Essentials of a Strong Risk Management Policy
Written by QuantArt Market
Updated on: 23rd October 2020
In this paper, we aim to outline the global best practices and the key ingredients of a good forex risk management policy which can protect a firm from fluctuating exchange rates and by doing so help save cost directly or indirectly leading to an improved bottom-line.
Foreign exchange risk is defined as the risk that arises because of trade and investments that were in a different currency than the home currency. Export, import, a foreign exchange loan, an overseas transaction or investment may involve at least two currencies wherein a firm is put at risk because the cash flows are dependent on the foreign exchange rate which changes every second.
Hence, it is necessary for a firm to first identify the risks involved in transactions involving foreign currency and then cautiously devise a risk management policy to mitigate its effect. The essential qualities of a good foreign exchange risk management policy are based on our research and experiences are as follows: –
1. Accurate Identification of Risk
The policy should be able to accurately identify the forex risks related to receivables, payables, borrowings & investments. When a receivable or payable gets recognized as “exposure”, it is crucial for successful risk management. For example, for a project import, the policy should accurately identify when the exposure starts. Is it: (a) when the order is placed, (b) when the shipment is done (c) when the invoicing is done (d) at the time of payment, or (e) at the time of project planning.
The policy should not ignore the strategic & business forex risk. For example, if the USDINR exchange rate is at 35.00 for any given reason, the BPO business may become unviable. Strategic forex risk is something which is neither crystalized nor certain, but where the business is fundamentally dependent on the exchange rate.
The process requires in-depth thinking about the company’s purchase and selling cycles to identify risks accurately.
The risk management policy should incorporate industry dynamics. For example, in some industries, the burden of currency fluctuation can be partially “passed on” to the end client, and in some industries, it cannot be passed on.
There are risks associated with domestic purchase and sales as well as where the commodity or service prices are determined by international prices, thus involving currency movements. For instance, a newsprint purchase and sale in India carry forex risk since prices are USD determined.
2. Correct Measurement
You can’t manage what you can’t measure! The saying aptly applies to forex risk as well. Sophisticated measures like ‘Value at Risk’ provide a good single number to monitor on a daily basis since it also considers correlation amongst various currencies. Other equally important measures are Net Open position, Tenure bucket, Wise currency wise open position, Hedge ratio, etc. An exposure book that involves Option as a hedging tool must also measure portfolio delta, gamma, vega, theta. Net open position as a measurement tool becomes defunct for a portfolio that uses options since a highly out of the money option may make the portfolio look 100% hedged but in reality, the company runs a substantial risk.
Interest rate risk needs to be ideally monitored as PVBP i.e. Present value of a basis point change in the curve for various time buckets. Another almost similar way to look at this will be to measure the impact on the firm if there is a parallel shift in the yield curve by 1%.
Currencies have correlation amongst themselves and the effect of such a correlated move must be reflected in the measurement of risk.
3. Protection from Extreme Fluctuation
The risk management policy should be designed to protect the business from extreme fluctuation in currency exchange. Global currencies move towards extremes, once in a while, resulting in forex losses that eat into business profits, at times making business unviable. For example, whatever hedge we choose, if the rupee moves to as low as 45.00 or as high as 75.00 in a year’s time, for a given portfolio, the business should never suffer more than the reasonable loss on account of forex fluctuation.
4. Discipline in Risk Management
A good risk management policy should make hedging an autonomous process reducing sole reliance on the human judgment about hedging. Often the human mind tends to postpone hedging decisions either “for better level” or to avoid “hedge cost”. Forex is not a core business activity of a company, hence, the open exposure at any time should be limited irrespective of the individual or collective views. Companies that manage risk using disciplined rule-based hedging have successfully avoided large forex losses.
When a certain discipline is brought into risk management, it allows businesses to look at available opportunities without being fearful, and thus it helps in capturing opportunity as well.
A strong policy is a function of well thought out plans and rules, in the absence of which the human mind will always take decisions based on greed and fear, and logic is bound to take a back seat mostly in such instances.
5. A healthy balance between Risk & Return
A penny saved is a penny earned. A good Risk management policy should not turn a blind eye to cost-saving opportunities thrown by the market. With careful analysis of available opportunities and optimum utilization of the available instruments and strategies, the policy should enable the business to save costs. This can be achieved only when the policy is flexible enough to allow the use of all possible tools & strategies in the market, as per the regulators.
Similarly, a good balance between economic and accounting considerations needs to be maintained. While we believe most decisions should be based on economic rationale, the policy should have in-built mechanisms to avoid huge quarterly fluctuations in P&L due to mark-to-market losses.
Most companies pay interest to the tune of INR 8%-12% p.a. but with appropriate policy and strategy, it’s possible to save 2%-3% cost per annum which can be a substantial boost to the bottom line.