The 3 Biggest Pitfalls of Hedge Programs
A successful foreign exchange hedge program requires both a well-planned implementation and careful maintenance.
Unclear objectives, poorly documented strategies, and bad data lead to confusion and unexpected results. Surprises happen. Fingers point. The result can be an unfocused program that will be scrapped – not because the company doesn’t have exposures and need risk management, but because the program is either not effective, or doesn’t appear effective. Below we have detailed the most common pitfalls that threaten effective risk management.
Ambiguous program objectives
Program objectives must be clear and direct. This can be difficult, due to the various forms of foreign exchange risk that impact companies in different ways. Should you hedge the currency impact on earnings, cash flow, or net investment? Are you protecting foreign entity margins or USD consolidated results? If you hedge balance sheet re-measurement, what if it results in hedge positions which are not aligned with the economics of the company (e.g. hedging USD at a EUR-functional subsidiary)? If you have a net investment hedge of an equity position in a EUR-functional entity, does that impact a decision to hedge EUR denominated inter-company sales to the entity? Should there be discretion on the timing of when hedges are placed? Questions like these arise when the program objectives are not clear, and should be answered at the outset of the program. Objectives should be well defined and documented in detail at the outset of the program so that there is no ambiguity around whether or not an executed hedge is achieving those objectives.
Lack of data integrity
Data gathering is frequently the hardest part of establishing and maintaining a hedge program. The hedging process itself may be fairly simple once exposures are defined, but a lack of data integrity, or adequate systems to support the hedging activity, can handicap a program. For example, cash flow hedging requires forecasts based on the transactional currency, but foreign subsidiaries may not produce such forecasts as part of their normal processes, and may view it as yet another special request from corporate. Balance sheet exposures may be easier to obtain, since they are contained in ERP systems, but you may need to verify the transactions are entered correctly, and the appropriate accounts are being re-valued. The best way to validate the exposure data is to calculate the expected gain/loss on the exposure and compare those expectations with the actual general ledger – calculations that can be simplified with technology (CapellaFX). Without clean and reliable data, there is no possibility of creating an effective hedge program.
Most hedge programs start small, so at first it may seem reasonable to assume that a handful of forward contracts can be adequately managed via a well-designed spreadsheet. Simplified hedge accounting rules make that approach seem even more realistic. However, over time, successful hedge programs will grow to address additional exposures, increase hedge positions, and undertake additional strategies. Spreadsheets will be transferred from person to person, and it will become difficult, if not impossible, to tell if the tool is working as intended. The danger of spreadsheet risk is well-trodden ground; there are numerous academic papers, practitioner anecdotes, and other published horror stories whispering a cautionary tale. As your program grows, hedgers should consider an automated solution which will increase team efficiency, offer greater capabilities through advanced feature sets, reduce reliance on key personnel, and eliminate spreadsheet risk from their hedge program all together.
This article points out three common pitfalls that companies may experience by setting up (or inheriting) a hedge program. Hedge Trackers offers services and tools that can easily mitigate the likelihood of making these missteps in your program. Our consultants will help clarify and document your objectives, and our CapellaFX software can validate your data and help eliminate spreadsheet risk in your hedge program, contact us today.