Exposure is traditionally the driving force of risk management, but it has its blind spots. With complications like associated risk, simple hedging percentages often prove  to be insufficient.
The key for companies is to quantify their diversification between different entities and exposures, particularly taking into account the impact of FX rate volatility on liquidity risk and earnings risk.
New emerging best practices
Most treasury departments receive monthly cash flow forecasts from their business units and are applying a fixed minimum and maximum hedging percentage for the current financial year, with possibly a lower one for the next financial year.
The treasury department may then back-to-back these trades with the business units and market or net and hedge with some level of guidance provided by the board. At this point, most treasury departments are done and report solely on this basis. Risk meetings become a discussion around whether the hedge percentage is adequate and appropriate. The analysis of the impact on earnings or liquidity is rarely done by treasury departments and, therefore, is not tied back to reporting to the board the success or not of the hedging program.
This is generally regarded as best practice, but it is one-dimensional given that no analysis is performed and no metrics are brought back to the board and CFO. More targeted risk methodologies have emerged that are better aligned with the requirements of corporate treasurers.
Two of the most important concepts being discussed are cash flow at risk (CFaR) and earnings at risk (EaR). CFaR is a model that measures possible shortfalls in cash flow due to FX rate fluctuations that could have a knock-on effect on a company’s profit and loss (P&L) and liquidity, while EaR is the value of earnings at risk due to FX rate fluctuations.
The link between CFaR and EaR
For corporates, the earnings statement and cash flow statement are key reports for the board and shareholders. The impact that market risk can have on these financial statements will, in turn, impact shareholder value, thus corporate senior management is particularly concerned with these risks. This is why both CFaR and EaR are important components of corporate risk management.
On the surface, the two methodologies may appear close to being the same. However, the relationship between liquidity and earnings is driven by a variety of factors, including the corporate intercompany structure, the locations the company is participating in and the policy around cash repatriations.
An assumption to consider when looking at how liquidity and earnings impact each other: The idea that treasurers can keep hedging cash flow exposures and, at the same time, look after the earnings at risk is not always true. Corporations are so focused on applying and following the advocated best practice that they often do not analyze the impact the hedging program is having on group earnings — even though this is a key metric of the CFO and the board.
There is a tradeoff where, at some point, the increase in cash flow hedges can increase the earnings risk, which can be undesirable. Understanding this relationship can shed light on what companies need to hedge and what they feel comfortable with in earnings versus cash flow risk, as well as how much cash flow risk hedges they want to layer or whether they want to start thinking about a way to protect earnings that is independent from liquidity.
Any intercompany purchases or sales in foreign currency are going to have cash flow at risk for one or both entities. Any time a company has third-party purchases in a currency that is not a functional currency of the entity or group, it is both CFaR and EaR. Cash flows in the domestic currency of the entity, but not the functional currency of the company, will have EaR but not CFaR.
The corporate treasury function is usually considered a support function within a company’s organization. As senior management sets its goals, priorities and focus, the treasury department needs to have the ability to achieve those objectives. The CFO will have an earnings target and will measure progress in achieving that target. However, CFOs do not always look to the treasury to reduce the risk of achieving that target due to FX rate volatility, as the CFO relies on market standard best practice using a hedge percentage program that does not tie back to a worst-case earnings impact number for FX volatility.
Technology supporting methodology
Because CFaR and EaR are data-dependent, having the right technology in place is essential to surface information quickly and accurately.
It is about having reliable data in a flexible format – meaning such data can be used in tools that vary from the Bloomberg Terminal and optimization tools to PowerPoint presentations. Data should also be customizable, with the ability to craft sophisticated constraints for modeling.
With the right technology and a hedging program that incorporates the tradeoff between CFaR and EaR, companies can determine where their risk exists and quantify its diversification. This enables companies to hit their defined level of risk year after year.