Simplifying the Complex World of FX Risk Management: Insights from Jeff Goggins
Understanding the complex realm of FX risk management can often feel like navigating through a labyrinth with no clear exit. Technical terms like balance sheet re-measurement, hedging, and central bank interventions may seem daunting. However, these concepts become approachable when explained by experts like Jeff Goggins, a Kyriba director, and a seasoned FX risk management specialist.
This episode comes with slides that Jeff and Kyriba shared with us! Download them with the link below!
In this article, we’ll dive deep into the world of foreign exchange risks with Goggins, who, as part of the advisory team at Kyriba, focuses on managing these risks. Kyriba’s treasury management system is renowned for providing automated cash management, bank connectivity, liquidity planning, payments, working capital features, and more.
Disclaimer: All opinions expressed are Jeff Goggin’s personal opinions and not Kyriba’s position.
From this engaging discussion, expect to learn about the following:
- What is risk exposure and when it starts and stops.
- The nature of foreign exchange risk and the different financial risks a company can face.
- The importance of carefully examining a company’s financial risk, more precisely, the foreign exchange risk.
- Techniques to hedge against these types of risks.
- The biggest challenge in FX risk management.
- The impact of high volatility periods on FX risk management.
- The role of artificial intelligence (AI) in financial risk management.
- And much more
We will also explore how AI might revolutionize this space in the future. This article aims to make these complex concepts comprehensible for everyone, regardless of their level of expertise. So whether you’re a seasoned treasury professional or a beginner seeking to understand the basics of FX risk management, this article promises a wealth of insights. Let’s dive in!
Understanding Risk Exposure in Treasury Management
Understanding the term’ risk exposure’ becomes quite crucial in financial risks, particularly focusing on foreign exchange (FX) risk. This term, as explained by Jeff Goggins signifies three main types of foreign exchange risks, often viewed by global companies.
Transaction-Based Risk
This risk involves two kinds of transactions – anticipated transactions and booked transactions. Anticipated transactions are those that haven’t happened yet, while booked transactions are foreign or non-functional currency transactions recorded on your balance sheet that will change in value.
Translation Risk
If you’re part of an organization that deals in multiple currencies, let’s say you’re a US dollar organization with an entity dealing in British pounds, translation risk comes into play. This risk arises when the books of the non-reporting currency entity translate into the reporting currency at the end of the month or quarter.
Net Investment Risk
This risk pertains to changes in the net asset value of foreign subsidiaries.
Understanding FX Risk
FX risk arises when a company operates internationally, has different subsidiaries or suppliers in various countries, and deals in different currencies. It is not just about a US-based company or a company located only in one country, trading overseas, but it also involves large-scale global companies. These companies not only have the main corporate entity conducting international business, but they also have numerous international subsidiaries dealing with other countries and currencies.
Jeff pointed out that the scenario becomes complex as the company expands. This complexity is similar to a large spider web of foreign activity where companies experience changes in the values of all their transactions and seek ways to manage that risk. As part of his work, Jeff helps such global companies set up hedge programs to tackle this risk.
Understanding Transaction Risk: Anticipated versus Booked Transactions
Anticipated and booked transactions form the basis of transaction risk. Understanding these concepts is crucial for treasury professionals. Insights from Jeff Goggins shed light on the intricate details of these concepts, providing invaluable information for those working in the treasury function.
Anticipated Transactions
Anticipated transactions are potential financial dealings that a company expects to happen. However, these are not yet confirmed and can be forecasted or expected activities. The primary challenge is determining the start of the risk associated with the anticipated or forecasted transaction. It varies according to different perspectives within an organization. The anticipation of foreign transactions being valued at a specific amount initiates this risk and continues until the actual transaction occurs.
A typical example would be a company that knows it will be selling products overseas in the future. The anticipated risk extends as far as the company foresees foreign revenues, but the exact point at which it’s decided to manage this risk depends on how certain the company is about the transaction’s occurrence.
Booked Transactions
On the other hand, booked transactions refer to financial activities that have already been realized and recorded on the company’s books. For instance, consider a US company that sells products in Europe. The point at which the company records the revenue from these sales on its books marks the start of the booked transaction risk.
This risk persists until the foreign currency received, let’s say Euros, is converted into the company’s base currency, in this case, US dollars. This conversion process entails a change in the value of the foreign currency, which needs to be reflected on the company’s books. Hence, the booked transaction risk extends from the point the transaction is recorded up until the conversion of the foreign currency to the base currency.
The Role of CFOs and Terminology Differences
It’s crucial to note that terminology might differ across different organizational roles. Often, CFOs might broadly refer to ‘translation risk,’ which may be used to indicate transaction risk. Therefore, treasury professionals must ensure they are on the same page with their colleagues, especially with top management, regarding the terminology and definitions used to describe transaction risk.
Why Anticipated Risk Matters
Anticipated risk is essential because it can affect a company’s annual budgeting and forecasting. To illustrate this, consider a US-based technology company that plans to sell a product in Japan. They set a revenue target that relies heavily on Japanese yen sales. If the yen’s value depreciates significantly during the fiscal year, the company might fail to meet its revenue target despite selling all the units it planned to. This scenario underscores the importance of understanding and managing anticipated risk.
Timing of Booked Transactions
The timing of when a transaction is booked can be crucial. Typically, booked transactions are recorded when an invoice is issued, and the risk lasts until the payment is received and converted into the base currency. The process between invoice issuance and payment conversion, also known as balance sheet hedging or re-measurement hedging, is a part of the booked risk.
To understand the foreign exchange and transaction risks comprehensively, one needs to be patient and willing to revisit concepts repeatedly. It’s a complex domain, but with time and perseverance, the concepts of anticipated and booked transactions, and their relevance to transaction risk, can be well-understood.
Understanding Translation Risk in Treasury Operations
Let’s start at the beginning. Translation risk is a financial risk that comes into play when a global company needs to convert its foreign subsidiaries’ financial results from local currencies into its reporting currency. Sounds simple enough, right? But there’s more to it.
Here’s how it works. You’re a company based in the United States, dealing in US dollars. You’ve got a subsidiary in Europe, where transactions are in Euros. For local tax reasons and other factors, this subsidiary keeps its books in Euros. Now, at the end of the month, you need to consolidate all these Euro transactions into one US dollar report for the entire company.
The Twist: Historical and New Transactions
You’ll notice two items on your books as you perform this consolidation. Some are historical items, like retained earnings, which stay at their old rates. Other transactions come into the books at the current exchange rates. As Jeff Goggins points out, this is where “translation noise” creeps in, leading to translation risk.
Translation Noise and Risk
What’s “translation noise“? It’s a term for fluctuations when you try to balance your balance sheet with old and new transactions at different rates. This juggling act can cause the value of your earnings or the overall value of your balance sheet to shift. This shift, or change in value, is a translation risk.
So, let’s paint a picture. Imagine you have a subsidiary in Mexico, and the value of the Mexican peso drops compared to the US dollar. This devaluation means the total value of the Mexican subsidiary’s balance sheet shrinks when translated into US dollars. This shrinkage is a loss, which becomes a balance sheet risk for the parent company. And that’s the core of translation risk!
To sum it up, translation risk is a change in value resulting from the necessary conversion of subsidiary books from their local currency to the parent company’s reporting currency. This includes the effects of historical retained earnings and new transactions added to the mix. Treasury professionals must understand and manage this risk to ensure the company’s financial stability.
Just remember, as Jeff Goggins emphasized, this risk isn’t just about changes in revenue; it also relates to the overall value of the balance sheet. With this knowledge, you can better anticipate and handle the complexities of treasury operations.
Understanding the Differences Between Net Investment Risk and Translation Risk
The financial journey of a company is not as smooth as it might appear. It often involves dealing with various risks, especially when the company has a global presence. Jeff Goggins shares valuable insights into this complex world of corporate treasury.
What is Net Investment Risk?
According to Goggins, net investment risk revolves around your company’s foreign entities. These entities have a foreign net asset value, also known as retained earnings. This is the historical money your company has made, which changes in value over time.
Let’s say your company has a European branch that has made significant earnings in Euros. The Euros, because they are held in a European entity, don’t pose a booked risk, which we discussed earlier.
But imagine, five years later, you decide to bring all these Euro earnings back to the United States. Now, if the value of the Euro against the dollar has dropped this time, you’d be getting less than you thought. This is your net investment risk.
Even though this risk doesn’t impact your books directly, companies can use it creatively for hedging purposes. Some might even let this risk float and don’t hedge against it.
How is this Different from Translation Risk?
Translation risk, on the other hand, is related to consolidating your financial statements into one global currency. Say, your company has a European subsidiary that keeps its books in Euros for tax reasons. At the end of the month, you’ll need to convert these books into US dollars.
Some historical items like retained earnings remain at their old rates, but new transactions come on your books at new rates. Your balance sheet has to balance, and this results in what’s called “translation noise.” This noise leads to translation risk. So, you could think of it as the risk of your earnings changing in value due to currency changes when consolidating your books.
Does Company Type Matter in These Risks?
You might wonder if these risks apply only to public companies. Goggins clarifies that these risks theoretically exist for all global companies, both public and private. But companies respond to these risks differently based on whether they are public or private.
Public companies, for example, are more concerned with addressing these risks, especially booked risk which affects their earnings per share. They aim to eliminate this volatility to present a consistent financial picture to their shareholders.
On the other hand, many private companies don’t prioritize hedging against this risk. They might not want to put cash at risk or go through the hurdles of hedging for a risk that doesn’t directly impact their key performance indicators.
Understanding and Managing Transaction Risk in Treasury Operations
Understanding where risk starts and stops is one of the first steps toward properly managing it. According to Goggins, this is no different for transaction risks. It is crucial to grasp your organization’s landscape, including understanding your legal entity situation, functional currencies, and operational structure. Once you have this knowledge, you can map your key transactions on a timeline, giving you a better understanding of when and where the risk begins and ends.
As Goggins explains, the risk start can differ for each company based on their operations, accounting, and views on risk. For example, if a company can adjust its pricing according to foreign exchange (FX) rates, it might consider itself naturally hedged and see no risk. On the other hand, if a company sets a fixed price for customers every quarter, it may perceive the risk as starting as soon as that price is set.
Aligning Stakeholders’ Viewpoints on Risk
Equally important is the alignment of stakeholders’ perspectives on risk. For instance, a US company’s senior management might perceive anything not in US dollars as a risk. However, if they have operations in Mexico with a functional currency of Mexican pesos, their local teams might view their risk as anything not in Mexican pesos, including US dollars.
This divergence in viewpoints necessitates a meeting of minds among stakeholders to define and measure risk collectively as a company.
To Hedge or Not to Hedge
Once the company understands and defines its risk, the next step is to decide what to do about it. According to Goggins, some businesses might hedge their risk, while others might want to influence their pricing by smoothing out rates over a longer period.
Contractual Measures to Mitigate Risk
Interestingly, Goggins also points out that some businesses adopt a different approach to managing risk – altering their contracts. This involves contracts where prices are readjusted according to changes in FX rates or the inflation rate. Although less common, this approach can help businesses pass on the risk to their clients, effectively making them immune to it.
However, Goggins warns that these contracts can sometimes create hidden risks. For example, a US dollar contract may carry a Brazilian REI risk if it readjusts to the Brazilian central bank rate at the end of the month. This illustrates why looking beyond the surface is important when assessing transaction risks.
The Intricacies of Foreign Exchange (FX) Risk Management and Stakeholder Expectations
In a multinational organization, there’s a challenging aspect to managing foreign exchange (FX) risks. It entails getting everyone on the same page, setting the objectives, and ensuring the treasury department receives accurate information to make sound decisions. Jeff Goggins shares insights during a recent podcast interview.
Getting Everyone on Board
According to Goggins, establishing a universal understanding and collaboration across the company can be daunting. This challenge often discourages some companies from undertaking transformational projects related to hedging. These firms may struggle to align their stakeholders, particularly when managing FX risks. The situation becomes even more complicated when dealing with subsidiaries and their exposures. Each subsidiary can have its own financial data set in its unique ERP system, making it hard for the treasury department to collect the information they need.
The Importance of Accurate Forecasts
Companies need to get accurate forecasts from their local entities or Financial Planning & Analysis (FP&A) teams to tackle the complexities of FX risk. While some firms can rely on historical data initially, they need up-to-date forecasts at transactional levels in the long run. Unfortunately, many FP&A teams only provide forecasts at the functional currency level. As such, getting this necessary data requires fostering a change within the organization, pushing for better visibility into transactions that may be driving risks.
Handling Different Stakeholder Viewpoints
As Goggins explains, multinational corporations often grapple with different stakeholder perspectives. Moreover, complexities arise when it comes to hedge accounting. For instance, a US-based company with Euro revenue in a Euro entity cannot get hedge accounting by hedging Euro revenue because of existing rules. Thus, corporations must determine what they can and can’t do to qualify for hedge accounting. This process requires engaging in numerous discussions to establish common ground.
Understanding the Definition of Risk
For US-based companies receiving payments in other currencies, the risk is the FX rate going against their favor, resulting in fewer dollars than expected. However, the complexity increases in a multinational organization. In such a setup, different functional currency entities have foreign transactions, which add to the overall FX risk.
Tech companies have a simpler setup by treating their international entities as US-dollar functional companies. This approach lets them treat foreign currency revenue as a risk at both the entity and corporate level, aligning their risk perspective with the accounting methods. However, a mismatch between accounting and economic intentions can occur for companies that set themselves up with the local currency as their functional currency.
The Complexities of Global Companies
To address these challenges, some global companies view their international operations as separate businesses, each dealing with risks in their local currencies. These companies deal with a translation risk which they explain in their earnings releases and other financial disclosures. A sound understanding of these factors can enable treasury professionals to manage their FX risks despite the complexities better.
Understanding US GAAP and Its Relevance to FX Hedging
US GAAP or United States Generally Accepted Accounting Principles, is an accounting guideline that most companies in the United States follow. This rulebook is organized by the Financial Accounting Standards Board (FASB) in the United States. One cannot overemphasize the importance of this guideline, especially when dealing with foreign transactions.
FASB’s ASC 830, a free-to-access segment of US GAAP, provides a framework for booking foreign transactions. The framework allows different companies to have varying approaches to booking transactions. However, the practices all fall under the ASC 830 guideline. This section also covers the concept of “re-measurement,” detailing how companies should re-measure their books on a transaction basis.
Diving into Hedge Accounting
Now, let’s dive a bit deeper into hedge accounting. ASC 815, another section of US GAAP, caters to hedge accounting, or as Goggins fondly calls it, “a whole other animal.” When a company hedges its risks and uses derivatives, it must record these on its books at fair value. Depending on the risk being hedged, the company may want to mark it for special hedge accounting treatment. You can find all this intricate detail under ASC 815.
If your company operates internationally, it may follow the International Financial Reporting Standards (IFRS). IFRS 9 is the hedge accounting counterpart for US GAAP in such cases. While there are subtle differences between the two, at a high level, they’re pretty much the same when it comes to standard FX hedging.
So, before diving headlong into any FX hedging, you must know what accounting framework your company follows. It’s part of understanding your company’s bigger picture.
Grasping the Concept of FX Hedging
Let’s get to the meat of it. So, how do companies hedge against these risks?
At the very basic, you want to eliminate the volatility of the foreign currency element from a transaction. This action can be as simple as calling your bank and locking in a rate with a forward contract for a future date. This process allows you to fix the value of the transaction.
For example, if you’re expecting revenue in Euros next month and like the rates today, lock in that rate with your bank. Therefore, regardless of whether the Euro value goes up or down, you’ve already secured your rate. This action is known as putting a “short” position on your books to offset the “long” revenue.
Aside from forward contracts, some global companies might use an option contract or sometimes collars. However, most companies stick to the basics with instruments and hedging in the FX world.
Now, that’s just the tip of the iceberg. It gets more complicated when you’re getting the information, deciding what you want, and then accounting and tracking everything. But, essentially, that’s how it works. You’re putting an offsetting position on your books by working with your bank.
Strategic Approaches to Hedging Transactions
According to Goggins, there isn’t a one-size-fits-all solution for each transaction. Different parameters change from one hedge to another, providing various strategic opportunities.
Variables in Hedging
One key factor in hedging is determining when your risk starts, as this decision shapes when you start putting the hedges in place. The end of hedging is another variable that depends largely on business-specific factors and can involve different instruments. However, Goggins emphasized that companies should be careful not to risk losing hedge accounting, which aids in balancing risk and profit over time.
Layering Hedges
In most cases, Goggins highlighted, companies structure their hedge programs by layering. Layering means they don’t hedge 100% of the risk simultaneously. Instead, they gradually build their hedging position, starting with a small portion and increasing it as the forecasted period draws nearer and their confidence in the forecast grows. The percentage that companies choose to hedge depends on the reliability of their forecasts and their comfort level with being wrong.
Hedging for Different Timeframes
Goggins also discussed different hedging strategies based on the forecast period. Some companies might be more confident with their quarterly forecasts than monthly ones. In such cases, they might hedge for the entire quarter and then unwind the hedge gradually each month based on the realized sales.
Hedging Types of FX Risk
Goggins clarified that companies could hedge both types. Public companies prefer hedge accounting as it allows them to hedge anticipated risk without creating an accounting mismatch between the hedging contract and the unbooked risk.
Hedge Accounting
With hedge accounting under IFRS 9 and US GAAP ASC 815, companies can record their derivatives without immediately impacting the Profit and Loss statement (P&L). They can hold the hedging result in Other Comprehensive Income (OCI), part of the equity. Only at the end of the hedge, if executed properly, is the result of the hedge booked in the P&L. If a company was hedging revenue, the hedge result would go into revenue, helping to balance any potential losses.
Hedging Booked Transactions
The hedging contract is marked to market and booked at the fair value at the end of each month for booked transactions. In such a case, the hedging contract, booked as FX gain or loss in the P&L, should ideally offset the reevaluation of the booked risk.
Major Challenges in FX Risk Management and the Impact of High Volatility Periods
According to Jeff Goggins, managing foreign exchange (FX) risks presents unique challenges. The most pressing of these revolve around increased volatility, especially in recent times, and the complexity inherent in FX processes.
Understanding the Impact of Increased Volatility
To start with, Jeff Goggins noted an increase in volatility over the past few years, which he attributed largely to more active central banks. These institutions have been adjusting their rates more frequently, leading to unexpected shifts in currency values. This, in turn, affects the cost of hedging, making it more unpredictable. Jeff explained this with a common example: a forward contract of hedging has a component based on interest rate differentials between both currencies. Hence, as central banks alter their interest rates more frequently, it changes how companies see their cost of hedging flow.
The surge in volatility has thrown many companies off balance, even those with existing hedge programs. These organizations find that their hedging costs significantly differ from anticipated, leading them to consider new approaches.
Moreover, high volatility exposes issues in hedge programs that might have previously gone unnoticed. When rates are stable, minor inaccuracies in forecasts or small flaws in a hedging program might not have a large impact. However, during volatile periods, these small mistakes can have significant repercussions. Jeff believes this increased volatility sheds light on issues companies have long ignored or overlooked in their FX risk and hedge programs.
Dealing with the Complexity of FX Risk Management
The second challenge Jeff pointed out was the complexity of FX risk management. He described FX as a “circular, iterative learning process” filled with various concepts, terminologies, and complexities, especially for global companies. Even experienced practitioners can find it difficult to navigate this landscape, especially when moving between companies with different operational procedures, functional currency setups, and hedge programs.
In addition to understanding the complexities, obtaining the necessary data to make informed decisions is another significant hurdle. Traditional ERP systems often fail to provide clear and direct reporting on non-functional currency balances. To manage this, companies must gather, aggregate, and analyze information from various sources, which can be an intensive administrative process.
However, Jeff sees FX’s complexity and learning process as an opportunity rather than a challenge. He finds it fascinating that the more you learn about FX, the more you realize there’s much more to discover. This constant learning curve keeps the field interesting and dynamic, encouraging practitioners to update their knowledge and skills constantly.
Impact of Artificial Intelligence on FX Risk Management, Hedging, and More
Jeff Goggins believes AI is opening up new horizons for Foreign Exchange (FX) risk management. First off, let’s discuss one of the biggest advantages that AI can bring to this field: better forecasting.
Forecasting: The Critical Element of FX
In FX risk management, forecasting plays a vital role. To ensure the effectiveness of their hedging programs, companies must accurately predict their exposure. If they’re off the mark, it’s a case of “garbage in, garbage out” – their efforts won’t yield the desired results.
Here’s where AI steps in. It can be a game-changer, providing a much-needed boost to this crucial aspect of FX management. Like how AI has transformed cash forecasting, Goggins also expects it to revolutionize FX exposure forecasting. By improving the accuracy of these forecasts, AI can help companies achieve more economical hedge programs.
Automating FX Execution
Beyond improving forecasting, AI has the potential to streamline the execution side of FX transactions. While some level of automation is currently available via multi-bank trade portals, there is room for more efficient streamlining. AI could automate the execution of FX deals, securing beneficial terms with banks and reducing manual effort.
Goggins suggests this automation could help reduce the administrative burden associated with FX transactions, making life easier for treasury professionals.
Wrapping Up
As we delve into the complexities of treasury management, specifically focusing on foreign exchange (FX) risk management, it’s clear that professionals in the field face unique challenges and opportunities. In our discussion with FX expert Jeff Goggins, we unearthed valuable insights into how understanding the impact of balance sheet re-measurement, risk management techniques, and the evolving role of AI can help treasury professionals navigate the convoluted world of FX.
Our exploration began with understanding balance sheet re-measurement, its nuances, and its undeniable impact on FX. Although complex, it’s a process that is key to gaining a clear picture of the financial state of any company with international dealings.
Diving deeper, we explored the various risk management techniques. Be it a systematic approach to hedging or taking advantage of natural hedging, a good understanding of these techniques is vital for treasury professionals to safeguard against potential risks. Amid all the complex concepts, Goggins reminded us of the importance of reliable data, emphasizing the age-old adage, “garbage in, garbage out.”
In the fast-paced and evolving world of treasury, staying updated with technological advancements is crucial. The introduction of AI and machine learning in the forecasting and execution of FX deals has the potential to streamline operations and increase efficiency, reducing the administrative burden on treasury professionals.
While the journey can be complex, persistence and continuous learning are the keys to mastering the intricacies of FX risk management. As technology advances, so will the opportunities for increased efficiency and precision in this space, opening up new avenues for those willing to grasp them. The future of treasury management holds exciting prospects, and it’s up to treasury professionals to seize these opportunities and navigate the complexities of the evolving world of FX.
