FX Risk Management That’s Fit for Purpose

As a global integrated risk assessment firm, Moody’s is passionate about managing risk. Several years ago, the company embarked on a review of its foreign exchange (FX) risk management process and concluded that the process could be improved.

“Moody’s conducts business in more than 40 countries, and we regularly have exposures to approximately 35 currencies,” says Alexander Ilkun, vice president of treasury. “Most of our sizable exposures are major currencies, like euro, Canadian dollar, and Japanese yen. Our exposures are generally stable; they don’t change significantly from one month to the next.” However, Moody’s saw an opportunity to improve visibility and agility in its currency risk management.

Historically, FX risk managers evaluated the company’s balance sheet exposures on a monthly basis. For any currency exposure above an established threshold, they placed a hedge using a hedge ratio approach. “Our prior approach was a bit simplistic. For example, the methodology limited our ability to easily interrogate large FX gains or losses,” Ilkun says. “We felt it was right to review the program to consider how additional insights may be able to better answer the questions about residual impacts as well as determining hedging actions.”

When Moody’s implemented a treasury management system from Reval, it decided to update a number of workflows, including FX risk management. To better understand best practices and move Moody’s processes in that direction, the treasury team engaged Chatham Financial. Together, the organizations reviewed the Moody’s risk management methodology, evaluating the degree of currency exposure the company faced with its balance sheet, net investments, and forecasted cash flows.

The analysis had three primary takeaways: First, the Moody’s currency team should manage companywide FX risk more holistically. Second, they should employ a Value-at-Risk (VaR) approach to managing net investment and forecasted cash flow risks. And third, the company should transform its hedging programs.

“We focused our balance sheet hedging program on mitigating the volatility of FX gain/loss,” Ilkun says. “We analyzed all of the accounts that are subject to remeasurement to FX gain/loss.” In doing so, they expanded their perspective to consider all currencies to which Moody’s had exposures. “Previously, we weren’t looking at U.S. dollars because we were focused on our economic exposure. However, if you hold U.S. dollars in non–dollar-functional entities, you may experience FX gain/loss volatility.”

To identify which currencies were generating the most risk, the treasury team analyzed each currency’s balance sheet impact from a VaR perspective. They began viewing the company’s exposures on a consolidated basis and estimating future trends in risk. This analysis revealed some risks that were not what the team would have predicted. “Employing the Value-at-Risk methodology allowed us to hedge those currencies that actually generate exposure on the books, reducing that risk to our predefined threshold,” Ilkun says.

Over time, Moody’s also recognized a natural hedging opportunity: Many of its balance sheet exposures could effectively offset the company’s net investment exposures. Moody’s engaged AtlasFX to help explore this and other potential areas of improvement to financial risk management efficiency. “We looked at how our various risk management programs were interacting with one another: How did balance sheet, net investment, and forecasted cash flow hedging come together?” Ilkun explains.

“We had grown our net investment hedges gradually, as we found opportunities externally to benefit from the interest rate environment through cross-currency swaps or euro bond issuances that we executed,” he continues. “When we started analyzing all of our exposures across the different programs, we determined that the balance sheet exposures and the net investment exposures on our books were looking in different directions. We worked with our hedge accounting colleagues to better understand how net investment hedges were recognized in the financial statements. This revealed an opportunity for us to use derivatives to naturally offset balance sheet and net investment exposures.”

All told, the new elements of the updated FX risk management program have dramatically improved the effectiveness of Moody’s financial risk management. “We are now analyzing more G/L accounts, and every currency, and we can validate that the volatility of our FX gain/loss has decreased considerably,” Ilkun says. “Before we started on this journey, we were in a different place regarding hedge effectiveness, which is currently around 100 percent. During a time when even major currencies have experienced previously unheard-of movements, the volatility of the actual currency impacts to our FX gain/loss—as measured by standard deviation—is about 80 percent less than the unhedged volatility.”

Another benefit of the FX risk management transformation emerged when Moody’s acquired a Brussels-based company. “Bureau van Dijk was, by far, the largest acquisition Moody’s has ever done,” Ilkun says. “Leading up to the transaction, management wanted to know how combining the companies would change our FX risks, and whether we needed to change our approach to financial risk management. What the VaR analysis enabled us to do was to measure our risks, both with and without the acquisition, and to determine where the combined company would push beyond the limits of Moody’s risk appetite.”

Through this analysis, Moody’s realized that the European acquisition would not have a drastic effect on its exposures. “The data indicated that our existing programs were fit for purpose for the newly combined group,” Ilkun says. “We were able to demonstrate to management that, at least from an FX risk management standpoint, we could merge the two companies without updating our policies.”

Ilkun attributes the success of Moody’s FX risk management overhaul to three factors. First, he says, the company tapped into external expertise whenever necessary, using insights from knowledgeable consultants to develop new practices—and leveraging the consultants’ recommendations as a driver of change. Having the weight of that expert opinion can help build momentum on buy-in for a new idea. “The dynamic is completely different if an external consultant supports and validates management’s conclusions,” Ilkun says, “confirming that the proposed change is a best practice or standard toward which the industry is moving.”

Second, Moody’s chose the right time to adopt a treasury management system that could handle VaR calculations. “Because technology is a tool, your technology investments should serve your specific needs and move you toward your goals,” Ilkun says. “We selected a system that fit our needs.”

And finally, “take a major project like this step by step,” he advises. “Patience is crucial. Move forward as quickly as the organization is prepared for, depending on how the organization works. As a risk assessment firm, Moody’s wants to take measured steps and to take only calculated, well-informed risks. We took our time with this initiative, and—in the end—it paid off.”

See also:

• Currency Risk Mitigation for Funds Awaiting Repatriation
• Taking Credit for a New Approach to Risk Management

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