Master the art of setting and applying an FX budget rate
A comprehensive guide for treasury, finance and risk managers to successfully apply a budget rate and factors to consider.
What we'll cover
In the global currency landscape, where many factors are constantly changing and evolving and, at times, presenting unprecedented challenges, this begs the question: How do we set a robust FX strategy?
This article goes beyond setting an FX strategy — we have a detailed guide to explain that. In fact, here we take one step back to answer the most fundamental and integral step in designing your FX strategy: how to set a budget rate.
A well-defined budget rate is the cornerstone of a successful FX strategy. In this guide, we'll decode the role of a budget rate, its importance, how to set it and what to consider before applying it.
Without further ado, let's jump in!
Ideal for
Whether you work with an SME, a large corporation or an institution, it's a must-read if:
- you work with a finance team
- you're a part of the accounting or treasury team
- you're a decision-maker of a business with international operations
What we will cover
- What is a budget rate
- Common methodologies to calculate a budget rate
- Questions to consider before setting a budget rate
- Best practices to achieve your budget rate
- Steps to apply a budget rate in your FX or treasury policy
What is a budget rate?
A budget reference rate, commonly abbreviated as budget rate, is a reference exchange rate that a company uses to set prices, costs, or benchmark for a campaign or budget period.
One goal of the FX strategy is to protect this budget rate, achieve financial stability, and fortify cash flow forecasts when transacting globally.
For example, if you are a UK importer buying your goods from a supplier in Spain and selling your final product in GBP, you will need to know the cost in GBP to calculate the selling price in the UK.
Setting a budget rate is essential for any business with international operations. It enhances financial planning, improves forecasting, provides certainty about the future value of FX exposures, and helps gauge the impact of FX market fluctuations on profit margins.
Common methodologies to calculate a budget rate
There is no straightforward answer or one-size-fits-all approach to implementing a budget rate in yourFX or treasury policy. It should be well-thought, considered within the overall FX strategy, driven by company forecasts and data, and tailored to suit your unique needs and financial goals.
If you are an importer, it can be your cost rate plus some buffer to ensure stability.
If you are an exporter, it is the rate you expect to convert your incoming foreign currency exchange to home currency.
Depending on the seasonality, if you want to set stable prices for the year at the start of your annual budget, the budget rate will coincide with your annual ‘campaign’. In this case, protecting the budget rate (with hedging strategies) against unpredictable currency rates is akin to protecting the campaign rate. However, the approach to arriving at this rate changes if you are a business that runs more than one campaign within a budget period. In this case, you will need to protect the budget rate of an individual campaign rather than the annual budget rate.
Different businesses approach this depending on their business situation, including FX flows, historical data, cash flow forecasts, needs, goals, and even risk tolerance levels. It can be:
- an average rate of the previous year prevailing spot rate
- prevailing spot rate plus/minus some pre-decided buffer
- desired target rate
- current forward rate
- average of previous/current hedges
- bank forecasts
Each year, each business, and each goal demands a unique approach.
Using last year's budget rate as a benchmark because the exchange rate favoured you in the previous year may not be the best approach. Similarly, using the current spot rate when budgeting may expose you to future fluctuations. Hence, this approach is best suited when you have a short-term outlook.
Depending on your goals, set a budget rate before the start of the financial year, season, period or order and, accordingly, design an FX strategy.
Questions to consider before setting a budget rate
If you are from the finance or treasury team, here are some of the questions that will help you assess your business circumstances, and FX flows before you set up a budget rate:
- What's your currency exposure?
- How accurately can you forecast your global cash flows?
- What are your profit margins, and how sensitive are they to currency fluctuations?
- If you set your prices, how do you set them?
- What are the payment terms?
- Has your business assessed the risk you are willing to take?
- Have you set a budget rate or prices already? If so, how long is it set for?
Steps to apply a budget rate in your FX or treasury policy
Your budget rate is primarily based on the FX policy that you employ. However, designing a risk management framework doesn't have to be a complicated process. We recommend using a simple six-step process to create your FX policy.
1. Identify and quantify your FX exposure
Before setting a budget rate, the first step is to assess your FX exposure based on your business needs. Consider factors such as the amount of FX you converted over the recent years and your expectations and projections for the coming budget periods.
2. Establish your hedging goals
Determine what you aim to achieve and set goals for it. Depending on your risk appetite, you can also determine the optimal hedging percentage of your FX exposure. For example, if your business wants to embrace a risk-averse approach, you may consider hedging more than 75% of your expected FX needs. On the other hand, if your FX needs are volatile, e.g., amounts fluctuate by more than 25% y-o-y, you may hedge a smaller proportion of your FX needs, let's say, 50%. Here, along with the currency exposure you want to hedge, you will also decide your budget rate.
3. Design a hedging program
Define an FX policy (static, hedging, layered hedging program) with your international business partner, such as Ebury. A FX policy is a high-level set of rules to follow to ensure that you are on track to meet your needs and objectives, including protecting your budget rate. This will contain how you wish to hedge, particularly with which hedging products, for which periods and for how long. After you define a hedging strategy, identify the right products (forwards, options*) execution method and approach to achieve the optimal outcomes.
4. Execute hedging strategy
Think about the execution process, accountabilities, and trades approval process – and include them within your business processes. If you don't have any Standard Operating Procedures (SOP) or other practices in place, maybe it's a good opportunity to develop them and communicate them to all the relevant stakeholders.
5. Monitor performance to make adjustments
Monitor and adjust the policy you define regularly to ensure you meet your goals and protect your budget rate. Enhance your policy to align with market conditions and your risk tolerance levels.
6. Review and compare
At the end of your cycle, conduct a comprehensive review of your hedging strategy performance against the goals, budget rate, and policy you set initially. Reflect on the learnings and incorporate them into the company's framework to achieve better outcomes in the future.
*Note: Hedging products availability may vary depending on your jurisdiction. Please get in touch with our team to learn about the products applicable to your country.
5 best practices to achieve your budget rate
Setting a budget rate isn't easy. But the right approach will help you build a resilient FX strategy, fortify financial stability, monitor your exposure, and optimise your international cash flows.Once you have set your FX policy, here are 5 effective ways to ensure your hedging policy and budget rate help you achieve your desired results.
Once you have set your FX policy, here are 5 effective ways to ensure your hedging policy and budget rate help you achieve your desired results.
Track market events
FX rates are heavily influenced by macroeconomics (inflation, interest rates), politics (elections), geopolitics (conflicts) and black swan events (pandemics, natural disasters). Hence, it is pivotal to examine these developments and ensure your budget rate has enough wiggle room from current rates. It will also help to study historical trends in currency exchange rates during different periods, depending on currency rate volatility levels.
GBP/EUR exchange rate - xe.com - 5 years: Sept 2019-2024
Ensure it is SMART
Like your financial goals, your budget rate and FX policy must also be SMART (Specific, Measurable, Achievable, Relevant, and Time-bound) to be effective. Setting a budget rate that's impossible to attain and can't be measured is futile.
Review periodically
It is crucial to review and fine-tune your budget rate periodically, say annually, to determine whether you need to update it.
Consider specialised external support
If setting a budget rate or FX policy within your team is overwhelming, consider partnering with FX experts like Ebury. At Ebury, we help you at every stage of FX policy, providing clear guidance and tailored strategies to help you navigate the complexities of currency management effectively.
Implement scenario modelling
Projecting different market conditions — bullish, neutral, or bearish — helps you predict the future movement of specific currency exchange pairs and how it might impact your business.
Don't leave your FX and budgeting strategy to chance
At Ebury, we will help you achieve whatever budget rate you set with a systematic approach. With our bespoke approach, dedicated support and hedging expertise, we work with you to design a custom and cost-effective risk management solution and help you execute and monitor it at every stage.
Disclaimer
The information provided herein is general in nature and should not be construed as financial or investment advice. The information provided here is not legally binding. The information, data or views expressed here are for the exclusive use of the recipient and are subject to changes without any notice. You may ask the support team or your dedicated relationship manager to provide additional information regarding Ebury products.
