How to formulate an FX risk management policy?

Does your company need an FX hedging policy? Or already have one, but it needs to be reviewed? Here is a great place to start!

Sooner or later (and preferably sooner), everyone will understand that the exchange rate’s future direction can’t be predicted with high reliability. Given this premise, a CFO or treasurer will find himself wondering how they should manage the currency risks of the company in which they work. They know that the accounting effects of conducting currency derivatives transactions can shake the ship, even if they have acted appropriately economically. All the more so if she/he gets it wrong in the economic aspect.

The way to act is to solve the problem in two steps.

• The first step is to formulate a currency risk management policy.
• The second step is the tactical policy implementation – using currency derivatives transactions and adjusting them to the actual cash flow, almost on a daily basis.

Formulate foreign currency hedging policy

In this stage, the CFO usually submits a reasoned and orderly motion for a resolution to the board of directors. The starting point for the discussion should reflect the theoretical or statistical risk that the company is facing in a scenario where it does not implement currency risk management at all. One of the techniques to present this risk estimation is using the Value at Risk model, but that is not in this article’s scope.

Assuming that the members of the board of directors are convinced that this risk must be reduced, then the main discussion should focus on the hedging percentage that the company must implement for different times horizons.

Most companies do not hedge 100% of the exposure for many justifiable reasons. But too many companies only hedge time frames overlapping with credit days. In doing so, they usually only deal with the aspect of accounting exposure but leave most of the economic exposure unhedged.

Given its unique characteristics, every company has to decide where it stands on this scale.

At this stage, it is also advisable to address whether the company decides to implement hedge accounting and discuss the advantages, disadvantages, and implementation costs involved.

Foreign exchange risk management policy template

We have created an automatic foreign exchange hedging policy generator to produce a preliminary working paper for you. All you have to do is answer a few questions, and a PDF document with an FX hedging policy template will be sent to you within minutes. 

It is recommended to treat this document as a preliminary working paper and make changes and adjustments to the unique company characteristics. Then, feel free to run the report with changes in answers and see the changes in the new policy sent to you again.

FX hedging policy implementation

This stage requires technical knowledge of FX derivatives and constant adjustments to the cash flow. CFOs are not interested in discussing these aspects in the first stage of policy formulation. Instead, the board of directors often authorizes the CFO to use hedging tools (options, structures, etc.), provided they are designed to implement the hedging policy.