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Mecklai FX Risk Management Survey

april 2009

Executive Summary
The 2nd Annual Mecklai FX Risk Management Survey was conducted in Jan/Feb 2009.
We had a total of 55 respondents (45 last year), 45 new ones plus 10 repeats from last year.
The survey was designed to correct for the unprecedented volatility in 2008 by selecting
respondents who were similar in structure and management focus to the companies who
participated last year.

The average performance of the group, measured using the Mecklai Risk Management
Index (MRMI), was 49, which was a small improvement over last year’s average score of
46. The best performer scored 84 (last year 70), while the worst scored 18 (last year 23).

As last year, we found that top management focus was very highly correlated (94%) with
the MRMI. We also found that the linkage between management focus and the design
of risk management processes as well as the sophistication of treasury operations was
much higher this year than last. Clearly, the significantly higher volatility in financial
markets has driven this greater pro-activity in risk management.

However, the survey results suggest that this increased hands-on approach did not
necessarily lead to better performance. While there were some exceptions, most
companies still showed a disconnect between greater top management focus and
well designed processes and operational sophistication, with the correlation of the
MRMI dropping off to 84% and 77%, respectively. Perhaps, given the significant FX
losses suffered by many companies, managements are less comfortable with devolving
adequate authority to their treasuries, which is a necessary condition for effective risk
management operations.

Unsurprisingly, the 10 companies that were repeats from last year increased their average
MRMI rating by 16%, from 43 to 50; of these, the best grew its score from 52 to 76.
Perhaps participating in the survey resulted in an increased focus and improvement in
operations in the area.

This year, we also studied companies that carried commodity price risk, and found, again
unsurprisingly, that these companies had a stronger focus on risk management. The 24
companies in the sample who had commodity exposure scored an average MRMI of 50,
as compared to 46 for the overall group.

The overarching conclusion from the survey is the need for process, process, process.
It also showed that while the majority of top managements understand the need
for a focused approach to risk management, there is often a wide gap between this
understanding the actual implementation of effective policies.

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Survey findings
Exposure intensity – As last year, we found only a modest (45%) correlation between
exposure intensity (exposure / turnover) and risk management effectiveness (as
measured by MRMI). While the average MRMI score did rise as we moved up the
exposure intensity scale, it was a bit surprising that as as many as 14 (out of 29)
companies with a high exposure intensity scored below 50 on the MRMI.

Size – Again, as last year, we found that good risk management practices were found
in companies of all sizes; correspondingly, poor risk management practices were also
randomly distributed independent of company size.

Importance of Risk Management Policy – The 30 respondents that had risk management
policies had an average MRMI of 51, as compared to an average of 37 for those without
policies. 19 of the companies with risk management policies were medium to large (over
500 cr), and these had an average score of 53.

Repeaters – The 10 companies that were repeats from last year increased their average
MRMI rating by 16%, from 43 to 50; 5 showed a 7-28 point increase, with three companies
improving their score by more than 20 points. On the other hand, 5 had a 2-14 point
decline; the two companies that showed the worst declines had one thing in common –
they were the only ones in the sample that reported reduced management focus.

Independent Treasury – 22 companies (40% of the survey) had “independent treasuries”,

of which 9 were manned by 2 full time people. However, only 13 of these measure
treasury performance on an objective basis, and only 5 of these link compensation to
performance. Rather surprisingly, four of the companies with independent treasuries
operated without a treasury policy.

Interface with business divisions – Only 27 (a bit less than half) of the companies
surveyed used treasury budget rates for export pricing; 18 of these modify their export
pricing rates monthly. 19 companies (about a third of the sample) debit/credit business
divisions for variations in their forecast – i.e., deviations in amount or due date.

Risk profile definition – Most of the respondents (78%) manage their trade and balance
sheet exposures separately.

On the trade book, a surprisingly small percentage of respondents (36%, 20 out of 55)
manage their risk on a portfolio basis; the majority of companies (64%) hedge their risk
transaction-wise. Perhaps reflecting this, 64% of companies manage imports and exports
separately, rather than using their natural hedge. Of the 18 companies that manage their
net portfolio, 10 use their EEFC accounts, while the balance try to offset payments and
realizations.

Mandatory hedging – Only 23 respondents have a mandatory minimum hedge (16 have a
greater than 50% requirement, while 7 have a less than 50% requirement); in 19 of these,
the mandatory hedge is determined by the company’s policy.

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 Mecklai Risk Management Index MRMI SCORES
90
AVERAGE 49
HIGH 84
80
LOW 18

70

ALSO IN LAST YEAR’S SURVEY

60

50

40

30

20

10

MRMI and Size MRMI and Exposure

90 90

80 80

70 70

60 60

50 50

40 40

30 30

20 20

10 10

0 0
LOW MEDIUM HIGH LOW MEDIUM HIGH
SIZE INDEX EXPOSURE INTENSITY

Size Index - As last year, large companies were defined as those that had turnovers in
excess of 1,000 cr; mid-sized companies were those that were in the 500-1,000 cr range;
and small companies were those below 500 cr.
Although the MRMI has a very low correlation with size (11%), we found that a higher
percentage of large companies crossed the 50-point mark. Nine (47%) of the 19 large
companies scored above 50, with 3 crossing 60. Four (25%) mid-sized companies scored
between 62-73, while the rest scored less than 50. No small company scored above 60 and
only 5 of them (25%) scored above 50.
Exposure intensity - The exposure index is a measure of the risk carried by a company
– the higher the index, the higher the risk faced by the company and one would expect
a stronger risk management operation. We, did, indeed, find some linkage – the chart
shows a steady improvement as you go from left to right; however, the correlation was
somewhat modest at 45% with an R2 of 0.21.
Nonetheless, there were several companies with high exposure intensities who scored
poorly, confirming considerable anecdotal evidence with companies with large FX
exposures having relatively weak processes.

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Statistical Analysis
MRMI
100%

80%

60%

40%

20%

R2=0.8237
0%
0% 20% 40% 60% 80% 100%
TOP MANAGEMENT FOCUS

Risk Management Processes Sophistication of Operations

100% 100%

80% 80%

60% 60%

40% 40%

20% 20%

R2=0.7111 R2=0.587
0% 0%
0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100%
TOP MANAGEMENT FOCUS TOP MANAGEMENT FOCUS

As last year, we found that top management focus was very highly correlated (94%)
with a higher MRMI score, which is logical since this should also result in strong risk
management processes and sophistication of treasury operations.

We also found that the linkage between management focus and (a) design of risk
management processes and (b) sophistication of treasury operations was much higher
this year than last – the coefficient of determination (R2) rose from 0.67 to 0.71 and from
0.45 to 0.59, respectively. Clearly, the significantly higher volatility in financial markets
has driven this greater pro-activity in risk management.

However, the survey results suggest that this increased hands-on approach did not
necessarily lead to better performance. While there were some exceptions, most
companies still showed a disconnect between greater top management focus and
well designed processes and operational sophistication, with the correlation of the
MRMI dropping off to 84% and 77%, respectively. Perhaps, given the significant FX

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losses suffered by many companies, they are not yet comfortable with devolving
adequate authority to their treasuries, which is a necessary condition for effective risk
management operations. Again, risk management is a highly technical subject and it is
unlikely that senior management has the appropriate skills to make the best decisions
in the market.

It would seem that over the next couple of years, as managements become more
comfortable with these relatively new processes, we will see a greater devolution of
authority to the treasury, which should result in a sharp jump in the effectiveness of
their risk management operation. We have already seen this in several companies we
work with, including some second-year participants in the survey – see box, last page.

Target rates for treasury – Only 25 companies had a systematic process for setting
target rates for the treasury; of these 8 companies use business division transfer price,
8 use Day 1 forward/ option prices, and 9 use budget (business plan) rates.

Monitoring and Reporting – The vast majority (78%) of companies run a regular mark-
to-market (MTM) of exposures; however, only 44% of CFO’s see this on an at-least
weekly basis. Only 62% of Board’s see the MTM.

Systems and Controls – About half the companies (28 out of 55) have independent
confirmation of transactions. A glaring lapse is that 12 companies that did have risk
management policies in place did not have independent confirmation of transactions.

68% of respondents understand the need for having automated processes, with
31 companies having operational ERP’s with 6 others having systems under
implementation. However, many of these systems are inadequate for risk management,
evidenced by the fact that entry of hedge transactions is possible only at 8 companies
while deal slip creation and output for risk management are possible only at 3
companies.

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Methodology
This 2nd edition of the Mecklai FX Risk Management Survey was conducted in Jan/Feb
2009. We had a total of 55 respondents (45 last year), 45 new ones plus 10 repeats from
last year.

To prevent the survey results from being unduly skewed by the unprecedented market
volatility in late 2008, we designed our respondent sample to ensure similarity (with last
year’s sample) in many parameters. For instance, this year’s sample had 16 companies that
followed IFRS, as opposed to 14 in last year’s survey. Again, the companies in this year’s
sample had a top management focus score of 8.89 (virtually identical with the sample last
year), and an exposure intensity score of 6.71 (as compared to 6.26 last year). One small
variation was that this year’s sample included 3 companies with turnover under 250 cr
(nil last year).

The survey had the same set of 62 questions as last year, divided into three sets – 20
questions dealing with top management focus (including the importance or forex
risk), 22 questions to understand the company’s risk management processes, and 20
questions to get a fix on the level of sophistication of the company’s treasury operations.
Many of the questions fed into more than one analytical parameter. The responses were
normalized and scores were arrived at for each parameter, which was then converted to
the Mecklai Risk Management Index (MRMI).

Since a reasonably large number of respondents – 24 out of 55 – were companies that

also had exposure to commodity risk, we added 6 additional questions to understand
how companies look at this important risk area, and find linkages between FX and
commodity risk management.

We also incorporated 9 questions on liquidity management, since ultimately companies

need to move towards an integrated treasury, and we plan to make these surveys valuable
across a broader spectrum of finance activities.

Companies with commodity price risk

24 of the companies surveyed carried commodity price risk across a spectrum of
different commodities. 15 companies were users, 1 was a producer and 8 were both.

Unsurprisingly, we found that these companies were more focused on risk management
– the average MRMI score for these companies was 50 as compared to 43 for the non-
commodity companies in the group (bringing the group average up to 46). Further 4 of
them were in the top 6 performers on FX risk management.

Regarding risk management operations, all but four of the companies were strongly
focused on the area, but only 9 (7 users and 2 user/producers) of them manage their
commodity price risk actively – i.e., using futures, either domestically or overseas. The
others mostly monitor their price risk and hedge it through physical contracts where
possible.

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 90
COMMODITY EXPOSURE

80

70

60

50

40

30

20

10

The most glaring gap, however, was in terms of risk management processes, with
only 9 companies reporting some degree of process orientation. This is, perhaps,
understandable since commodity price risk is much more complicated, both in terms
of its impact on a company’s business and because risk management is much more
difficult. Significantly, however, 3 of the 9 companies with good processes were among
the top 6 MRMI (FX risk management) performers.

Liquidity management
To get a broader understanding of how companies use their treasury function, we
added 9 questions in this survey on liquidity management. Since the domestic funds
market is very constrained in terms of instruments and liquidity, most of the questions
were on process – type of cash flow forecasts used, scenario analyses, reporting, etc.

We found that 21 companies (38%) had relatively poor liquidity management processes;
perhaps unsurprisingly, these companies also scored a bit lower on the MRMI scale –
47, as compared to the survey average of 49. In our view, this is probably a reflection
of FX risk and liquidity being managed as different silos in the finance function,
rather than having them run as an integrated treasury. Of the companies that did have
reasonably good processes, more than half maintained cash forecasts for a minimum
12-month period, and all of them used scenario analysis (mostly having to do with
payments from customers) to manage their contingent lines of credit.

Interestingly, only 18 (33%) of the companies in our survey reported feeling a credit
squeeze from their banks during 2008.

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Conclusions
The overarching conclusion from the survey is the continuing need for process, process,
process. While the majority of top managements understand the need for a focused
approach to risk management, there is often a wide gap between this understanding the
actual implementation of effective policies.

The best performers in the survey (1) understood and accepted the distinction between
cash and accounting gains/losses; (2) had a strong integration between their treasuries
and their businesses, with treasury providing budget rates to businesses; (3) defined their
risk profiles based on business forecasts (rather than actuals); and (4) had strong analytic
processes, reporting and controls.

Tips from the Top Three

The top 3 performers – scoring 84, 76 and 72 – in the survey were all medium sized (500-
1,000 cr) companies, one in the IT sector and the other two in manufacturing. Two of the
three also participated in last year’s survey, and, over the past year, were able to increase
their scores from 52 and 37 to 76 and 72, respectively.

There were some distinct similarities in their approaches. For instance, all three have
Board-approved policies and independent treasuries. The treasury is closely linked in to
operations and provides budget rates to the businesses – annually, in the case of the IT
company; weekly, in the manufacturing companies.

All three companies identify risks based on business forecasts, and to make this process
more meaningful, two of the three companies charged the divisions for variations
between actual flows (either due date or amount) and forecasts. All three separate the
capital account from the trade book, and make a clear distinction between cash and
accounting gains/losses.

In all cases, the treasury benchmark is derived using forward rates and/or option pricing,
and all three have a minimum hedging requirement of 50% or more. All three run a
regular MTM of the full portfolio, have independent confirmation of transactions, and
report MTM-based performance to the Board. Reflecting the importance given to the
operation, the CFO’s of all three companies are regularly involved in hedging decisions.

Two of the companies manage imports and exports separately, while the one managing
the net exposure uses its EEFC as the main tool for management. Market operations are
kept simple – only forwards, vanilla options, and, in one of the three, zero cost options.

mecklai financial services limited

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