code book which allowed the Americans to decipher many secure messages that the Japanese forces sent one another.)

General Omar Bradley did something similar in the European theatre of the Second World War: targeting smaller islands off Italy’s coast to ensure supply lines were secure before invading.

You may be wondering how this relates to hedging currency risk

In developing your hedging strategy, you may want to get clarity on your business objectives, your risk tolerance, and the level of flexibility your business needs. These elements are often part of a broader business strategy and typically are fairly well fixed.

Executing the strategy typically requires access to a wealth of information, from cashflows and contracts to supply chains and timelines.

Some questions you might consider:

  • What does your hedging policy allow? Are you looking for certainty, or are you comfortable with less certainty so that you can potentially take advantage of upside, should a market move in your favour?

  • How far in advance can you predict your currency needs and cash flows? Are you comfortable with a portion of your requirements remaining unhedged, and how much and for how long?

  • What about general market conditions? In more volatile markets (or with more volatile currency pairs, such as exotic currencies) you may need either more or less flexibility.

Some businesses have long-term commitments and thus more cash-flow visibility, longer-dated contracts, or pricing that can’t be easily changed. Others simply need to hop to the next “island” before planning their journey to one after that. If they have flexibility in their deliveries and payment schedules, or can easily change their pricing, they may be comfortable with more flexibility and uncertainty.

Mapping and visualizing exposure

For General MacArthur, Admiral Nimitz, and Admiral Halsey in the Pacific in the 1940s, visualizing the path to achieve their objectives was crucial. Different tactics suit different conditions, and testing different scenarios can help you make a more informed decision about your hedging

In the following example, we compared the high, low, and average exchange rates for the CADEUR pair for most of 2023 to illustrate the translational risk for a hypothetical manufacturing company based in Montreal.

First, here is the data set for our illustration:

Assuming that our hypothetical manufacturer can forecast 1 million EUR in revenue for three months, we’ll look at the impact of the exchange rate on margins. For our purposes, we’ll compare the worst CADEUR exchange to the average, maintaining the desired 20% margin:

In this scenario, ABC would post a loss of CAD 8,630, or 3%. The treasurer would then buy a forward contract for CAD 8,630 to protect against loss should the exchange rate underperform the average at the end of the three months. If the rate at the end of the three-month period reaches the average, or if the rate improves versus the average, she can simply let the forward contract expire.

Again, this is a hypothetical situation but being able to model the scenario can add confidence to the hedging process.

Communication and consensus are keys to success

You might also consider who would contribute to the process, and their roles. . Each member of your team has a different role and different expertise. Questions to consider asking yourself include:

  • What information and data do we need to understand our projected cash flows, obligations, and risk factors? What do we know, what can we project, and what DON’T we know?

  • Who contributes to developing the strategy?

  • Who has the authority to approve the strategy, and to direct the team to implement the strategy?

  • Who monitors results and measures outcomes, and how often will you report on outcomes?

Many treasury teams manage their analyses and create their scenario modelling on spreadsheets that require manual input. Under that method, though, it can sometimes be more challenging to make changes on the fly and quickly gain consensus across disciplines, especially across locations and with dispersed teams. Thus they need to find ways to collaborate and communicate revisions and adjustments effectively, even across locations and to dispersed teams. This can be as important as knowing your forward supply lines are in place.

Choosing the right tools

In an earlier post, we discussed hedging tools that you might consider and the roles they can play in a plan. You might be more comfortable with forward contracts, which offer rate certainty but not upside participation. You might be considering more complex FX structured products, such as options, that offer some protection and some upside but less certainty than a forward contract. Again, your choices will likely be shaped by your objectives, risk appetite and your hedging policy. Scenario planning and modeling outcomes (‘if this, then that’ scenarios) can add visibility and help you make more prudent decisions.

The following chart, from a 2022 Duke Financial Economics Center study, illustrates a range of exposures that could lead to a business’s decision to hedge, and the instruments used by the survey participants:

Forward contracts were used most frequently by the survey participants.

We also presented, in our 8 September 2023 blog post, the concept of blending tools and tactics, including layered hedges and ‘rolling’ hedges, that can offer more flexibility in terms of timelines and amounts hedged. Please bear in mind, though, that while these hedging products can be useful tools, they can also add complexity to the planning process. A careful cost-benefit-analysis of each product’s pros and cons is an important first step before implementing any of these products.

Timelines

Determining the right timelines and hedging schedule for your business is another important consideration.

Following is an illustration from the 2016 Deloitte Foreign Exchange Survey. Among the survey participants who hedge, many use lower hedge ratios over longer time horizons. This can help them to protect a portion of their exposures, and adapt or update their tactics to market conditions as they gain more visibility. Of course, your plan will be aligned to your own policies and risk appetite and may not conform to this example.

Scenario planning and modeling outcomes (‘if this, then that’ scenarios) can add visibility and help you make more prudent decisions. Tactics might need to adapt to changing market conditions, but the business objectives and strategy tend to be fairly well fixed.

What’s next?

Corpay’s platform provides a range of analytical and visualization tools that can help businesses map their exposures, cash flow expectations, model their risk under different market conditions, and support scenario planning exercises so they can more confidently and proactively develop and implement their strategy. We can even upload spreadsheets into our system. This can be more efficient and faster than putting pins in a map on a wall, or sharing spreadsheets across dispersed teams.

Corpay also provides personalised support. Our Currency Research and Market Commentary can help you better understand market movements, and our risk management team can help you execute your strategy.

There is no one-size-fits-all, no absolute right or wrong when considering an FX hedging plan and weighing the trade-offs. Be clear on your business objectives, your tolerances for risk, the level of certainty you need, and how the tools at your disposal (each with pros and cons) can help you achieve your goals.

Please contact us for more information, or for a chat about your requirements.

Please note: 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.

Author

Moiz Mujtaba

Moiz Mujtaba

Director Product Management - CRMS

Moiz Mujtaba brings 14 years of B2B, B2C payments tech experience with academic background in Finance as a CPA (Australia) and an ACMA (UK). He currently leads the development of Corpay’s FX risk management product line.

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