Managing your Currency Risk on Your Balance Sheet
Balance Sheet Risk
Any company that has operations or sales overseas will have an exposure to currency fluctuations, which means that the profitability might change because of a change in exchange rates. In recent times we have seen higher than normal volatility among the currencies. Especially the US-Dollar (USD) has strengthened, and many currencies experience various degree of high inflation which may also lead to further adjustments to the exchange rates in the future.
So, if a currency moves in the wrong direction it can lead to losses that may even wipe out the expected profit from the sales abroad.
Fortunately, companies can protect themselves against these risks through currency hedging.
Currency hedging can be managed in SAP Treasury and Risk Management (TRM) – a series of solutions that are geared towards analyzing and optimizing business processes in the finance area of a company.
There are generally two types of currency risks:
- Cash flow risks
- Balance sheet risks
In this case we will look closer at the process to hedge balance sheet risks through an example. This is typically managed by two different persons at the company. First, we have the financial risk manager whose responsibility it is to identify and reduce the financial risk. Once financial risks have been identified and a hedging strategy has been established it is up to the dealer to ensure that the financial trades that have been requested are being executed at the best possible rates with the appropriate banks.
Identifying your Exposure
In the first instance, the financial risk manager (TT) needs to identify the balance sheet risks to know what to hedge and how much to hedge. He uses the app “Review Balance Sheet FX Risk” which will give him an overview of the total balance sheet exposures in the different companies and currencies, and how much has been hedged already.
In our example, TT would like to hedge the open balance sheet exposures by year end so that the value of the balance sheet will not be impacted by FX rate movements until the end of the year. To do this, TT starts the app “Review Balance Sheet FX Risk” where the exposure is shown for all companies. He then drills down to one of the exposures to identify the underlying exposure per currency and identifies an open exposure for Canadian Dollar (CAD) which must be hedged.
In this case, the sources for the calculated key figures are the balances from open items in accounts receivable (AR) and accounts payable (AP) in financial accounting. TT can define which exposures are relevant to him and include other types of exposures such as cash positions, assets or other financial positions.
The advantage of this app is that you can get a complete and fast overview over all your balance sheet exposures and can identify open exposures in one view right away.
VIDEO 1: Identify Exposure for CAD
Creating a Snapshot
After the identification of the exposure, TT needs to create a snapshot of the exposure to know what to hedge and to document the exposure at the time of the decision to hedge.
TT takes a snapshot using the “Take Snapshot – Balance Sheet FX Risk” application. First, he selects the area for the snapshot and gives the snapshot a name. Here, only the CAD exposure is selected for hedging for the year end.
The advantage of this app is that we have a clear documentation of what the exposure was at the time when the decision was taken to hedge. Later reporting may show different results, but the snapshot is the record of the exposure at the time.
VIDEO 2: Create Snapshot for Year End
Create and Process Hedge Requests
Next, TT needs to ask the dealer (DA) to create a trade to hedge the exposure he has just identified. Consequently, he needs to ask the dealer to create an FX forward trade with a bank, which is best done with the SAP Trading Platform Integration app. This app integrates SAP TRM with the trading platforms that offer trades from the bank with the best offer.
To avoid error prone manual input on the trading platform, a message is sent to SAP Trading Platform Integration. This is done via the creation of a trade request in the app “Process Hedge Requests – Balance Sheet FX Risk”.
So, TT starts the app and selects “Create” to create a new trade request to cover the exposure fixed when he took the snapshot (video 2). As the end of the trading year is Friday, December 30th, this particular day is chosen instead of December 31st.
The advantage of this step is that you have an automated and system supported handover of the deal request from the risk manager to the dealer without emails, manual notes, or phone calls.
VIDEO 3: Create Hedge Request for FX Forward
Process Trade in Trading Platform Integration
To get the best forward FX trade from the banks, the dealer (DA) starts SAP Trading Platform Integration. Here, he starts the app “Manage Trade Requests” where he first loads the trade requests that need to be processed.
Before forwarding the trade to the trading platform of choice, DA checks that all banks he wants to ask for a bid still have a counterparty limit available so he can close a deal with them. So, DA checks the limit and sees that two of the five banks selected for a request have a breached limit. He can also see the details of the limit breach. DA decides not to deal with these banks and removes them from the list of banks that will be asked to bid for the trade.
The trade request is then sent to the the trading platform where banks are asked to provide quotes for the deal. Because the amount is below the threshold for auto trading, the dealer is not logging in to the trading platform itself to approve a quote, but lets the platform automatically select the best trade.
Seconds later a trade comes back from the trading platform. The status of the trade request changes to “Completed” which means that the new trade is now in the system and the original request is closed. DA can jump from the trade request to the closed trade.
In the trade itself, DA finds the details for the FX trade including the opposite amount and the details for the rate with the forward rate, spot rate and swap rate. In addition to the rates for the winning bid, DA also sees the details from the other two banks that didn’t win the trade.
The advantage of using the Trading Platform Integration is that you have a secure and automated integration to multi bank electronic trading platforms.
VIDEO 4: Manage Trade Request
Checking the Effect of the Hedging Transaction
After the processing has finished, the new trade is automatically forwarded to SAP S/4HANA. To find the new trade, TT goes to “Manage Financial Transactions”, searches for trades entered that same day and finds several trades. For the best view of the specific data, TT selects the tab “Foreign Exchange” from where he can also navigate into the trade to see all details.
Finally, TT can check that the exposure has actually been covered by starting the app “Review Balance Sheet FX Risk” again. Running the app after the trades have been completed, TT sees the amount from the hedging deal under “For Hedge” – the exposure is now zero and hedge quota is 100%. Again, he can drill down to see the details of the trade.
VIDEO 5: Review of New Trade and Covered Exposure
In this showcase, we have followed the end-to-end process of closing an open balance sheet FX risk position. In our example, we used a simple FX forward deal to close the exposure, but other instruments can be used as well such as FX Options.
You can read more about the end-to-end process for the Hedge Management of Balance Sheet FX Risk in the SAP Help Portal
A similar process can be shown for Cash Flow Hedges. Here you should use the Hedge Management and Accounting of Net Open Exposures (FX Risk). You can read more about it in the SAP Help Portal.