A Structured Approach to Financial Risk Management
1 Unclear Risk Management Objectives
3 Absence of Appropriate Performance Benchmarks
The design and implementation of an effective FX risk management
In order to design an effective FX hedging strategy, it is
With almost any business activity, performance
necessary to know exactly what the strategy is intended
measurement is essential to determine the effectiveness
to accomplish. While this may appear to be self-evident,
of a chosen strategy. If a company’s marketing department
volatility experienced in the foreign exchange markets over the past
the process of determining a company’s FX hedging
designs a new advertising campaign, the impact of that
couple of years has highlighted the need for large and small businesses
objectives is not always as straightforward as it sounds.
campaign on future sales will be closely monitored to
Stating a simple objective, such as “protecting the business
determine whether the campaign should be continued.
from FX volatility” may be stating the truth, but it is not
And just like the decision to launch a new advertising
specific enough to effectively guide the design and
campaign, the determination of an FX hedging strategy is
implementation of an FX hedging strategy. Is the goal to
a key strategic decision, which can have a material impact
protect the balance sheet or the P&L? Should accounting
on a company’s bottom line. As such, it is important that
results be prioritised over cash flow impacts? What is the
a system is in place which allows the performance of the
relevant time horizon? These are the types of questions
hedging strategy to be measured.
strategy can be a challenge for many businesses. The extreme level of
to carefully consider their FX hedging requirements, and whether their current hedging programs are sufficient to meet their risk management objectives. This white paper highlights 10 key pitfalls that companies should be aware of when evaluating their current hedging strategy.
that must be answered to allow the design of an effective
FX Hedging - 10 Common Pitfalls
The choice of benchmark is also critical, and should be
closely linked to the objectives of the hedging strategy.
A company’s risk management objectives represent the
1. Unclear Risk Management Objectives
2. Lack of Structured Hedging Strategy
3. Absence of Appropriate Performance Benchmarks
If, for example, the objective of the hedging strategy is
foundation of its FX hedging strategy. As such, these
to ensure that a company achieves its quarterly budget
objectives should be closely aligned with the overall business
rate, then the benchmarking metrics must also include
strategy, and they should be clear, specific and measureable.
the achievement of this objective. If the hedging strategy
2 Lack of Structured Hedging Strategy
is designed to incorporate a “market view”, then the
benchmarking system should include a metric that compares
the achieved rate to a relevant passive hedging portfolio.
The reluctance of many companies to adopt a formal,
4. Allowing a “Market View” to Drive Strategic Hedging Decisions
7. Failure to Consider Internal Risk Reduction Opportunities 8. Failure to Consider the Impact of Correlations between Exposures
system will usually result in the “success” of the hedging
FX markets is paramount, and formal hedging polices may
strategy being determined by reference to inappropriate
be seen as cumbersome and bureaucratic. However, lack of
6. Inefficient Pricing of Hedging Instruments
Failure to implement an effective benchmarking
need to remain flexible when managing risk in the volatile
5. Use of Complex Derivatives as Hedging Instruments
documented hedging strategy is perhaps understandable, as...