Foreign Exchange (FX) Risk Management Policy

An FX policy is a documented set of directives outlining organizational objectives, strategies and procedures with regard to managing currency risk. It can be broken down into five broad sections: 1) Identification of Risks & Exposures 2) Risk Assessment & Quantifying Risk 3) Risk Evaluation 4) Risk Response 5) Risk Reporting & Monitoring. It includes exposure types to be managed, and tactics to be implemented to alleviate this risk, including specific financial instruments to be utilized. Any business operating with an exposure to overseas markets will be exposed to foreign exchange rate risk, commonly known as transaction, translation and economic (TTE) risks, and need a formalized approach to manage these risk to avoid ambiguity and uncertainty when faced with making FX-related decisions. It is imperative to have a plan in order to deal with these complex risks consistently and efficiently, especially when FX markets take off!

Changes in FX rates directly influence the overall costs and profitability for an organization relative to overseas business dealings. Failure to implement an FX risk management plan can leave your company exposed and ill-prepared to manage the effects of unfavorable currency moves. Currency volatility can have a severely adverse effect on a company’s bottom line, but it doesn’t need to! Many companies either inconsistently manage their FX risk or tend to give priority to issues like following FX markets and the selection of FX hedging instruments. These matters are important, but they always come at the end of a risk management process that must begin with identifying and then measuring the foreign exchange exposures that you want to manage. Lack of quantifying exposures and risks leads to inconsistent results and often when losses are generated, a company's financial statements show only parts of the transaction and portfolio risk making it very difficult to pinpoint where the losses stem from. We cannot monitor, track and evaluate what we do not measure!

The most important impact of currency changes, which come from structural risk, finds its way into the income statement through movements in revenues and costs but not as an explicit line item. In fact, standard financial reports can even lead to the wrong conclusions about a company’s exposure to movements in currency rates by overemphasizing the accounting effect on earnings rather than the real effect on cash flows. This is why the first step of a comprehensive FX policy concentrates on identifying cash flows as the focus should be on these rather than earnings. Hence why we must measure first, so that we can then manage the risks intelligently and correctly.

Transaction Cost Analysis

Trust, but verify. Many corporations assume that their FX provider is dealing with them in fairness and honesty, and actually have no idea the spread they are being charged. This in part stems from being told by their FX sales rep that their rates are "market rates" when likely this was only true for a transaction or three when the client's business was first being courted, but has since been "adjusted" upwards, unbeknownst to the client (i.e. bait and switch or get 'em and spread 'em). When making a price, an FX broker/bank firstly considers their own positions and exposures, and then skews the price for each client according to a (usually) sophisticated model that takes into account credit ratings (e.g. Dunn and Bradstreet), market conditions and the client’s likely activity. All historic client trade history is logged and this adds to the richness of this data.

Our Transaction Cost Analysis uses an independent exchange rate, so it is easy to compare banks /brokers and to understand their attitude to your business (e.g. fair shake or plunder and loot) based on their adjusted spreads. Deals involved in currency transactions are typically undertaken by a bank/broker often with little to no transparency on executed rates and times. They also push clients into non-linear products like vanilla/exotic/structured options because these are infinitely more difficult for clients to price, which means they can make larger profits on those transactions. We can help place an accurate value on these deals, past and present, and the costs associated with them.

FX trading costs directly hit a company's bottom line. For example, exchanging $1,000,000 USD at a USD/CAD rate of 1.3000 when the true interbank rate was 1.3100 just cost your company $10,000 on one transaction! For an arms-length transaction, which is pretty much the business model of every bank and FX broker, this would equate to a huge, unwarranted and undeserved fee! This directly impacts your profits, but you will never receive a bill showing you the real cost. Without knowing currency trading costs, an accurate and detailed cost / benefit analysis cannot be performed on your FX provider and you will wonder how much they are making converting your currencies every year.

Our analysis reveals your actual FX transaction costs in a way that is transparent and easy to understand.
    Your benefits:
  • Protection in an over-the-counter (OTC), unregulated market
  • Cost transparency for currency transactions: spot, forwards, options
  • Measure to manage costs as you can't control what's not quantified
  • Identification of saving potentials by benchmarking FX costs
  • Assess the competitiveness of your deal prices by isolating cost impacts from deal size, deal type, currency and FX counterparty
  • Validation of current FX Execution arrangements
  • Satisfy fiduciary responsibilities a company has to its shareholders
  • Capability to negotiate with current FX providers

Smart Beta Currency for Return

Smart Beta Currency for Return (SBCR) is very similar to our Active Hedging services in that it seeks to protect revenue and profit margins from rainy days, but it can add another dimension to currency risk management rounding out an overall program. The main difference is that the SBCR may have a different base currency and / or risk objectives than the company's actual underlying FX exposures, and may require the establishment of alternative FX and hedging facilities (e.g. credit lines). Companies would use SBCRs when they want their underlying FX exposures hedged separately from a more alpha (i.e. return) oriented objective that seeks to capitalize from various currencies' mismatch in terms of Value, Carry and Momentum.

SBCRs are generally funded by cash deposits (i.e. margin) and positions are netted and cash settled for a profit/loss rather than an actual exchange of the position's underlying notional value, that is no exchange for physical. Compared with Passive and Active Hedging, SBCRs take advantage of leverage meaning that the deployment of cash to meet regulatory margin requirements is more efficient by utilizing an SBCR. Initial and maintenance margins can often be 25% to 75% less. A dedicated currency specialist, focused exclusively on adding alpha via currency exposure will employ strategies utilizing a blend of a fundamental, discretionary and systematic approaches in line with your liquidity needs and return objectives. The goal is to minimize cash drag by managing surplus cash to earn a return.

Bastion Currency Management leads the industry in third-party foreign exchange services. Our professional FXperts put the "Person" back in Personal; right where it should be!

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