Managing FX Risk: An Eight-Step Plan to
Establish a Corporate Foreign Exchange Policy
By Dave Napalo, Senior Vice President, Foreign Exchange Division, Wells Fargo
F
ollowing the corporate failures of
recent years, the Sarbanes-Oxley Act
(SOX) has set in motion a groundswell
of changes in corporate governance and
risk compliance. Corporations have been
challenged to respond to the proliferation
of new standards that establish measure-
ments for good risk management practices.
The requirement for impeccable financial
controls has touched virtually every area of
a company’s business.
The reach of SOX has clearly extended
to the practice of foreign exchange (FX)
risk management, an area already thrust
into the spotlight due to the market volatil-
ity that has prevailed for some time. As a
consequence, many corporations have
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undertaken an assessment of whether their
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O FX risk management practices are appro-
N priate for their underlying exposures, as
S well as whether their financial controls
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pass muster in a SOX environment.
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E As part of that process, a sound formal
D policy for FX risk management is a major
step towards satisfying the new standards
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for financial controls. The policy must lay
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A out clear mandates for action and gover-
T nance with clearly defined responsibili-
E ties. To craft a policy, we recommend an
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eight-step approach:
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N simpler and rely upon measuring recent
T STEP ONE: DEFINE CORPORATE
PHILOSOPHY AND OBJECTIVES
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The first step is to establish a framework for
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D the policy. It outlines the principal business
U lines and overall corporate objectives and
S stipulates those areas where the company
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is prepared to take risk. For example, a
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Y company in the laser technology field might
recognize that risks necessary to remain at
F the cutting edge of research cannot be
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hedged away. Conversely, most companies
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U will identify risks that can be hedged away
M – for example, foreign exchange, interest
rate and commodity risks that may affect
Reprinted from the March 2005 issue of TREASURY & RISK MANAGEMENT magazine
financial performance. In most cases, com-
panies state their intention to offset their FX
risk since it is not an area in which the com-
pany has a competitive advantage.
STEP TWO: IDENTIFY EXPOSURES
The next step involves identification of
major exposures – generally, these expo-
sures are grouped under the headings of
transactional, translational and economic
exposures. Transactional exposures would
relate to buying or selling in any foreign
currency. Translational exposures would
relate to protecting the value of overseas
investments and reported income. Eco-
nomic exposures might be the most diffi-
cult to capture because they relate to
issues that usually arise from foreign com-
petition. It is also useful to include as an
addendum to the policy a glossary of
terms, including acronyms that are unique
to a company’s practices and operations.
STEP THREE: QUANTIFY EXPOSURES
This step measures the degree of impor-
tance of the exposure. The specific mea-
surement technique can vary. Some com-
panies may use sophisticated modeling
techniques such as value-at-risk to measure
exposures. Equally valid approaches are
historical changes of currency relation-
ships and their impact on exposures.
Whatever the approach, the objective is
to define which exposures are significant.
Any hedging activity should be propor-
tional to the exposure.
STEP FOUR: DEFINE RISK MANAGEMENT
POLICIES AND PROCEDURES
In this step, specific actions and responsi-
bilities are identified. Those exposures that
present significant risks to the company
are identified and designated for hedg-
ing. The chain of responsibility for making
© 2005 by Wicks Business Information
decisions and executing them is formally
established. Ranges of acceptable hedg-
ing activity should also be established. For
example, a company might elect to hedge
no less than 50% but no more than 80%
of forecasted foreign sales over a speci-
fied time period. Each exposure must be
systematically addressed. This step will
necessarily be complex as it represents the
heart of any hedging policy. Most compa-
nies include in this section an explicit state-
ment that speculative activities should not
be undertaken under any circumstances.
Speculative activities would include any
action that would add to, rather than
reduce, the financial risks of the company.
STEP FIVE: IDENTIFY STRATEGIES
TO MANAGE RISK
In this step, derivative strategies to manage
risk are explicitly identified. Approved
derivatives will reflect the procedures
established in Step Four. In order to pro-
vide additional flexibility, most companies
will specify a range of approved deriva-
tives, including forward contracts, pur-
chased options, and forward-equivalent
option-combination strategies. The specific
hedging technique selected will depend on
the circumstances of each exposure. For
example, if certainty of an outcome is the
main objective, forwards are likely to be
the required derivative. Alternatively, for
competitive reasons, a company may need
upside potential from currency movements.
In this case, authorizing purchased options
and option-combination strategies will pro-
vide the desired trade-off of protection
against adverse market moves while pre-
serving upside potential from the underly-
ing exposure. It is advisable to provide a
broad choice of hedging instruments at the
outset since amending the policy later to
include more choices is usually administra-
tively burdensome.
STEP SIX: EXECUTE STRATEGIES
This step governs the actual execution of a
derivative instrument for a hedge. The indi-
viduals approved to enter into transactions
would be identified. Levels of approval
based upon size or nature of transaction
would be specified. A counterparty or
counterparties, together with credit limits
for outstanding positions, would be estab-
lished. This step also includes implement-
ing appropriate internal controls, including
independent confirmation of trades.
STEP SEVEN: MONITOR
EXPOSURES AND HEDGES
Once risk management actions have been
taken, the process does not end. Monitor-
ing must become a standard practice:
• The hedge actions need to be moni-
tored for performance, as FAS 133
requires a company to reflect the mark-to-
market results of the derivatives in finan-
cial statements.
• The underlying exposures must be
monitored on an on-going basis to insure
that the position does not become over or
under hedged.
• Responsibility for the appropriate
measurements needs to be defined.
• The chain of responsibility to whom
the results are communicated and in what
format should be established.
• An escalation procedure should be
in place if there is ever any evidence of an
erroneous outcome or impropriety.
• Finally, there should be a secure set
of controls for measuring the hedging out-
come. Any spreadsheet used for measur-
ing purposes should have a secure back-
up in an audit function. To the extent pos-
sible, hard-coded formulas should be used
to avoid corruption of internal equations.
STEP EIGHT: REVIEW AND
MEASURE PERFORMANCE
Risk management should be a process of
continuous improvement. The policy itself
should be viewed as a living document.
Within the policy, there should be an explic-
it commitment to review the policy on an
annual basis to confirm that it is meeting its
compliance objectives of risk reduction and
enabling the company to reach its financial
“Wells Fargo believes that each company should analyze its own policies and procedures relating to how it mitigates risk and the above steps should be only used as a
guide in doing so. It is not meant to replace the advice of your own tax and legal professionals.” ©2005 Wells Fargo Bank, N.A. All rights reserved. Member FDIC
Why Foreign Currency Options?
Whether developing or evaluating the company’s FX risk manage-
ment policy, a risk manager should include solutions that respond
quickly to rapidly changing market conditions.
In a global environment where competition continues to intensify,
an increasing number of finance professionals are realizing the
potential opportunity costs of locking into inflexible positions that
result from forward contract hedges. Risk managers should consider
the following benefits provided by an FX policy that includes the
use of foreign currency options:
Ø Flexibility: Unlike forward contracts, foreign currency options allow the
hedger to exercise the option only when it is advantageous to do so.
Ø Profit potential: Purchased options do not limit the upside potential
of an exposure in the event of favorable market movements.
Ø Customizable: Options can be tailored to the company’s specific risk
profile and the strike price can be determined based on premium and
risk-management requirements.
Ø Protection: By using options, the risk manager can reduce the impact
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of currency volatility on company profit performance.
Ø Zero-cost strategies: Option-combination strategies can provide
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option-like protection without up-front premiums.
Ø FAS 133 hedge accounting: Many foreign currency options qualify for
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special hedge accounting treatment under FAS 133. D
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goals. This process should be documented, A well-crafted risk management policy is an A
reviewed, approved and signed so that the essential component of this process. Once T
mandated officers can attest to the integrity goals and responsibilities have been made E
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of the provisions on an on-going basis. clear, every person in treasury will benefit
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from the well-defined mandate. The policy N
CONCLUSION will provide a sound foundation for SOX T
The benefits of comprehensive FX risk man- compliance. And ultimately, the sharehold-
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agement should be realized in a more pre- ers will benefit the most from improved
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dictable and stable financial performance. financial controls and performance. D
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Dave Napalo is a Senior Vice President in Wells Fargo’s Foreign
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Exchange Division. A veteran of the foreign exchange markets, Y
Napalo leads a Risk Management Group charged with helping the
bank’s clients develop successful financial strategies by identifying F
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and mitigating risk when conducting business internationally.
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For more information, call 1-866-819-7462. M