Understanding Client Needs

Before proposing a derivative, sales representatives interview the client to confirm its foreign currency and borrowing flows and the purpose of the transaction. Compliance staff use the same content when they check the procedures for that interview and its record.

Why needs come before the proposal

Understanding a client's needs is the starting point for deciding which transaction to propose, and for what amount and period. In the client business flow, it is the step that comes before the proposal and explanation. The whole flow is covered in The Client Business Flow.

Figure description

This is the order in which understanding needs proceeds between the client and the sales representative. The client tells staff about the receipts and payments of foreign currency or interest that arise from its business, and the purpose of the transaction, and the sales representative asks about the amount, timing, period, and certainty. The representative then sorts whether the purpose is hedging, keeps the proposed transaction within actual needs (the receipts and payments that actually arise from the business), and checks that it works as a hedge (hedge effectiveness). The representative explains the results to the client, confirms that the client received the explanation, and keeps a written record that is the basis for reviewing, after the contract, whether actual needs continue. When the purpose is not hedging, the check of hedge effectiveness does not apply.

The Financial Services Agency's "Comprehensive Guidelines for Supervision of Major Banks, etc." (the supervisory guidelines for major banks) set out how a bank should handle OTC derivatives with corporate clients. If the transaction is for hedging, the bank checks the following three points and explains the results to the client¹.

1. The transaction works as a hedge even in light of the client's business conditions (purchasing, sales, and funding environment) and how it sets prices with its suppliers and customers.
2. The situations in which it works as a hedge are expected to last until the end of the contract.
3. The transaction does not end up making the client's future business harder to foresee.

For securities firms and similar businesses, the "Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc." include an item on checking whether the client understands the same three points for OTC derivatives such as currency options and interest rate swaps². All of these points rest on an interview about the client's business and its actual needs.

Finding out the client's risks by amount, timing, and period

In the interview, staff pin down the foreign currency and interest flows that arise from the client's business, with figures for the amount, timing, and period. Consider a hypothetical example in which Company F is a corporate client.

Company F exports products to a customer in the United States and is paid in dollars. It expects to receive USD 500,000 a month over the next 12 months, USD 6 million in total. Of this, the first six months, USD 3 million, are already covered by orders. Company F also has a 1 billion yen loan at a floating rate, with 5 years left until repayment. The sales staff summarize what they heard in a table like the one below.

Besides amount and period, the "Certainty" row matters for the decisions that follow. The USD 3 million already ordered and the USD 3 million forecast differ in how likely they are to fall through.

Staff also ask whether the client can pass market moves on to its customers and suppliers through its prices. Whether a transaction works as a hedge is judged taking into account, among other things, whether the client has the bargaining power or pricing power to soften the impact when exchange rates or interest rates move³. Whether price increases or cuts can absorb market moves changes the judgment of whether a derivative works as a hedge. When a company considers hedging, it also first considers whether it can pass price changes on to its customers, and whether to hedge if it cannot⁴. Conversely, fixing purchase prices and the like through a hedge can affect the client's price competitiveness³.

Checking whether the purpose is hedging

Staff check whether the purpose of the transaction is hedging or speculation, that is, trying to profit from market price moves. What the financial institution needs to check depends on the purpose.

The suitability principle is a principle of the Financial Instruments and Exchange Act: a firm must not solicit in a way that is inappropriate in light of the client's knowledge, experience, and financial situation and the purpose of entering into the contract⁵. When a bank deals in derivatives, the supervisory guidelines for major banks require it to take into account the client's knowledge, experience, and financial situation and the purpose of the transaction⁶. The three checks in the major banks' guidelines apply when the purpose is hedging. In Company F's case, the flows from its business (dollar receipts and interest on the loan) come first. If the aim is to fix them, the transaction is a hedge.

When the purpose is not hedging, the check of hedge effectiveness does not apply. However, in the FSA's supervisory guidelines for financial instruments business operators, the step of checking how large a loss the client can tolerate, and whether that loss would seriously affect its business or finances, is not limited to hedging transactions⁷. The same guidelines also set out a step of explaining the loss the client can tolerate by comparing it with the loss in the worst-case scenario⁸.

Avoiding transactions larger or longer than actual needs

Staff keep a transaction proposed as a hedge within the amount and period of the actual needs they found out about. Any part beyond actual needs remains without anything to hedge and becomes a separate position that can gain or lose depending on the market.

In Company F's case, an FX forward to sell dollars is within its actual needs if the amount is USD 6 million or less over 12 months and the period is 12 months or less. If Company F entered into FX forwards to sell dollars for three years, the second and third years would exceed the expected receipts confirmed in the interview. For the loan, an interest rate swap with a notional amount above 1 billion yen, or a term longer than the 5 years left, would fix interest after the loan is repaid or on more than the loan. That part has nothing to hedge.

The same problem can arise even within these limits if actual needs later shrink. Even when the hedging instrument itself has no loss, a hedge may stop working before the end of the contract if the client's business shrinks³. Staff therefore ask how certain the forecast part is, and check that the transaction does not extend to the less certain part.

How much to hedge

Even when the hedged amount stays within actual needs, how much of those needs to hedge depends on the client's risk management policy. The share of the actual needs that is hedged is called the hedge ratio¹¹.

Compare the yen amounts Company F receives when it hedges its USD 6 million of receipts with FX forwards at 150 yen to the dollar, at hedge ratios of 0%, 50%, and 100%. To keep the example simple, assume that all USD 6 million arrive on the same day and that the rate that day is either 140 yen or 160 yen to the dollar. The unhedged part is converted into yen at that day's rate.

At a hedge ratio of 100%, the company receives 900 million yen whatever the rate. If the yen strengthens to 140, it receives 60 million yen more than without a hedge, but if the yen weakens to 160, it receives 60 million yen less. At 50%, the difference from not hedging is halved to 30 million yen at either rate. The higher the ratio, the less the amount received depends on the market, but the smaller the gain when the market moves in the company's favor.

The hedge ratio also changes how much of the forward exceeds actual needs if those needs shrink. Suppose Company F's receipts fall to USD 4 million. With a 100% ratio and forwards for USD 6 million, USD 2 million exceed actual needs. The company has to buy those dollars at that day's rate to deliver them, so, as in the previous section, that part can gain or lose depending on the market. With a 50% ratio and forwards for USD 3 million, the forwards stay within actual needs even if receipts fall to USD 4 million. Whether to use different ratios for the ordered part and the forecast part also depends on the client's policy.

In a survey sent in March 2022 to listed manufacturing companies with overseas operations, 50 of the 92 responding companies (54%) said they had internal rules on the share of their currency exposure to hedge¹². Among the 48 companies with such rules that answered the question on the hedge share, 18 (38%) hedged almost 100% and 14 (29%) about 50%, and about 50% was the most common answer among smaller companies. In the question on hedge periods (multiple answers allowed), 3 months was the most common answer, given by 36 of the 73 companies that answered (49%)¹². The steps for a company's hedging shown in the Tokyo Commodity Exchange casebook include deciding the hedge period and volume and checking that the transactions are appropriate in light of its risk management policy⁴. Whether a client has rules on how much to hedge gives staff a guide to the amount and period to propose.

Recording what was heard as the basis for review

Staff record the actual needs and purpose they found out about and the results of the hedge effectiveness checks. A bank confirms with the client that the client received explanations, including the results of the hedge effectiveness checks, and keeps a written acknowledgment that the client received them (the FSA's supervisory guidelines for major banks call it a "confirmation document, etc."; our translation)¹³. Securities firms and similar businesses carefully confirm the client's investment purpose, write it on a client card or similar record, and share its content with the client¹⁴.

The record is the basis for reviewing, after the contract, whether the actual needs continue. In Company F's case, staff compare what happened to the USD 3 million ordered and the USD 3 million forecast against the record from the interview.

Building the transaction on what was heard and explaining its risks and the treatment of early termination is the step covered in Proposals and Explanations.

Notes

1. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-3-1-2(2)①イ, item c (page 218) (in Japanese). ↩

2. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), IV-3-3-2(6)③ (pages 165–166) (in Japanese). ↩

3. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-3-1-2(2)①イ, item c, notes 1 to 3 (pages 218–219) (in Japanese). ↩ ↩² ↩³

4. Tokyo Commodity Exchange, "ヘッジ取引の事例集" (Casebook of hedge transactions, in Japanese) (2021), page 53, "ヘッジ取引実施ステップ" (Steps for carrying out hedge transactions). ↩ ↩²

5. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 40, item 1. ↩

6. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), the opening text of III-3-3-1-2(2)①イ (page 217) (in Japanese). ↩

7. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), IV-3-3-2(6)①ロ (page 165) (in Japanese). ↩

8. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), IV-3-3-2(6)①イ and ロ (page 165) (in Japanese). ↩

9. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 38, item 4 and the proviso. ↩

10. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-3-1-2(2)①イ, item f and its note (page 219) (in Japanese). The examples of clients under the exception and of judging on the substance are in the same note. ↩ ↩²

11. The Research Institute of Economy, Trade and Industry survey summary (January 2024) writes "為替リスクエクスポージャーに対するヘッジの割合" (the share of hedging relative to currency risk exposure; our translation) (page 11), and Chart III-2-4 of Bank of Japan, "金融システムレポート（2017年4月）" (Financial System Report (April 2017), in Japanese) shows the "ヘッジ比率" (hedge ratio) for life insurers' foreign bond investment. An English version of the report is available: "Financial System Report (April 2017)". ↩

12. 伊藤隆敏, 鯉渕賢, 佐藤清隆, 清水順子, and 吉見太洋, "日本企業の為替リスク管理とインボイス通貨選択：2021年度「日本企業の貿易建値通貨の選択に関するアンケート調査」結果概要" (Exchange rate risk management and invoice currency choice of Japanese firms: summary of the results of the fiscal 2021 survey on the choice of trade invoicing currency by Japanese firms), Research Institute of Economy, Trade and Industry (January 2024), chapter 2, page 11, and Table 3-3(a) (the questionnaire was sent in March 2022; 73 companies answered the question on periods) (in Japanese). ↩ ↩²

13. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.) (October 2026), III-3-3-1-2(2)①イ, item d (page 219) (in Japanese). ↩

14. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.) (October 2026), III-2-3-2-1(1)②イ (page 52) (in Japanese). ↩