- FX budget rates can play a key role in global financial planning, budgeting and contract negotiation.
- The likelihood of meeting a budget rate varies according to rate methodology used.
- Incorporating budget rates can help assist with business performance measurement, assessment and communication, helping enable global corporations to make informed decisions.
Innovation sector companies expanding globally are exposed to foreign currency exchange risk (FX risk): the risk that movements of a foreign currency exchange rate will impact business performance (i.e., revenues, margins, cash-burn, earnings, etc.). An “FX budget rate,” incorporated into global financial planning, budgeting and contract negotiation processes, can be used in conjunction with strategies intended to help mitigate the effects of adverse currency moves.
The FX budget rate is the exchange rate used to convert projected non-USD revenues and expenses (denominated in a foreign currency) into USDs. FX budget rates can help
- analyze and measure business performance. An FX budget rate can help a company understand the extent to which currency gyrations impact year-over-year revenue, margins, operating expenses, cash burn, and other important business metrics.
- more accurately communicate performance. The ability to separate FX currency market fluctuation from other factors means companies are better able to report business results more accurately without obscuring FX impacts, internally and externally. Along these lines, FX budget rates, are central to the communication of non-GAAP constant currency metrics which are increasingly being used by global public companies.
- determine individual and operational metrics. An FX budget rate provides a benchmark against which management, treasury, and sales professionals charged with overseas business unit performance can be evaluated.
- pave the way for the development of a risk management strategy. A forward hedge strategy, for instance, can help with mitigating the impact of adverse currency outcomes and uncertainty around the FX budget rate. Options-based currency strategies may be used by corporations looking to outperform FX budget rates, that is, in order to achieve a realized budget rate that is more favorable to the business than the budget rate established at the beginning of the year.
FX budget rate methods
Commonly used FX budget rates methods include
- Current spot: Current foreign exchange rate (“spot rate”), which represents the price of the foreign currency for an exchange that typically occurs two business days after the trade.
- Current forward rate: The price of the foreign currency for an exchange that typically occurs more than two business days in the future (and up to many years in the future).
- Prior period average: Average of prior comparable period FX rates.
- Off-market rate: Spot rate plus/minus a predetermined cushion (i.e., one standard deviation).
- Consensus forecast: Median FX rate derived from aggregated independent forecast data.
Consider a US corporation doing business in Europe (with an operating functional currency in euros) and a 10 million euro buy projected over the next year. If, after a year, the actual annual average FX rate exceeded the FX budget rate, the actual spend in USD would be higher than budgeted and bottom line performance metrics would be affected.
Below is a projection of how much the euro can move versus the USD based on historical statistical patterns.
The company would use an FX budget rate to measure performance, interpret and communicate results both internally and externally.
Table 1 compares five FX budget rate methods and projected spend in USD. Depending on method, reporting can differ, sometimes materially.
FX budget rate methods perform differently
To get a sense of how the various budget rate methods are expected to perform, we ran an empirical study covering the years 2006 to 2016. Analysis assumes that a US-based corporation sets a budget rate at the start of each quarter for a euro purchase that will take place one year in the future (44 total 1-year periods). Both the frequency and the magnitude of budget rate misses (expressed as a percentage of spot) are reported for each method. (Table 2).
Data shows the following:
- 22 of 44 quarters saw less favorable euro rates compared to FX budget rates.
- The probability of meeting the FX budget rate when using the current spot rate (Column A) or the current forward rate (Column B) is essentially a coin toss.
- The off-market rate strategy (Column D) was the most successful method, meeting FX budget rates 93 percent of the time.
- Companies relying on consensus forecast data (Column E) would have reported performance that missed actual reported rates 66 percent of the time — the worst performing method.
Understanding the magnitude of a miss is equally important. Table 3 provides a summary of FX budget rate performance (how closely a FX budget rate tracked with the spot rate).
Data shows the following:
- Average magnitude of misses (expressed as a percentage of the spot rate) was 7.0 percent.
- Prior year averages (column C) is the underperformer.
- Consensus forecasts for FX budget rates (column E) was second only to the prior year average in its magnitude of error. To learn more about why consensus forecasts fail to perform as anticipated, see the wider discussion in my FX article How currency movements can affect your global business.
There are risks to using a FX budget rate without a hedge strategy (i.e., remaining “under-hedged”), and, “outperformance” cannot be achieved without taking risks, or using options.
Hedging with financial contracts is generally less costly than self-insurance, in other words, using firm capital to absorb or cover FX losses.
In some cases, FX budget rates are fixed and cannot be changed in response to changes in business climate. Some corporations do have latitude to adjust budget rates as needed, naturally at the expense of impacting key performance metrics.
Corporate life stage
Early stage companies may use FX budget rates on an ad hoc basis to price and negotiate sales contracts or one-off projects. Later stage companies may use them to communicate corporate performance to investors, establish overseas sales unit goals, publish quarterly constant currency results, etc. Your choice of FX budget rate depends on your corporation’s stage in the life cycle, risk management objective, and risk strategy or policy. As stated, there is no guarantee of meeting a budget rate without a hedging plan in place. The table below summarizes these tradeoffs.
Implementing an appropriate FX budget rate and hedging strategy into your company’s FP&A process can help with mitigating FX currency risk, providing more accurate reporting, and establishing benchmarks against which to measure performance. Rate choice should include input from key stakeholders (management, treasury, business units, etc.), and accountability should be shared across your organization.
You should give careful consideration to your company’s stage in the corporate life cycle, risk tolerance objective and strategy.
If you’d like to discuss your specific situation to see if FX currency products as described in this article may be right for your company, contact your SVB FX Advisor directly, or Ivan Oscar Asensio, SVB FX Risk Advisory, at firstname.lastname@example.org.