How to Measure Success in Your Cash Flow Hedging Program?
Most people have heard the expression “you get what you measure,” and it doesn’t take much time observing behavior in the corporate environment to realize that this is very true. Well thought out performance metrics are critical in creating a productive work environment, and there is plenty of anecdotal evidence showing how various dysfunctional behaviors in the workplace can be traced back to poorly constructed or out of date performance metrics.
Shareholders certainly have common ways of measuring the performance of the companies they own, as they look to see quarterly earnings targets met, revenues growing and expenses contained. Given the international nature of most businesses, the foreign exchange environment can obviously have a significant impact on these results, and yet these FX impacts are often poorly understood, both inside and outside the company.
Many companies with significant international exposures choose to hedge their FX risk with “cash flow” (or FAS 133/ASC 815) hedges and/or “balance sheet” (or FAS 52/ASC 830) hedges, in order to reduce the volatility from FX. The term “cash flow hedging” is a bit of a misnomer, as cash flow hedges don’t necessarily cover the entire cash flow period. Cash flow hedges often cover a certain amount of time until forecasted revenues and/or expenses are realized, and become receivables/expenses. The final period between when revenues/expenses are realized and when the receivables/payables are eventually collected/paid is typically covered by a company’s balance sheet hedging program. This paper will be focusing solely on the topic of cash flow hedging.
Cash flow hedges typically cover the items of the income statement that have far more accountability within the company compared to balance sheet hedges, since there is far less ownership of the balance sheet throughout the company, from a metrics standpoint. For this reason, the gains/losses from the cash flow hedges are more likely to be allocated to the various businesses and regions within the company, and therefore the need to understand the impacts goes well beyond the Treasury team. Since these hedging impacts often show up on the revenue and expense lines of the income statement, they become important for investors to understand as well.
THE EASY WAY OUT?
Before discussing some of the best practices in measuring the success of a cash flow hedging program, it’s worth noting that not all companies with significant international exposure do any hedging at all. The typical argument for this passive approach is that FX hedging is a zero-sum game long term, and that they can guide their investors towards the true fundamentals of their business by providing “constant currency” analysis. This analysis typically takes the form of a year over year comparison based on foreign exchange rates being held constant from the previous year.
For example, a company may communicate on their quarterly earnings call that even though revenue grew only 3% YoY in USD terms (the actual results for the quarter), revenue grew by 7% YoY in constant currency terms. The 4% difference was due to the weakness of foreign currencies against the dollar (not an uncommon result for some companies recently, due to significant USD strengthening). The company is hoping that investors would look past the actual 3% result in USD terms and model future company growth based more on the 7% constant currency growth rate (though most of the time the true growth rate probably lies somewhere in between the two percentages).
While providing constant currency guidance is better than providing nothing at all for investors, it still fails in reducing the volatility of the actual results, which could have been smoothed out with an effective cash flow hedging program. Investors in your company aren’t being compensated for taking on extra FX risk, and they don’t have the ability (or desire) to identify and hedge this risk on their own. Even if you make the zero-sum-game argument that FX impact on cash flows over the long term will be a wash, the volatility of those cash flows matters as well. Higher earnings volatility increase the beta of any given stock, and the higher risk level will depress the stock price, all else being equal.
For companies that have decided to take on the challenge of hedging their cash flow exposures, they are faced with a number of decisions that are dependent on their specific business and corporate structure. FAS 133 has certain rules concerning what type of FX exposures can receive hedge accounting treatment, and identifying where these exposures can be hedged depends on the functional currency setup of their international entities, IC billing relationships, ability to forecast various items of the income statement, and many other factors. There is therefore no “one size fits all’ approach to cash flow hedging, but in coming up with the right strategy for your company, there are some best practices to consider.
DON’T “SET IT and FORGET IT”
Almost every company has an annual planning cycle, and will typically require assumptions of what FX rates to use in planning for the upcoming year. While this is a necessary starting point, most companies also have quarterly or even monthly updates to these annual plans that may be the “main” plans that really serve as the performance metrics for the company. If these updated plans don’t include changes in FX rate assumptions (as the initial assumptions can certainly go stale very quickly), then the company may find that any USD based targets for their non-US regions (which are using stale FX rates to convert to USD) are either far too easy or far too difficult to meet.
Having local currency based targets for the international regions can solve the problem for their specific performance metrics (local currency based quotas that are set once per year may be a good idea for international sales teams, for example), but someone at the company will still have responsibility for the USD equivalent plan, so the stale FX planning rate problem still exists. Rather than dealing with the complexity of layering in new FX rate assumptions into their updated plans, some companies choose just to hedge their entire year’s forecasted exposure at the time of the initial plan (typically a month or two before the year begins).
This is probably the easiest thing to do from an internal administrative perspective, but not really the best solution from an external market perspective, and unless your FX exposures represent a very small percentage of your business, it is probably not a good way to go. Even though you have hedged your results for the year and can match these hedged rates with your planning rates for the entire year with this approach, you have not smoothed out the impacts of FX over time. Instead, this approach creates an abrupt “staircase” type of FX rate impact from one year to the next, which would not be compatible with how the markets your company is involved with would be absorbing FX changes over time.
For example, if you were hedging forecasted EUR revenues and your annual planning cycle concluded in March of each year (assuming a fiscal year that begins in April, for example), you could have initiated hedges in March, 2014 (maturing between April, 2014 and March, 2015) at a rate of 1.39. The following year you could have initiated hedges in March, 2015 (maturing between April, 2015 and March, 2016) at a rate of 1.05. In this example, the longest dated hedge executed at 1.39 rolled off in March, 2015 immediately before the next hedge at 1.05 took effect in April, 2015.
The drop from 1.39 to 1.05 represents almost 25% weakening of the EUR, which is a tremendous hit to take in consecutive months. While the company would have been thrilled with a 1.39 revenue hedge lasting as long as it did, the precipitous drop to 1.05 places immediate margin pressure that can’t realistically be offset in any way. The goal of cash flow hedging should be to buy enough time to adequately deal with any shocks in the FX markets, and help smooth out the results accordingly. The immediate drop from a 1.39 hedge to a 1.05 hedge doesn’t accomplish this, as the businesses customers certainly would not be able to absorb an attempted offsetting 25% EUR price increase in one month, long after the initial EUR weakening began.
UNDERSTANDING THE LAYERS
Rather than potentially buying more time than you probably needed with the last 1.39 hedge, and buying less time than needed with the first 1.05 hedge, a layered approach is usually the better way to go, and will provide far smoother results. As mentioned earlier, however, this does require that Treasury partner effectively with FP&A in updating the planning cycles, and also with whomever is providing any specific forecasts and getting allocated cash flow hedging FX gains/losses.
Merely providing the cash flow hedging FX gain/loss details in isolation of how they fit in with the overall plan is insufficient. Instead, the FX risk manager must provide the analytic details that build the bridge back to the plan their business partners understand and for which they are accountable. The FX risk manager must work with FP&A in updating and communicating a rolling set of planning rates that keep up with the updated rolling targets for the company. They also need to help explain the inevitable deltas between these forecasted plans and the actual results with the hedging included. These inevitable deltas will either be volume driven or rate driven, and the details of these impacts need to be understood.
Volume drivers not only will come from pure forecast deviation, but also from the common cash flow hedging strategy of hedging less than 100% of the forecasted exposure. This is often the case due to the desire to maintain hedge accounting treatment, which can be put at risk from frequent over-hedging. Everyone therefore needs to understand both the accuracy of the forecasts given, and also the impact of the unhedged forecast (which will be the difference between the planning rates and the eventual accounting rates, multiplied by the percentage not hedged per policy).
On the rate side, the hedges won’t perfectly offset the difference between the planning rates and the eventual accounting rates at maturity if the hedges were not executed at the planning rates. The best practice of updating the planning rates with the rolling planning cycle can reduce these deltas, but not necessarily eliminate them. The best FX rates to provide when planning for future quarters should include the actual hedges already in place for that period, but will also typically require an estimate for the future hedges that have not yet occurred. Whatever assumptions are made (current spot or forward rates are just as good of assumptions as any) will ultimately be inaccurate, and this contribution to the noise needs to be tracked.
Below is an example of a dashboard that incorporates these drivers.
Green-yellow-red dashboards are particularly helpful in improving forecasts over time, as no one wants to have a color other than green associated with a forecast they have responsibility for. Forecast providers need to know when their forecasts deviate substantially from the actuals even when the impact isn’t harmful to the bottom line (which will depend upon FX movements that are out of their control). Converting the total income statement impact to a pennies per share (or fraction thereof) metric can be helpful for quarterly earnings call preparation, in the cases where FX impacts are material enough to discuss on these calls.
The next two charts isolate CAD revenue, and the bridge from revenue at the planning rate to the actual revenue realized at the future accounting rates with hedging included. The first chart is a high level waterfall chart, while the second provides the drilled down numbers that explain all the volume driven and rate driven deltas.
Like any other type of performance, when it comes to cash flow hedging programs, you get what you measure. Without proper metrics in place, those in charge of cash flow hedging may do a poor job of mitigating FX risk for their companies. Companies should not be speculating on the direction of exchange rates, attempting to maximize profits if currencies move in the “predicted” direction. Nor should they purely minimize their administrative burden, ignoring the impact that an overly simplistic hedging approach may have on their competitiveness in predictable scenarios.
A good cash flow hedging strategy is one that minimizes the amount of pain across widespread currency strengthening or weakening scenarios, buying enough time to react to competitive shifts while smoothing out the impacts on the income statement. This strategy must be well understood by all stakeholders, and be well integrated into the company’s planning cycles, with frequent feedback on what may be causing unnecessary volatility. It is up to the FX risk manager to develop and maintain the right business contacts, keeping a pulse on any changing business models or strategies in order to ensure the success of the cash flow hedging program into the future.
The information contained in this publication is provided for information purposes only. The information contained herein has been obtained or derived from public sources believed to be reliable, but we do not represent that it is accurate or complete and should not be relied upon as such.Any opinions or predictions constitute our judgment as of the date of this publication and are subject to change without notice.
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