More companies are developing policies to manage foreign exchange risk, but do they stand up to a best practices approach?
Matthew N. Daniel, Managing Director, and Stuart Laramore, Senior Vice President, Wells Fargo Foreign Exchange Risk Management Group
According to Wells Fargo’s Foreign Exchange Risk Management survey, nearly two-thirds (64%) of companies maintain a formal policy to address foreign exchange (FX) risks, but only 17% of survey respondents indicated that they measure potential FX risk.1 How you structure your company’s policy — and the ways you quantify risk — will have an effect on performance.
Here are three common inadequacies that we help customers address as they build stronger FX risk policies.
- Anchoring a policy to methods deployed by other companies and not to a “best practices” approach
- Policies are not prescriptive enough
Each company’s risk management policy should be individualized to their specific needs and circumstances. In general, risk management policies should be carefully constructed to recognize that risk and risk management mean different things to different people. It is especially important that policies be written with language that is specific and clearly articulated in a way that avoids confusion.
- Identify objectives and expected results
- Clearly define terms and limits
- Identify and classify activities and strategies that are permitted, prohibited, or require additional approval
In addition to defining the expectations of what the risk management program will achieve, the policy should articulate what the risk management program will not achieve. Many companies exposed to FX risks are constrained in one way or another in their ability to manage their exposures. So, a policy that claims an objective of “eliminating FX risk” may not be setting the correct expectations with senior management.
- Creating a policy only when you are ready to start hedging
Creating an FX policy is a dynamic process. Companies exposed to FX risk may wish to develop a risk management policy whether they are actively hedging those risks or not. One of the main principles of a best practice approach is identifying and quantifying risk, and this level of oversight is just as important for companies that are actively hedging as it is for companies that are not currently hedging their exposures.
For companies that are in the initial stages of building an infrastructure for managing FX risks, they may not have fully developed their objectives around FX risk management, or perhaps their exposures are quickly changing and evolving, or they simply do not have the ability to monitor and understand their risks. Companies’ experiences in managing FX risk also change over time. As a result, the development of a risk management program and the processes for managing risk also should develop and change over time.
Companies that have not fully assessed their risk management needs may wish to consider developing a basic risk management policy as an interim solution, while working toward the goal of a more comprehensive policy.
Common practices do not always equal best practices.
The objective of most FX risk management programs is to manage foreign currency risk by developing and implementing a hedging program with robust oversight and management policies and procedures. To achieve this goal, many companies follow a “best practice” approach consistent with the Enterprise Risk Management framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The COSO Framework offers integrated principles, common terms and practical implementation guidance for companies to create and develop their enterprise risk management processes. The COSO Framework generally consists of the following eight components:
The first three steps — 1. Defining corporate objectives, 2. Identifying potential risks, and 3. Quantifying potential risks — are among the more challenging but important steps in this process.
Risk quantification is essential to help management understand the risks and make appropriate decisions regarding how to manage those risks. Defining hedging objectives of a risk management policy consistent with corporate objectives aligns a company’s risk management activity directly with its business objectives, thus helping reduce confusion about the use of derivatives or interpretation of the policy.
1. Wells Fargo. “2016 Foreign Exchange Risk Management Practices Survey.” January 2016.