Discover how the medical technology firm Dräger saves time and money in FX hedging thanks to automated calculations of its FX exposures and optimised hedging. (This article was co-authored with Mark Blatt, Strategic Projects, Finance & Controlling, Dråger.)

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 TIP

When Dräger and TIPCO 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 optimise and automate their exposure analyses and risk calculations, they were slowly realising 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 the words of Mark Blatt, Strategic Projects Finance and Controlling at Dräger: “We appreciated the fact that we had TIPCO on board as a sparring partner from Day 1. They didn’t simply want to sell us a system but also had the practical experience to support us with proposals on how to take correlation effects and different cashflow maturities into account while building our model.”

In a joint workshop, Dräger and TIPCO 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. Mark Blatt: “The volume of data was simply too high to handle without a specialised calculation engine.” Fortunately, TIPCO was in the process of launching the latest version of its RiskSuite at about the same time – a dedicated TIP-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 TIP RiskSuite which is why TIPCO 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 TIP based on underlying data from SAP. On the one hand, actual cash flows are prepared in SAP, with these acting 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.

Fig. 1 Treasury system landscape at Dräger

Seamless integration between TIP and SAP. All underlying data are automatically imported from various SAP modules and then compiled in TIP. Planned exposures are then derived and the risk calculation performed, with both processes being highly automated

Source & Copyright©2020 – TIPCO

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 in TIP are automatically corrected to take overdues and changes in customer payment behaviour into account. The annual exposure is then converted in TIP into planned exposures with the aid of forecast growth factors for the following years in each currency. In the next step, TIP 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.

Fig. 2 Fully automated derivation of exposures in 5 steps

Actual cash flows form the basis for planned exposures

Source & Copyright©2020 – TIPCO

Once the planned exposures have been calculated, the FX risk manager can initiate the risk calculation in TIP at the press of a button. This entails transferring the exposure data prepared in TIP and the derivatives imported from SAP to the powerful calculation engine of the TIP 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.

Fig. 3 Detailed analysis of FX risk

Exposure, risk and hedging ratios per currency, including a diversified portfolio CFaR. (sample data)

Source & Copyright©2020 – TIPCO

Is the current hedging strategy already the most advantageous? Or could cost-risk considerations improve it further? According to Mark Blatt: “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 optimisation criterion from the various optimisation options offered by the TIP 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 optimisation criterion, the TIP RiskSuite uses its optimisation function to determine THE single optimum hedge portfolio out of millions of possible hedge portfolios which keeps risk within the defined limit while minimising 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,” is how Mark explains the value of this analysis.

Fig. 4 Efficient hedge portfolios

Based on a freely selectable range of the target risk (horizontal axis), TIP calculates the optimal combination of risk and hedging costs (yellow line) to provide a sound basis for hedging decisions. The ‘costs’ resulting from every target risk level are presented in the form of interest rate differences based on the relevant optimal hedge portfolio (blue line). (sample data)

Source & Copyright©2020 – TIPCO

TIP not only provides a chart of the optimisation 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).

Fig. 5 Detailed analysis of FX risk after optimization

 The optimal hedging ratios including hedging costs per currency pair and in total. (sample data)

Source & Copyright©2020 – TIPCO

TIP 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 optimisation 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,” Mark explains.

For optimisation 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-TIPCO team are 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. TIP already differentiates between exposures relevant for hedge accounting purposes and those which are not.

Asked for his conclusions about the joint project, Mark: “The TIP 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.”