Setting Risk Management Goals: Determining risk appetite and target risk levels

Once foreign exchange exposure is assessed, the next step is to set risk management goals. This involves determining how much risk the company is willing to take on and what its target risk levels are. Achieving stakeholder agreement on risk appetite, and a strategy designed to achieve business goals is the foundation of a successful implementation.

In our last blog post, we discussed the value of meticulous planning and understanding all the tools at hand to create a strategy to achieve the business objectives. We cited the example of General Dwight D. Eisenhower’s meticulous tactical planning and logistical expertise to achieve his goals on the battlefield.

Our next post takes us from the European Theatre of the Second World War (WWII) in the 1940s to the Korean peninsula in 1950, when General Douglas MacArthur was appointed to lead the newly established UN Command (the UNC) after North Korea’s invasion of South Korea. The command included troops from sixteen nations (including South Korea and the United States), with five additional nations providing medical support and supplies.

After WWII, the Korean peninsula was divided into two separate nations along the 38^th parallel. North Korea had the backing of the USSR and China, and South Korea was supported by the US and the UN and other allies.

In June of 1950, North Korean troops crossed the 38^th parallel into South Korea. The South Korean military was ill-prepared for the attack. Over time, the UN Command gathered strength, consensus, the North Korean Army pushed southward. US and South Korean troops held the North Korean Army at bay at the Busan Perimeter in South Korea, and the tide of battle seemed to turn.

In September UN troops landed in Incheon, behind North Korean lines, and recaptured Seoul. Driving the North Koreans back over the 38^th parallel awakened hopes of an early ceasefire. General MacArthur pressed on through North Korea; in November 1950, he was met at the Yalu River by 30,000 troops from the Chinese People’s Volunteer Army, fighting in support of North Korea. By April of 1951, the Chinese and North Koreans had recaptured Seoul.

To complicate matters, General MacArthur and US President Harry S Truman had different goals: MacArthur aimed for a decisive victory; President Truman was eager to end hostilities and bloodshed.

MacArthur was relieved of his command that same month, and the UNC recovered Seoul in May 1951. Peace talks began in July but the parties could not agree on terms. Talks dragged on for two more years as the opposing armies crisscrossed the 38^th parallel, with heavy casualties and no definitive outcome. While Armistice was at last signed in July of 1953, a formal peace agreement was never finalized.

This example illustrates how crucial it is for businesses’ stakeholders to reach a consensus on their business goals, margin requirements, and risk appetite in order to develop their hedging strategy.

Gaining consensus

It might help to start with the outcomes of your prior programme. Did you achieve the intended results? Have you made changes to your business and have the objectives changed? How far ahead can you plan?

What is your company’s hedging policy (treasury policy) and risk appetite? Are you looking for protection against adverse market movements? Certainty on pricing no matter how the market moves? Participation in favourable market movements? How much flexibility do you need?

Once this is agreed, you can model your strategy and potential outcomes. Creating different scenarios for your board will help make the case for implementation. Regular performance evaluation can help to keep you on track to achieve your goals.

Hedging examples to achieve different objectives

Tactics can be adapted to market conditions, and the predictability of a business’s exposures. A business expanding a product line or developing new supplier relationships may need more flexibility in their hedging programme than a business with long-term requirements. A one-off FX requirement is tactically different from a fixed monthly obligation over months or years.

Below we will describe two different kinds of hedges that can be adapted to specific business needs, and how to execute, monitor, and test the effectiveness.

Rolling hedge

A rolling hedge progamme offers flexibility when market conditions are changeable, or requirements are variable. With a rolling hedge, as the expiry date of your existing hedge instrument approaches (be it an option structure or a forward contract), you enter a new option contract with similar terms, or renew the existing contract with a later maturity date.

You might implement this kind of hedge if you are able to predict your needs only a few months ahead, or are able to change pricing in response to changes in the market. As an example, you might hedge at one rate for months one through three and revisit your needs and renew or renegotiate terms when the initial hedging instrument Is close to its expiry date. This structure allows you to take advantage of favourable movement and lock in some profits by changing the strike price, or protect against adverse movements, by pushing out the expiry date.

Layered hedge

If your business has more predictable requirements, a layered hedge could allow you to vary the duration and hedging instruments you are using. You could set up a hedge for the first quarter of your year (months one through three), a second hedge for months two through five, a third for months three through six. This allows you to achieve a blended exchange rate and smooth out the effect of fluctuations in the market.

Here’s an example of a client who employs a blend of rolling and layering hedging programs. With an average monthly requirement of US$3.0 million, the client is looking to hedge 40% of forecast needs. With a plan to add leverage-based hedging tools where leverage can only represent up to 15% total monthly FX exposure, total potential hedges may not be more than 55% of US$3.0 mil.

In the example below, the client is looking to protect up to 12 months in advance. The intention is to add about one month’s worth of intended hedges every month, at an opportune market entry point. This monthly hedge amount is spread out across the next four months (25% in each month) for the benefit of ‘layering-in’, to achieve more normalized average rates every month. Purple portions represent one month worth of hedges spread out evenly in last 4 months to create what is also known as a ‘ladder’ approach to hedging.

The example below is for illustration only. Amounts, percentages, product mix, and tenors are completely customizable based on clients’ hedging policies and preferences.

DISCLAIMER: This brief example does not disclose all of the risks and other significant aspects of trading in such products. In light of the risks, you should undertake such transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading is not suitable for many members of the public. You should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances.

The layered hedging approach might incorporate futures hedges, forward hedges, money market hedges, and currency option hedges, protecting you from adverse currency fluctuations and helping to achieve your financial objectives.

Conclusion

General MacArthur’s leadership was characterized by a knowledge of his terrain and his troops, often from many different nations.

He had great successes on the battlefield—and off—with daring tactics, and with clear objectives. At times his tactics were less successful.

During WWII and in his time in Japan he gained consensus and support for his strategies. Despite the challenges of managing troops from so many nations, his tactics resulted in success in the early days of the Korean conflict. When his objective diverged from that of his Commander-in-Chief, his active military career ended.

In our next post, we discuss MacArthur’s Island-Hopping Campaign during WWII, and the value of visualization and scenario planning in its success. Applying this approach to your business will help you to understand risk exposures and potential outcomes under different scenarios.