Foreign Exchange Risk and Treasury ManagementLast week, I have posted 6 Ways to Control Foreign Exchange Risk which focuses on how to neutralize loss possibilities of transactions involving foreign currencies. Foreign exchange risk and treasury management best practice offers approaches on how to manage foreign exchange risk and treasury function, organize its personnel to enhance the most effective day-to-day roles and contributes maximum value to the company. Enjoy!



Centralize Foreign Exchange Management

A company that has multiple divisions conducting business with other countries may be spending too much money hedging its foreign exchange risk. Each division will hedge its exposure without regard to the exchange positions of the other divisions, which may result in excess hedging costs. The reason for the excess costs is that one division may have a large account receivable that is payable in (for example) British pounds, while another division may have a payable in British pounds. Each one may pay to hedge the risk on pounds, when in reality, from the perspective of the entire company, the receivable and payable positions of the two divisions offset each other. Only the difference between the two positions needs to be hedged, which is less expensive.

Another problem is that there are intercompany payments between subsidiaries located in different countries; these transactions should be netted to arrive at the minimum possible flow of foreign exchange.

To take advantage of these offsetting positions, a company needs to centralize its foreign exchange management in one place, so that a coordinated effort to net out all exchange risks can be created. This is not just a matter of moving all of the foreign exchange people from outlying locations into one building, but also (and much more importantly) a matter of channeling the flow of foreign exchange information from all divisions into a single location. This may call for customized interfaces from each division’s accounting systems to the central database, or perhaps an extract of data from a centralized data warehouse.

This function can also be outsourced to a bank that specializes in foreign exchange netting, such as CitiBank or Bank of America, though one should periodically comparison shop their foreign exchange rates to ensure that they are competitive. It can even be manually stored in an electronic spreadsheet, though this approach requires some attention to the transfer of all intercompany payables and receivables to the person who is netting out the transactions; this involves setting a timetable that specifies a monthly settlement date, and then works back-wards from that date to determine the deadlines by which all subsidiaries must report their payables and receivables. Once this information is gathered, it must then be merged to determine a company’s net foreign exchange position at any given time. Once this information is available, a company can achieve significant cost reductions in its hedging activities.

There are two other factors favoring the use of centralized foreign exchange management:

  • Reduced amount of currency being shifted between corporate subsidiaries results in a smaller amount of cash float within the organization [though this can be eliminated entirely with the use of wire transfers instead of checks].
  • The other possibility is to use the netting of intercompany payables and receivables to make leading or lagging payments, which are effectively short-term loans that may assist in dealing with short-term cash flow problems at certain subsidiaries.


However, these changes in the timing of payments can take on the appearance of intercompany loans, so expert international tax advice should be obtained before trying such an activity.


Implement Continuous Link Settlement [CLS] System

Foreign exchange settlement has been a prolonged affair in which there is significant risk of one party’s defaulting before a transaction has been completed. To avoid this risk while also speeding up the settlement process, a number of major banks banded together to create the Continuous Link Settlement (CLS) system, which is operated by CLS Bank [of which the founding banks are shareholders).

In essence, member banks submit foreign exchange transactions to CLS Bank, which matches up both sides of each transaction during a five-hour period (which represents the overlapping business hours of the participating settlement systems). If the exact settlement criteria are not met for each side of the trade during this time period, then no funds are exchanged.


How Does CLS Impact the Corporation?

It gives the cash manager exact information about the availability of funds in various currencies, which had previously been difficult to predict with precision. With foreign exchange information, they can now optimize their short-term investment strategies.

Some of the better-known members of CLS Bank are Bank of America, CitiBank, Goldman Sachs, JPMorgan Chase, Mellon Bank, Morgan Stanley, and State Street Bank and Trust. Other banks can submit their foreign exchange transactions through these member banks, so access to the CLS system is quite broad.



Using Natural Hedging for Transaction Risks

When a company engages in transactions that involve another currency, it incurs a transaction risk that currency fluctuations will adversely impact its cash flows. They frequently purchase derivatives to hedge against these transaction risks. However, some organizations are reluctant to follow this path, because:

  • derivatives can be expensive; and
  • FAS Statement 133 requires a company to charge fluctuations in the value of a derivative to the current reporting period if it cannot prove that the derivative effectively hedges an exposure.


The latter issue also requires a considerable amount of documentation work.

To avoid the use of derivatives, some companies have centralized their treasury operations, which gives the treasurer sufficient information about companywide transaction flows to determine where transactions can offset each other. This information allows treasurers to create natural hedges, which require no FAS 133 documentation and are free. When using natural hedges, there will still be some residual exposure if revenues and costs do not exactly offset each other, but the remaining exposure is greatly reduced. This technique is possible only if treasury operations are centralized, or if the information needed to construct natural hedges can be obtained by other means, such as through a data warehouse that accumulates information from multiple sources.


Process Foreign Exchange Transactions Over the Internet

Companies typically purchase or sell spot or forward contracts in foreign currencies in order to hedge their transaction activities that involve other currencies. However, this is a labor-intensive process involving calls to several banks to see which ones quote the best price. In many cases, the accounting staff simply does not have time to make a number of calls, and so chooses by default to deal with the same bank every time, thereby sidestepping the chance to obtain lower prices on its foreign exchange transactions. In addition, the incidence of errors in orders placed by phone is high, due to communication or transcription problems.

These problems can be avoided through the use of an Internet-based foreign exchange transaction site, such as or These sophisticated trading sites allow one to request prices from multiple banks that provide executable live quotes using a reverse auction method. Under this approach, banks offering quotes know the identity of the trader, but do not know which other banks are bidding. This method results in the best price for a trader, and in addition yields great efficiency in the trading process, since there is no need to waste time making multiple phone calls to banks to obtain a range of quotes.

These on-line systems have other advantages, too. For example: one can download information about a completed trade into the corporate treasury management system, as well as create audit reports detailing the results of each transaction. It is also possible to create reports that summarize trading patterns and transaction reports with banks, as well as print or download trade ticket information.

There are also no transactional errors, since the Web site automatically matches and stores the financial and settlement details for each party to a foreign exchange transaction. Also, most sites give traders access to research, analytical tools, and current news reports. Further, some sites offer customization of the interface, so that one can see only specific fields, create templates for repetitive trades, and modify standard reports. It is even possible to use instant messaging between both parties to a transaction! In short, there is a wide array of advantages to these excellent sites that make them a clear improvement over other methods for completing foreign exchange transactions.


Implement Treasury Workstation To Offset The Cost

The multitude of treasury-based transactions can take up a large part of the finance staff’s workday and is highly subject to error. These tasks involve management of a company’s cash position, investment and debt portfolio, and risk analysis. The normal approach to these tasks is to track, summarize, and analyze them on an electronic spreadsheet, with manual input derived from all of the company’s banks and investment firms on a daily basis. In addition, any changes resulting from this analysis, such as the centralization or investment of cash, must be manually shifted to the general ledger. Given the highly manual nature of these tasks, this frequently results in errors that must be corrected through the bank reconciliation process. A treasury workstation can greatly reduce many of these work steps.

A treasury workstation is a combination of hardware and software that will manage cash, investments, debt issuance and tracking, as well as provide some risk analysis functions. It is an expensive item to purchase, typically ranging from $30,000 for a bare-bones installation to $300,000 for a fully configured one.

The difference between these prices is the amount of functionality and bank interfaces added to the treasury workstation—if a buyer wants every possible feature and must share data with a large number of financial suppliers, then the cost will be much closer to the top of the range. Given these costs, this best practice is not cost-effective for companies with sales volumes under $50 million. Also, because of the large number of interfaces needed to connect the workstation to other entities, the installation time can range from one to nine months.

Why Spend So Much Money and Installation Time on a Treasury Workstation?

Because it automates so much of the rote finance tasks. For example: if an employee enters an investment into the system, it will create a transaction for the settlement, one for the maturity, and another for the interest. It will then alter the cash forecast with this information, as well as create a wire transfer to send the money to an investing entity. Here are some of the other functions that it can perform:

  • Bank reconciliation. It can do the bulk of a bank reconciliation, leaving just a few non-reconciling items to be resolved by an employee.
  • Cash forecasting. It can determine all company cash inflows and outflows from multiple sources in order to derive a cash forecast.
  • Cash movement. It can originate electronic funds transfers.
  • Debt tracking. It can follow short-term debt with a link to a dealer-based commercial paper program.
  • Financial exposure. It can identify and quantify financial exposure.
  • Foreign exchange. It can determine a company’s cash positions in any currency.
  • Investment tracking. It can track and summarize a company’s investment positions in money markets, mutual funds, short-term and fixed-income investments, equities, and options.
  • Risk analysis. It allows an employee to use it as a giant calculator, performing what-if analyses with yield-curve manipulation and scenario analysis.


Based on this lengthy list, it is evident that a large company can derive a sufficient benefit from a treasury workstation to offset its substantial cost.


Optimizing the Organization of Treasury Operations

A large multinational company typically became large at least in part through acquisitions, which leaves it with a complex set of banking relationships and accounts, as well as a highly dispersed treasury management group that resides in a multitude of locations. This results in the inefficient use of cash, which in turn reduces interest income and does not allow a company to pay down the optimal amount of debt.

These problems can be mitigated by implementing regional treasury management centers, usually one per continent. By doing so, the treasurer can concentrate those treasury staff with the highest levels of expertise in the same locations, while also achieving a much higher level of control over the underlying cash pooling and foreign exchange transactions, not to mention better clerical tracking of any resulting intercompany loans. By concentrating activities into this smaller number of regional treasury centers, the treasurer can also more easily obtain online access to the overall status of cash flows for the entire company.

The price of this increased level of efficiency is a considerable amount of resistance by individual companies within the corporate conglomerate, since local controllers and chief financial officers will be reluctant to hand over the administration of their cash flows to a regional center that is outside of their control. Also, such a high level of cash management calls for centralized information flows that can only be provided by a companywide enterprise resource planning (ERP) system, which is an extremely expensive system to purchase and install. Consequently, the multinational optimization of treasury activities is so expensive that it is a reasonable option only for the largest companies.