In working with our clients on developing an FX, interest rate, commodity, or investment management policy, we first use an iterative process involving:
- Risk Analysis. With client assistance, we develop a normalized current operating P&L or EBITDA by currency, ignoring intercompany flows. We then show the FX risk of this P&L by restating it using historic exchange rates from last 5-10 years: same external currency flows, just different historic P&L FX rates. We can further simulate various passive hedging strategies to graphically show how FX hedging can reduce quarter-to-quarter and year-to-year FX volatility.
- Metric Framework. To quickly clarify the real hedging objectives, we show how common objectives can be fairly measured. As explained in A Metric Approach to Risk Management, metrics can range from sophisticated performance measures to pure reduction in risk measures to requiring zero GAAP P&L ineffectiveness. Without metrics, the default metric will always be whether the hedges made money, an unfair metric that is a loser's game for treasury.
- Benchmarking data. We share freely our benchmarking data of how other companies manage their financial risks, including the important operational issues. This includes the 12 principles from The Group of 31 Report: Core Principles for Managing Multinational Foreign Exchange Risk. These principles are equally applicable to commodity hedging, and many are also applicable to interest rate hedging and investing.
- GAAP-Effective Hedging Techniques. As explained more fully at GAAP Hedging, we determine how to best achieve the desired economic hedging objectives by structuring hedging processes to be effective under FAS 133, IAS 39 in International GAAP or AcG-13 in Canadian GAAP. This includes two useful techniques based on post-FAS 133/IAS 39/AcG-13 earnings: Marking-to-Earnings™ and Hedging-to-Earnings™.
Then, once the policy elements have been decided, we have found that an effective way to facilitate the policy's approval is to write two documents:
- A succinct policy document for the approval of senior management or the Audit Committee that focuses on policy objectives, exposure definitions, performance measures, and execution responsibilities.
- An operational policy and procedures manual for how the policy will be executed. This includes information reporting, trading practices, back office controls, compliance reviews, etc.