The setting of budget rates is crucially important for a corporation as it can drive not only the corporation’s hedging but also its pricing strategy as well. Budget exchange rates can be set in several ways. The benchmark or budget rate for an investment in a foreign subsidiary should normally be the exchange rate at the close of the previous fiscal period, often referred to as the accounting rate. On the other hand, when dealing with forecasted cash flows, the issue becomes more complex. Theoretically, the budget exchange rate should be derived from the domestic sales price, which is the operating cost plus the desired profit margin, as an expression of the foreign subsidiary sales price. Thus, if the parent sales price for a good is USD10 and the Euro area sales price is EUR15, the budget rate should be 0.67. The actual exchange rate for Euro–dollar may be some way away from that. Thus, the corporation needs to evaluate the degree of demand for its product relative to changes in the product’s Euro price to see whether or not it has leeway to cut its Euro price without also reducing margin substantially in order to set a budget rate that is closer to the spot exchange rate. If there is a major difference between the spot and budget exchange rates, either the hedging or the pricing strategy may have to be reconsidered.
Corporations can also set the budget rate so as to link in with their sales calendar and thus their hedging strategy. If a corporation has a quarterly sales calendar it may want to hedge in such a way that its foreign currency sales in one quarter is no less than that of the same quarter one year before, implying that it should make four hedges per year, each of one-year tenor. Alternatively, instead of hedging at the end of a period, thus using the end-of-period exchange rate as its budget rate, the corporation may choose to set a daily average rate as its budget rate. In this case, if the corporation chooses as its budget rate the daily average rate for the previous fiscal year, it only needs to execute one hedge. It stands to reason that the best way of achieving this in the market place is to use an average-based instrument such as an option or a synthetic forward, entered into on the last day of the previous fiscal year, with its starting day being the first day of the new fiscal year. Of late, an option structure known as a double average rate optio (DARO) has become increasingly popular among multinational corporations. This allows a corporation to protect the average value of a foreign currency cash flow over a specified time period relative to another period. This is a simple way of passive currency hedging, taking out discretionary uncertainties and instead putting the hedging programme on auto pilot where it can be more easily monitored.
Whether a corporation hedges currency risk passively or actively, once the budget rate is set the Treasury is responsible for securing an appropriate hedge rate and ensuring there is minimal slippage relative to that hedge rate. Timing and the instruments used are key to being able to achieve that. The last point to make on budget rates is that they flow naturally from relative price differentials. This however is also the heart of the concept of PPP, which states that exchange rates should adjust for relative price differentials of the same good between two countries. While PPP models are of relatively little use in forecasting short-term exchange rate moves, they have a substantially better record in forecasting exchange rates over the long term. Thus, a corporation could do worse than setting the budget rate with a PPP model in mind, albeit with the realization that tactical hedging may be necessary either side of that budget rate over the short term in order to capture exchange rate deviation from where PPP suggests it should be. Finally, it is important to underline that budget rates can provide companies with one thing only: a level of reference. Set up randomly, they are of very little use. And at some point, prolonged currency moves against the functional currency must be passed on, or strategic positioning and hedging must be addressed; in any case two topics well beyond our budget rates discussion. In the end, while the process of setting budget rates cannot resolve all of a corporation’s issues, it can be dramatically improved by clearly defining the company’s sensitivities and benchmarking priorities. The hedging frequency as well as the choice of the hedge instrument will naturally flow from this process.