Best Practices

The Decline of the Dollar-Then and Now

When it comes to foreign exchange, the more things change, the more they remain the same. Today, the dollar is weakening dramatically.  Volatility is high.  European and Asian companies are struggling to manage the negative impacts of the strength of their currencies compared to USD.  Meanwhile, Europeans vacationers are coming in hordes to cash in on their newfound buying power. U.S. interest rates are easing. Gold is trading around $800. The British Pound is trading above 2.05 to the USD. US firms are asking themselves whether they should be hedging.  Regulatory bodies are talking about changing disclosure requirements.  All of these things are as true today as they were back in 1980!

Of course, after 1980, things changed. The dollar regained its strength and companies on both sides of the Atlantic (and the Pacific) were forced to react to new market realities. Many stakeholders who took their eyes off the fundamentals in the late 1970s were unprepared for changes in the early 80s that led to serious economic consequences. Then, as today, the dollar's weakness had obscured some underlying problems.

The Shape of Things to Come?

Looking at economic history in terms of seven-year cycles, we can examine the events after the rebound of the dollar in 1980 for signs of things to come in 2008, just four cycles later. In 1980, economic impacts drove regulatory bodies to do what they always do after a crisis in confidence: increase scrutiny on stakeholders.  This led to the introduction of FAS 52 in 1981 and increased disclosure requirements.  If current trends follow suit, a rise in the dollar will be marked by economic losses and financial restatements by U.S. multinationals, followed by another round of regulations and stakeholder scrutiny.

There are many recent examples of industry-leading, European and Asian multinational companies that have suffered material losses due to the strength of their currencies relative to the U.S. dollar-SAP, Reuters, Lufthansa, and Cannon, among them.  FX-related corporate losses for U.S. multinationals will be triggered by a sharp - even if not sustained - dollar strengthening. Some of these companies will face serious consequences, revealing themselves as the "Enrons of FX".  The dollar's turn-around will trigger sudden, unexpected financial results that will have a domino effect on corporate value.  Economic surprises will lead to further scrutiny by stakeholders. This will trigger compliance questions with dramatic negative impacts like those experienced by Allied Defense.

Today, European and Asian companies have been forced to ask themselves, "How do we more accurately identify and quantify currency exposures?" and "How do we communicate this to stakeholders, so they are not surprised?" 

Better Data and Automated Processes Lead to Predictable Results

All companies that generate revenue or incur costs in foreign currencies can suffer from foreign exchange volatility. But for companies with inadequate or non-existent exposure management policies, the fallout can seriously impact the bottom line, jeopardizing share prices for public entities, or the prospect of a successful IPO for start-ups.

From one perspective, the risk of currency fluctuations is one of the easier financial risks to manage. Exchange-traded options, currency swaps or forward contracts can all lock in exchange rates to protect cash flows from the effects of currency swings. But before these kinds of hedging strategies can help, companies need to understand and accurately quantify their exposure so they know where-and why- they are vulnerable.

The Chief Finance Officer who seeks greater involvement in the definition of currency risk management policies, and endorses a holistic, collaborative approach to the problem can set his or her organization on the right path to getting their accounting and compliance right, so they can focus on optimal economic decisions. The automation of these processes increases efficiency, reduces errors and supports the kind of cross-functional collaboration needed to ensure that foreign exchange exposure management becomes a economic strategy, rather than an unanticipated consequence of uncoordinated activities.

Wolfgang Koester, FiREapps

To Discuss this Blog in the Forum Please Click Here 

The real issue with FAS 133 is not documenting the hedge! When FAS 133 arose, everyone was scrambling to figure out how to show effectiveness and document it properly.

Tools arose to support the process and the documentation as well as provide tools for testing this post trade activity. But the root cause of many restatements are not the lack of use of those tools, nor the incorrect use of derivative contracts, but rather what exposure is being hedged.

Treasury departments today are still overwhelmed by receiving data from the controller and adding forecasts from the all too often overly optimistic sales.  Most treasuries that we talk to have little confidence in the data that they use to come up with their exposure, but they have often no collaboration in this very difficult process and do what they are supposed to do: Calculate the exposure given the data they are supplied.  If the result ends up not matching the hedges, then all the documentation and post trade testing in the world won't help with receiving effectiveness under FAS 133.

A May 17, 2007 article in CFO magazine states that 1 out of 10 public companies are restating given "flat out misses".  Let me put that in numbers. Out of roughly 14,000 publicly traded companies 1,420 have had to restate.  You think that is high?  From what Professor Fireapps has seen, another 5,000 will restate over the next 24 months unless the C level gives them tools and allocates funding to fix the problem before it rises to the top.

The CFO needs to own the FX process and support a cross functional and silo collaboration to really understand the company's foreign exchange exposure and institutionalize a process with proper controls and reporting mechanisms. When the operational issues are fixed, then the economic and compliance risks will fall into place.

Yesterday's interest rate hike by the Bank of Japan shows a cyclical trend to less collaborative efforts by the G10s to stabilize currencies resulting in continuous and increasing currency volatility.  This volatility will continue to highlight inefficiencies in the way many corporations are managing their currency exposures - having in most cases tasked the under funded treasury departments to do a lot (manage the entire companies currency exposure) - equipped with little if anything.  The result of missing earnings or having to adjust forecasts are very costly (i.e. SAP lost USD 6 Billion in market cap by adjusting forecast by USD 100 mil.) and should be taken very serious by the C level and the Board of Directors.  (Treasurers in organizations are already taking this seriously, but can only do so much with little to no budget.)  CFOs and CEOs specifically should recognize the pressures that the treasury department is under.  When they get lucky they get praised - typically no bonus consideration - when they get unlucky and currencies go against them they fear for their job.  In my opinion a bad risk reward for any employee.

Caution: Professor FiREapps sees a continuous problem of inaccurate re-measurement within the guidelines of FAS 52.  The focus has been FAS 133 and little if any focus has been given to FAS 52.  We see the problem having occurred as many companies were and still are moving to an enterprise wide system that is configured/accounts set up by junior staff members that do not fully understand what accounts need to be "FLAGGED" for re-measurement purposes under FAS 52.  As the setup is in many cases tedious this is not reviewed periodically (i.e. quarterly).  A tool is available to get FAS 52 indicative reports for compliance or possible issues.

Please let me know what you are seeing with respect to

• 1) Volatility
• 2) FAS 52

Companies feel as long as it is not prohibitively expensive, the goal is not just to protect 75 or 80% of their exposure - as often written in the risk management policy - but rather to protect as much as possible.  They state that the policies are written with significant room in order to be able to state that the company is policy compliant.  Goals are defined with room, but lack definitive intend.

Does your company:

• 1) Manage to the minimum protection (i.e. 80%)?
  
• 2) Manage to 0 +/- zero around zero?
  
• 3) Take a view on the direction of the underlying exposure and given anticipated market direction actively decide to manage towards either end of the allowed spectrum?

"SAP misses target, in large part due to foreign exchange. Result: 10 percent decrease in share price and USD 6 Billion in market cap loss!"

Some think it is ironic that the large ERP Company missed earnings due to FX. Prof FiREapps is not surprised. Why?

1) SAP is  just like any corporation that does not have a well defined process in place. I could tell from their financials that they had the risk and it was only a matter of time. 

2) ERPs like SAP are designed to focus on history and make that data available for analysis and decision making.

3) The recent increase in volatility will hurt many more corporations. They will surprise investors and themselves resulting in significant impact on the share price.

4) If one believes that they should know - as they are closer to the source than others; I can only non- scientifically say: "the hairdresser always has the worst haircut" :-)

Don't forget: foreign exchange volatility and surprises will not get a free pass any longer. SAP is just the latest proof for that.

Should you be interested in the SAP analysis and possible process change, please let me know. Given the level of interest, a detailed research piece could follow.

Also I am curious about the follwing:

1) Are you surprised that SAP missed their numbers due to FX?

1. YES
2. NO
3. Never thought about it

2) Does it surprise you that a USD 30 mil loss reduced the market capitalization of SAP by more than USD 6 Billion?

1. YES
2. NO

3) Did you know that Google had the exact same thing happen roughly 6 months ago? (They lost 8% due to FX losses).

1. YES
2. NO, I did not know surprise, but that does not surprise me
3. NO, I did not know and I am surprised

4) (Optional) Do you think your company could have the same surprise sometime in the future

• a. YES
• b. NO

In most cases the currency exposure is just the number that a spreadsheet calculated with the information provided.  Analyzing the data within spreadsheets has been an impossible task.  While seemingly impossible, one needs to know and understand the input data not only for informational value or better decisions, but also for regulatory purposes. For example, not having visibility to whether all monetary assets and liabilities are properly identified for re-measurement can cause significant problems. 

Not only the treasury departments, but also controllers and the C level of organizations are affected.  Analysts are increasingly asking the tough questions regarding currency exposures.  The hard truth is that if the C level does not have the right answers, the share price will reflect that.

Professor Fireapps is working on a White Paper that will dig deep into the area of what corporations need to know.  As the Professor is drafting the paper based on its 20 plus years of experience, he would appreciate any specific questions and feedback that can be included in the study.

Corporations should not be concerned about where is the Euro heading or where is the Yen or BRL going.  While important, the overriding and more appropriate concern is volatility.  In one of the best practices papers recently written by the Wolfgang Koester, he points out that timing is one of the three focal areas for effectively managing foreign exchange exposures.  I believe volatility in part is what commands timing.

Why?  Most companies re-measure their currency exposures after the end of the month.  With no volatility during the month, this suffices.  With volatility this action highlights an ineffective process. Let's examine a common example that happens in corporations on a fairly frequent basis.

In this example, on December 3^rd the FX manager calculated the corporate exposure and hedged the foreign exchange exposures the company had as of November 30^th.  Next, as is common, a regional manager in London sells Euros and buys USD on December 8^th.   If the company is like many companies in that they re-measure monthly, the hedges will not get adjusted until January 3^rd (the next time FX exposure gets re-measured). 

During times of relatively low volatility such as we experienced over the summer of 2006, the market risk is probably manageable. However, in the recent month the Euro appreciated and this action would create significant negative volatility and surprises for management including the CEO and CFO.  They will have assumed that the company was hedged and may even be disappointed that they did not participate on the upside of the Euro.  The bad surprise will be that essentially they will have been over hedged and actually short in Euros - created by the net of early selling the Euro and not adjusting the hedge until next month. 

The irony is that the FX manager has been asking the treasury for more help and better tools. Management has been asking: Why?  You are doing a great job.  Sound familiar?  How about FX managers and treasurers warning of China unpegging.  That will cause volatility making the recent decrease in the value of the USD look like childs play.

Volatility often brings systemic as well as process issues to the surface.  Earnings reports on Q4 2006 will show surprises that analysts love to punish.

As pointed out by Brent Callinicos, CFO of Microsoft Platform, in CFO magazine, "Shareholders and analysts don't give you a pass for saying, "We would have made our earnings but for foreign exchange." Many studies indicate that shareholders punish that.

Last week, I presented at Thunderbird, the highest ranked international business school in the US.The topic was obviously foreign exchange and as I commenced the discussion I asked the audience for the two hour session not to be a monologue but a dialogue. I was very fortunate that these graduate students were top caliber, had genuine interest and great questions.One of the first questions were:Why do you talk about exposure and not risk, and what is exposure?

I thought that was an excellent question and worthy discussing further.

Exposure in its most generic term is defined as the condition of being unprotected, and investigating further is defined as the disclosure of something secret.When digging into FX one sees that it is clearly a piece or sections of sensitized material, applicable in both foreign exchange as well as photography.In the area of medicine acute as well as chronic exposures come to mind (short- and long-term respectively); both causing health effects that are immediate or can occur days or even years later.

All definitions whether in photography, medicine or foreign exchange lead to the root of solving a problem:managing exposure.In any case mismanagement will lead to bad pictures, significant impact on shareholder value and illnesses. While some may say I want to manage risk, the fundamental question remains what is the root of the risk.It is the exposure that causes the risk.

So for the purpose of FXbestpractices I begin with the fundamental definition of foreign exchange exposure being the state of laying open or bare, to danger; and the accessibility to anything that may affect, especially detrimentally a company’s well being.The laying bare to the danger are those currency exchange rate changes that influence the company’s value.

As a next step in foreign exchange best practices one will want focus on the more specific type of exposures, including accounting exposures, operating exposures, transaction exposures and translation exposures.

Accounting Exposure

The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates.

Operating exposure
Degree to which exchange rate changes, in combination with price changes, will alter a company's future operating cash flows.

Transaction exposure

Risk to a firm with known future cash flows in a foreign currency that arises from possible changes in the exchange rate.

Translation exposure

Risk of adverse effects on a firm's financial statements that may arise from changes in exchange rates.

FX Best Practices mandates that one understands one’s company’s exposures well.Today’s practices ( not best practices ) often are to accumulate numbers from all over and put them into a spreadsheet and with that calculate the exposure.At the surface that sounds correct.The issue however becomes how much does one really understand what one just calculated.Best practices today commands that one understands the outcome and where all numbers are derived from.The most common complaint from corporations is that the G/L not really reflects the currencies that are being remeasured well and that there is quite a lot of discussions about GIGO (garbage in garbage out).

I find this a scary discussion as most companies will tell you that they are not certain how good their data is to calculate the exposure, but this is just the way they have always done so and pray that they don’t get – what I refer to as the imminent surprise ( it will come ).If one does not understand the FX exposure, one subsequently will not understandthe risk, making it rather difficult to manage.Whenever I come across a company that does not hedge it is 90% of the cases because they don’t understand the exposure.

FX Best Practices: Look at exposure by finding analytical tools that help you not just represent what you already know from your systems ( not only but also G/L ) but for analytical tools that organize the data into an easily understood and intuitive format that can be verified by all. Ensure that the tool has processes and flexibility available the ensures a continuum and therefore increased confidence in ones data. Best practices today looks at shifting the middle office from data gatherers to data analysts and decision makers.

Once one has real confidence in ones data – the exposure – the risk calculation will fall into place and the decisions is what one can focus on.

A continuous theme when talking to treasuries throughout the world is that there is a genuine lack of trust in their data related to foreign exchange, and any tools that simply measure their existing data areas of no use or help.

This has been a common theme that I have known and studied almost since the Smithonian Agreement of the mid 1970s.What I find interesting is that I have never heard it with more frequency than in the past couple of years.Why is that?

I have a couple of not mutually exclusive theories but look forward to hearing your thoughts.

The core of the problem is that the world is becoming – as Thomas Friedman points out – flat and the management of corporations are looking for their ERPs to solve the problem that they were told the ERPs could solve.Better data!?!?We all know that ERPs have not really delivered on that promise and as such the ERPs are simply presenting and organizing existing data reflected in one or more systems.

The analysts are not comfortable with the data as the systems were not built for analytics but for organization of data.As foreign exchange is getting to be a larger and more exponential problem the tools provided by companies such as Oracle, SAP, Sungard, Hyperion and other treasury systems have simply been providing the service of combining and measuring existing data. So treasuries are still having to resort back to spreadsheets.The issue with the spreadsheets are that they were never intended for what at the end of the day is risk management and as PwC has pointed out 95% of all spreadsheets in use to solve for financial answers have 5% plus errors to the bottom line.

Treasuries are looking for the magic that really does not exist.Make my data better!There is no easy fix. The fix comes with tools that provide clear and intuitive analytic capabilities that make it easy to look at the existing data and highlight inconsistencies and errors and then take actions.The only way that I am aware of to fix the garbage in garbage out problem is to have tools that facilitate data checks and eventually commence more rigid processes that change the environment and as such raise the bar for the people providing the data in the first place.

What tools have you seen out there that allow for good and clear analytics to solve these financial problems in any area of treasury, finance, accounting and tax?

Over the past 30 years corporations have been surprised again and again by unexpected occurrences in the currency markets. Professor FiREapps believes it is time to examine the issues and processes that evolved in the 1970s with the Smithsonian agreement and got stuck in the 1980s with the spreadsheet technology. 

The professor has yet to see a public company that has revenues in excess of USD 100 million and that directly or indirectly does not get affected by currency.  As such, there are many ever changing challenges that almost always become surprises.  The blog is there to flush out many of the issues and create a platform to discuss them. 

Professor FiREapps has spent more than 20 years working with Corporations and Governments addressing all types of risks.  As such he will raise strategic as well as very recent issues that he has come across.  It is his hobby to look for any related topics for foreign exchange corporate risk management and address them.

Categories will include:

• National events:  i.e. China un-pegging
• Process improvements in managing currency risk: i.e. technology
• Strategic issues: i.e. to hedge or not to hedge.  Is that really the question?
• Tactical issues: i.e. the people doing the day to day work are often concerned about the results more than management, especially when the results are positive.
  

“Front page article - Financial Times”

US investors have shifted a record proportion of investments to international equities. 

We know what they are trying to say as it relates to asset managers, but what does that mean for corporations?

Investors are looking for additional return and believe that the USD will continue to weaken and thus the foreign equities value for US investors will increase. 

Over the past 20 years whenever the front page of a paper such as FT or WSJ call for higher or lower currency, the trend is over!  So if corporations are holding off protecting non US Dollar revenue, start protecting it. The speculative upside is over. The dollar is toppish.

If management is questioning why you are protecting procurement cost currency exposure, be reminded that corporations - with the exception of banks or investment banks - are not in the business of speculating in currencies. As such the cost of protecting against currency swings should be seen as part of doing business abroad, and as such as part of COGS.

Companies that do not priorities managing risk at the beginning of a Merger and/or acquisition will be surprised.  Five years ago nobody was looking at the risk/liability of pension funds affecting the value of companies. Inevitably that became an unnecessary surprise.  How about those backdated options?  Surprised?!?!?  The next avoidable surprise: foreign exchange.  The merger of two companies has netting or grossing effects with respect to currency.  This can today be avoided but has not been the focus nor received the attention by corporations or even their advisors. 

Recently we had a client who came to us very early on in the acquisition process.  The foreign exchange exposure was defined and it turned out that there were natural hedges that would reduce the cost of the acquisition.  Additionally, the exposures flushed out international cash that could be used to pay for part of the deal as it was cheaper than raising additional debt.  On the other side of the perspective a different company had a net investment and when spinning it off it created a loss from foreign exchange that was completely unexpected. The key task of integration is to expose and analyze predictable risks, address them and execute decisions related to them.

Easier said then done?  Not worth doing before a deal closes?  Let's take the example of RWE of Germany buying American Water Works for billions of Dollars.  Should they hedge the US Dollar acquisition given that they have Euros to spend?  What do you think?