gram. By isolating what will and will not be the subject of hedging will effectively
limit the scale of the exposure management program. A list of accepted financial in-
struments which treasury is authorized to use for risk management is also important
to control of operations given the ever-growing list of second-generation risk man-
agement products, many of which have complex valuation and exposure profiles.
Even a short list today would need to determine the firm’s policy toward the use of
forwards, purchased options, written options, complex options, structured products,
and straight interest rate swaps and cross-currency interest rate swaps. (See Chapter
7.) Finally, the firm’s risk management guidelines should address the desirability of
any minimum or maximum exposure coverage, by exposure size (amount), or by per-
centage required forward cover (e.g., 50% forward cover required on all booked ex-
posures of $100,000 or more).
(b) Front-Office/Back-Office Division. There is little debate among treasury man-
agers worldwide that the one critical element to preventing risk management system
failures is the separation of front office activities, the design and construction of cur-
rency-related activities (transactions, hedging strategies), and back-office activities,
the booking and settlement of transactions and hedging activity. Many treasuries are
now outsourcing their back-office activities as an additional physical and fiduciary
step in preventing any conflict or system failure. Regardless of whether these duties
are carried out by internal or external personnel, it is fundamental that the duties be
carried out by different personnel, with different upward-reporting requirements in
the organization, and be physically separated if at all possible.^12
(c) Position Monitoring and Performance Measurement. Once a currency risk man-
agement program is under way, treasury must monitor all positions and periodically
measure its own performance against some benchmark.
Position monitoring is a critical issue facing many treasuries today as a result of
the increased use of derivative products, many of which are difficult to mark-to-mar-
ket on a frequent basis. This difficulty is a combination of the complexity of the in-
strument’s valuation, and the timeliness and appropriateness of critical inputs, such
as market volatilities, which are integral to the determination of true value. Position
monitoring must be pursued in parallel for all outstanding (identified) exposures, and
for the structured instruments, positions, or derivatives used for the hedging of such
exposures. For decentralized multinationals with foreign exchange risk management
at the subsidiary or regional level, it is necessary for the parent and the subparent to
be aware of these position values on a daily basis if possible. This requires the abil-
ity by treasury to mark-to-market all outstanding positions with contemporaneous
market data. A number of major information vendors such as Reuters now provide
the software and information linkages that allow constant mark-to-market valuation
of all positions.
Performance measurement is a topic of some debate. Recent surveys indicate that
nearly 30% of all treasuries do not consider performance measurement or other
5.5 FOREIGN EXCHANGE MANAGEMENT 5 • 17(^12) The subject of separation of strategy and confirmation/settlement has of course gained enormous at-
tention after the fall of Baring Brothers which was nearly single-handedly the result of Mr. Nick Leeson’s
control over both front- and back-office job duties, allowing fraud and abuse and, in the case of the old-
est investment bank in London, failure.