Monitor currency exposure and hedge currency: the steps in order

Currency exposure is monitored by gathering foreign currency positions from the business and netting them by currency. Treasury compares the net figures with policy limits and places approved hedges with banks. Back office confirms each deal, accounting records and revalues it, and a risk committee reviews the results.

The steps in order

1. Set the hedging policy. The treasurer drafts the policy. It defines which exposures may be hedged, the permitted instruments, the target hedge bands and the approved counterparties. The chief financial officer or the board signs it off. Everything downstream depends on this document, so it should be reread whenever the business enters a new market.

1. Collect exposure data. Business units forecast foreign currency sales and purchases. Accounts receivable and accounts payable supply invoices already booked. Procurement flags large contracts that have been signed but not yet invoiced. A treasury analyst sends the request and chases late submissions.

1. Check the receivables behind the numbers. Booked receivables only count as exposure if they will be collected. The credit team reviews ageing and the status of any disputes. Collectors contact debtors whose balances are slipping. An overdue invoice that is likely to be written off should come out of the exposure figure before anyone hedges against it.

1. Consolidate and net. The analyst loads the submissions into the treasury system or a workbook. Positions are grouped by currency and by settlement period. A euro payable in one subsidiary can offset a euro receivable in another, and the result is a net position for each currency.

1. Compare against policy. Treasury measures what is already hedged against the net exposure and checks the gap against the bands in the policy. Where cover falls short or exceeds the limit, the analyst proposes new trades or adjustments to existing ones.

1. Approve the proposal. The treasurer reviews the recommendation. Trades above certain thresholds go to the chief financial officer under the delegation of authority. The approval is written down before any dealing starts.

1. Execute with banks. A dealer requests quotes from several approved counterparties and accepts the best one. The trade can be a forward, a swap or an option. The dealer logs the trade time and the rate obtained.

1. Confirm independently. Someone outside the dealing desk, usually in the treasury back office, matches each bank confirmation to the deal ticket. Mismatches go back to the bank on the same day. Keeping this person separate from the dealer is the main control against unauthorised trading.

1. Designate and document for hedge accounting. If hedge accounting is used, the technical accounting team records the hedging relationship, the risk being hedged and the method for testing effectiveness. The documentation has to exist at inception. It cannot be written afterwards.

1. Revalue at period end. General ledger accountants revalue monetary balances held in foreign currency. Treasury supplies market values for open derivatives. The accounting team then posts the gains and losses to the correct accounts.

1. Settle maturing contracts. Cash management makes or receives payment on each contract as it falls due. The underlying commercial cash flow should arrive around the same time. When it does not, treasury decides whether to roll the hedge forward or close it out.

1. Report and reconcile. The analyst prepares foreign currency reports showing exposure, hedge cover and results. Every figure in these reports should trace back to a general ledger balance. A controller signs off that tie-out. The risk committee reviews the pack and challenges any breaches.

1. Compare forecast with actual. After settlement, treasury checks the original forecasts against what the business actually billed and paid. Units that over or under forecast consistently are told, and their future submissions may be adjusted before hedging.

Where handoffs usually break

The weakest link is normally step two. Sales teams treat forecasts as targets and inflate them. Procurement forgets to mention a contract priced in a foreign currency. Treasury then hedges an exposure that never arrives, and the hedge becomes a speculative position.

Steps ten and twelve are the other common failure. Treasury values derivatives in one system while the ledger holds a different set of balances. If no one owns the reconciliation, the gap only comes to light at audit.

Questions to ask the people who run it

• Which business units submit forecasts on time, and what does the analyst do when one does not?
• How are forecasts built in practice? Are they pulled from a system or typed in by hand?
• Who decides that an overdue receivable is no longer a real exposure?
• Has a trade ever been placed before written approval existed? What happened?
• Who actually matches bank confirmations, and does that person ever cover for the dealer?
• When a hedged cash flow is late, who makes the call to roll the contract, and how is that recorded?
• Is hedge documentation prepared at the time of the trade or assembled later for the auditors?
• Which figures in the risk committee pack fail to tie to the ledger, and how are those differences explained?
• What workarounds exist that the policy does not mention?

The answers often show a process that relies on one experienced analyst's spreadsheet. Any redesign should capture what that spreadsheet does before replacing it.

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