Elevating Your FX Risk Management Program

For companies operating internationally, managing foreign exchange (FX) risk is an essential priority. Risk is inherent when transacting in multiple currencies, due to mismatches in the functional currency and the transactional currency. Finding ways to account for the mismatch and plan accordingly can be challenging, given that the difference between the two currencies changes by the moment with underlying exchange rates.

This constant movement makes planning for future transactions all the more important. Expected future transactions will affect cash flows, margins, net income, and other areas of financial statements. Companies can plan for this by setting a budget or forecast rate for future transactions, with a goal of limiting the impacts of currency volatility.

To understand what that movement might look like, businesses can take historic data and project it into the future to predict a range of outcomes or confidence intervals, which can be applied to specific transactions they know will occur at a later date. There are several strategies a company might employ to accomplish this, including implementing a cash flow hedging instrument.

Cash flow hedges lock in the amount of future cash flow by redenominating the transactional currency back into the functional currency, thereby helping eliminate currency volatility from a particular transaction. One of the most commonly used cash flow hedging solutions is a forward contract, which locks in the value of a future transaction at a specific exchange rate.

These contracts are customized to match the terms of a company’s future cash flows, so they can be set to occur on a specific date or range of dates. If a company knows it will have a purchase in a foreign currency at a certain point in time in the future, a forward contract provides them with the opportunity to know exactly how much it will cost them in their functional currency.

Workwear Outfitters

One company that has put forward contracts to use with great effect is Workwear Outfitters, a manufacturer of work apparel and footwear based in Nashville, Tennessee. Because the company manufactures much of its apparel at facilities in Mexico, it needed to find ways to manage intercompany exposures. While their revenue stream is in U.S. dollars, as its products are sold in the U.S., much of their cost structure for payroll, overhead, and plant operations in Mexico is in Mexican pesos.

Prior to establishing a hedging strategy, Workwear was subject to the spot market, which left them exposed to the volatility of the peso, and this led to price margin erosion and inconsistent monthly performance. The company wanted to achieve cost certainty and predictability in its financial planning and budget by mitigating the volatility of foreign exchange as a component of earnings.

Workwear Outfitters worked closely with PNC over a period of months to establish a hedging strategy, monitoring data carefully to quantify exposures. Ultimately, they implemented a layer window forward structure that allowed Workwear Outfitters to adjust hedges over time as they gained better certainty on the accuracy of forecasted exposures – an approach that has ultimately allowed them to achieve their objective of stabilizing gross margins.

For the treasury team at Workwear Outfitters, the process revealed several key takeaways that may be helpful to companies considering implementing a hedging strategy:

The value of consulting bank experience: Designing a hedging strategy can be an intimidating prospect for even the most experienced treasurers. Working with PNC to understand the guidelines proved to be tremendously helpful and educational.
Involve internal stakeholders: In order to be successful at implementing hedges, accurate forecasting is essential. Treasurers should be sure to incorporate all informed internal stakeholders, including the CFO, treasury, accounting, and financial planning and analysis, in the planning process.
Monitoring and reporting: Regular reporting is central to refining forecasts and adjusting a hedging program accordingly. It’s also important to have a strong accounting framework to track hedges closely, since lack of accounting effectiveness can lead to inaccuracy in hedging.
Start small: Because implementing a hedging program may be daunting, consider starting with one area – which in the case of Workwear Outfitters was intercompany exposures – and implementing a strategy piece-by-piece. As companies achieve success in one area and experience a growing comfort level, they may have an easier path forward to adding to a hedge program.

The bottom line, according to Tom Armes, managing director of Foreign Exchange for PNC Capital Markets, is that companies need to know they don’t have to take on the challenge of implementing hedges alone. “There are a lot of complexities involved in setting up a hedging solution, and the situation is going to be different for every single company. By working with a banking team that brings consultative knowledge you can develop a customized plan that offers real peace of mind, in addition to effective results.”

Webinar Replay: Elevating Your FX Risk Management Program

In a recent webinar, representatives from the PNC Capital Markets Derivative Products Group provide insights into how individuals and businesses can prepare for changing monetary policy and hedge interest rate uncertainty.

Click here to log in and view: Access an on-demand replay of the webinar here.

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