Highly automated FX risk management and optimized hedging
Dräger is a leading international company in the fields of medical and safety technology. “Technology for Life” is the company’s claim. Whether in an operating room, in an ICU, at the fire brigade, or for rescue services: Dräger products protect, support, and save lives.
"The solution allows us to discuss the most suitable blend of risk and costs on a factual basis. This enables us to avoid scenarios with a relatively low level of additional hedging at considerable extra costs."
As hedged as necessary, as cost-effective as possible: A new dimension in FX hedging
Discover how the medical technology firm Dräger saves time and money in FX hedging thanks to automated calculations of its FX exposures and optimized hedging.
Respirators for intensive care units, thermal imaging cameras for fire brigades, and personal respiratory protection systems for miners: Dräger’s medical and safety technology is marketed in 190 countries around the world. The treasury department at this Lübeck-based group manages a portfolio of 41 currencies. This makes it essential for the associated FX exposures to be managed in a highly automated, cost-effective, and practical manner.
Designed in Excel, implemented in Nomentia
When Dräger and Nomentia first sat down to discuss the issue of FX risk management at the end of 2018, the company’s risk managers were still deriving their FX exposures in Excel based on SAP data exports and no end of manual work. While trying to further optimize and automate their exposure analyses and risk calculations, they were slowly realizing the limitations of spreadsheets and were therefore open to the idea of professional system-based support.
However, before tackling the issue of which system to select, the first challenge was to decide on the conceptional approach to take to FX risk calculation.
In a joint workshop, Dräger and Nomentia set up a cash flow at risk (CFaR) model in Excel which also took correlation effects into account. The outcome: an initial indication of group-wide FX risk which allowed Dräger to estimate whether an investment in a system would pay off.
While preparing the risk model, it soon became clear that this could only be implemented in a system able to deal with high data volumes and complex calculations. Neither the data transfer between SAP and Excel could be sufficiently automated nor could a standard Excel solution handle a comprehensive CFaR calculation – the latter representing a challenge even for many treasury management systems.
Fortunately, Nomentia was in the process of launching the latest version of its RiskSuite at about the same time – a dedicated module for quantifying financial risk resulting from FX-, interest rate- and commodity-exposures.
Scoping and implementation “on top of” SAP
Dräger’s FX risk management approach of putting a strong emphasis on the economic risk resulting from the long-term cash flow forecast could be optimally accommodated by the RiskSuite which is why Nomentia was selected based on a direct comparison with another specialist provider in the area of FX risk management. The implementation phase kicked off with a joint scoping workshop at the company’s headquarters in Lübeck in May 2019. During this workshop and in the following days, all of the key details were defined relating to data sources, exposure derivation, and risk calculation.
The aim was to enable both the exposure as well as the risk to in future be calculated fully automatically in Nomentia based on underlying data from SAP. On the one hand, actual cash flows are prepared in SAP, with these actions as the basis for exposure forecasting given that the future development of business can be relatively reliably predicted. On the other, SAP provides accounts receivable (AR) and accounts payable (AP) data for the coming months, as well as FX derivatives which are traded at Dräger using 360T and the market data required for risk calculation.
Fully automated FX exposure and risk calculations
The calculation of the FX exposure based on these underlying data is fully automated: After the actual cash flows have been imported, the annual cash flows are automatically corrected to take overdue and changes in customer payment behavior into account. The annual exposure is then converted into planned exposures with the aid of forecast growth factors for the following years in each currency. In the next step, Nomentia transforms these into monthly planned cash flows based on the average monthly distribution of cash flows over the past three years. The last step entails these planned cash flows for the first forecast months being replaced by the cash flows associated with the AR/AP entries in each currency already entered into the system.
Once the planned exposures have been calculated, the FX risk manager can initiate the risk calculation in Nomentia at the press of a button. This entails transferring the exposure data prepared in Nomentia and the derivatives imported from SAP to the powerful calculation engine of the RiskSuite. This engine then calculates the CFaR of the FX portfolio by means of Monte Carlo simulations. The output is an integrated risk analysis report which not only highlights cash flows, hedges, net exposure, and risk levels in each currency but also identifies the diversified total risk ‘carried’ in the FX portfolio as well as the current hedging ratio in each currency.
Let’s get down to the optimization: Cost-risk profile
Is the current hedging strategy already the most advantageous? Or could cost-risk considerations improve it further?
"We want to ensure that our hedging strategy achieves the selected target risk level with minimal costs incurred. That’s why we opted for ‘cost of carry’ as an optimization criterion from the various optimization options offered by the RiskSuite. In other words, those ‘costs’ which are incurred as a result of the interest rate differences of the relevant currency relative to the Euro."
Based on the selected target-risk and using cost-of-carry as the optimization criterion, the RiskSuite uses its optimization function to determine THE single optimum hedge portfolio out of millions of possible hedge portfolios which keeps risk within the defined limit while minimizing total cost-of-carry. The result is a curve of efficient hedge portfolios for a defined range of target risk-taking cost/risk aspects into account.
"This perspective allows everyone involved in the risk management process to discuss the most suitable blend of risk and costs on a factual basis. This enables us to avoid scenarios with a relatively low level of additional hedging at considerable extra costs."
Nomentia not only provides a chart of the optimization results but also presents these in the form of an easy-to-understand table. The column ‘hedge ratio’ now depicts the optimal hedging ratio calculated by the system which is necessary in order to achieve the target risk level (€11m in the example below) at minimal cost (€2.94m).
Nomentia also offers full flexibility in terms of defining target hedging ratios. At Dräger, for example:
"We hedge based on various hedging ratios depending on the timing of the cash flows. We use the optimization function for the following year based on discrete hedging ratios, which means that a currency is either hedged to a defined percentage or not at all."
For optimization purposes, hedging ratios can also be defined as constants ranging between 0% and 100%. It is also possible to define target hedging ranges for some currencies which vary over the course of time while other currencies can be defined as constantly unhedged – to account for illiquid currency markets for example.
Fewer time inputs and lower hedging costs
The Dräger-Nomentia team is currently developing a solution to automatically deliver the calculated exposures back into SAP so that these can then be used in the ERP system for hedge accounting purposes. Nomentia already differentiates between exposures relevant for hedge accounting purposes and those which are not.
"The RiskSuite allowed us to implement a solution within six months which, due to automation and seamless integration with SAP, has drastically reduced the time inputs for exposure calculation. The optimisation of our hedge portfolio reduces hedging costs and the integrated reporting is the most practical basis for the Board to reach decisions."
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