By Matthew N. Daniel, Managing Director, and Stuart Laramore, Senior Vice President, Wells Fargo Foreign Exchange Risk Management Group
Nearly two-thirds (64%) of companies maintain a formal policy to address foreign exchange (FX) risks, but only 17% measure potential FX risks.1 How you structure your company’s FX risk policy — and the ways you quantify risk — will affect performance.
To build a stronger FX risk policy, avoid these three common pitfalls:
1. Anchoring your policy to other companies’ methods instead of a best practices approach
Common practices are not always best practices. Most FX risk management programs aim to manage FX risks by implementing a hedging program with robust oversight and management policies and procedures.
To achieve this goal, many companies follow a best-practices approach consistent with the Enterprise Risk Management Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The COSO Framework offers principles, terms, and guidance to create enterprise risk management processes by following eight steps.
The first three — define objectives, identify exposures, and quantify exposure risks — are challenging but important steps in this process.
Risk quantification is essential to help management understand the risks and make appropriate decisions regarding how to manage them. Defining hedging objectives of a risk management policy that are consistent with your corporate objectives aligns your company’s risk management activity directly with the business goals. This can help reduce any confusion about derivative use or interpretation of this policy.
2. Not making your policy prescriptive enough
Individualize your risk management policy to your company’s specific needs and circumstances. Risk and risk management mean different things to different people, so avoid confusion by writing policies in specific and clearly articulated language. A risk policy should:
a) Identify objectives and expected results.
b) Clearly define terms and limits.
c) Identify and classify activities and strategies that are permitted, prohibited, or require additional approval.
The policy should also articulate what the program will not achieve. Many companies exposed to FX risks are constrained in their ability to manage exposures. A policy that claims an objective of “eliminating FX risk” may set incorrect expectations within senior management.
3. Creating a policy only when you’re ready to start hedging
Creating an FX policy is a dynamic process. Whether or not you’re already actively hedging your exposures, a best-practices approach calls for identifying and quantifying risk.
If you’re in the initial stages of building an infrastructure for managing FX risk, for example, perhaps you haven’t yet fully developed your FX risk management objectives. Perhaps your exposures are evolving. Or you simply don’t have the ability to monitor and understand your risks.
Furthermore, your company’s experience in managing FX risk changes over time. As a result, the development of a risk management program and the processes for managing risk should also change over time.
If your company has not fully assessed its risk management needs, consider creating a basic risk management policy as an interim solution, while working toward the goal of a more comprehensive policy.
Matthew N. Daniel is a managing director for the FX Risk Management Group at Wells Fargo. Stuart Laramore is a senior vice president and member of the strategy, policy, and financial reporting practice of the FX Risk Management Group for Wells Fargo.
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1. Wells Fargo. “2016 Foreign Exchange Risk Management Practices Survey,” January 2016.