Measuring Your Currency Risk Management Portfolio
When you commence a risk management portfolio, it’s important to remember that you are making decisions for both the short and medium term. In most instances, the objective is to attain certainty regarding your currency requirements as well as the attainment of a particular exchange rate level on an annual basis.
Primarily, the review process is focused on comparing performance against a designated benchmark, often known as the Budget Rate, but this can result in a biased comparison, where the wrong things are compared to each other over the wrong time frame.
Imagine a scenario in which an importer achieved an average exchange rate of 0.7100 for the first 6 months of FY 2019, 1c better than their Budget Rate of 0.7000. Was this a success? Probably. How about if we added that this was 3c better than the average spot rate over the same period but 5c below the previous year’s average rate. Was this still a success? Maybe…
How about now adding the knowledge that you had to modify your policy guidelines somewhat, thereby changing your risk parameters and with market conditions not likely to improve you may need to continue these modifications for the foreseeable future. What about now?
This example hopefully helps illustrate the complexity of appropriate benchmarking. There are many moving parts, some of which you can control – risk taken, timeframe considered, budget rates – and many others you cannot.
As individuals, it is important that we can each measure our own success in a way that is appropriate to the circumstance. Ideally this will include a robust and repeatable framework, which may or may not use benchmarking tools.
Typically, currency portfolios are benchmarked against the following:
- Average of the prevailing spot rate for the period
- Budget Rate set for a specified period
- Current Policy Guidelines implemented for the currency portfolio’s management
This type of benchmarking can be useful if considered over medium to long terms. However, it can sometimes misalign the reason that currency positions are implemented. Perhaps most prominently, it sometimes leaves business owners prone to subjective decisions to try and outperform the market. At its extreme it can lead decision-makers down a path where they expect to be able to outperform the market at all times and on an ongoing basis.
The best benchmark is one that is forward-looking and aligned to your financial goals as well as your internal business practices. The challenge of course, is that a forward-looking assessment is incredibly difficult to quantify and there is no such thing as a “one-size-fits-all” approach. Benchmarking tools are powerful, but you cannot unshackle the backward-looking nature of them. What matters is whether the currency portfolio decision might be expected to help achieve longer-term business objectives into the future.
This mismatch requires care and highlights an important point regarding process versus outcome. Specifically, it is entirely possible to have a strong process, or a good decision with a bad outcome, just as it is possible to have a poor process with a strong outcome.
more often than not a robust and consistent process will prevail and result in
strong outcomes and vice versa. This is
a key reason that comparisons are taken over both short and long-term time
horizons – it allows the strength of the process, or the combination of many
decisions to unveil itself.
To bring this to life, we can suggest a checklist:
Aligning the Framework with your Goals
- Is there a clearly defined financial goal?
- Are you appraising the result over a suitable time horizon?
- If using a benchmark, is it realistic?
- Do you have a robust policy that is easy to understand?
Avoiding Bad Decisions
- Can you avoid recency bias (ie. focusing beyond the recent past)
- Are you aware of your own loss aversion (ie avoid making panic based decisions in fast moving markets)
- Can you avoid overconfidence bias (ie not making decisions in very strong markets)
All things considered, appropriate benchmarking is a powerful tool – both analytically and behaviourally. Done correctly, it can help decision markets stay on course and focus on the right things. But, done incorrectly, it can have significant consequences.