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Forex Trading And Money Management: Legal Considerations In Toronto
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Key Factors That Affect Foreign Exchange Rates
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Businesses need the right strategy to manage the risk of fluctuating foreign exchange rates in a volatile market. Read how to reduce the risk of an FX hedging strategy.
Forex Management Agreement
In our volatile global economy, few businesses are exempt from the risk of foreign currency fluctuations. In fact, every organization that does business in a foreign country or even transacts with foreign companies faces currency risk and the associated volatility risk. So how can they stay ahead of markets that can swing as fast as the next headline? For many corporate treasurers, the answer involves hedging.
Risk management strategies allow international organizations to identify their risks and reduce their impact. Currency hedging can mitigate risks caused by currency exchange market volatility, including reducing income volatility and protecting future cash flows or asset values.
“You should be informed about what’s going on in the foreign exchange markets,” says Chris Braun, head of foreign exchange at Bank of America. “However, for the corporate treasury team, any currency hedging program should focus on risk mitigation rather than market trading.”
In fact, this kind of risk management has tangible value. A five-year study of more than 6,000 companies in 47 countries found that FX hedging was associated with lower volatility of cash flows and returns, lower systemic risk, and higher market values (Bartram, Brown, and Conrad). In an important study of US companies, Allayannis and Weston showed that currency hedging increased market value by 4.87%.
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“From a corporate treasury perspective, the goal is to provide stability that allows for better planning and forecasting,” explains Braun. “Public companies really need to be careful when forecasting earnings and making sure they’re reporting the potential earnings per share estimate, and hedging helps them do that.” Private companies share concerns about cash flow stability/predictability and will also choose to hedge.
While there are three main hedging instruments – spots, forwards and options – and many combinations of them, the basics of FX hedging can be simplified by identifying the source of risk and focusing on the primary objective of the organization, which is either to reduce cash flow volatility in functional currency or income volatility in reporting currency.
Despite the many complexities of international business, these sources of risk can also be divided into five categories, each of which requires its own solution:
In order to categorize these exposures, Braun has provided a table below that identifies the type of risk and the associated impact on the income statement or balance sheet. Using this combination of factors, the grid determines which strategies are most commonly used in the associated accounting model.
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“Before you get too deep into any solution, you should categorize and think about each of these risks and how they relate to each other,” he explains. “Before focusing on a solution, you really need to understand the underlying problem and how it affects the company’s income statement and balance sheet.
While an organization’s risk scenarios may change over time, the two most common hedging strategies often go hand in hand. Cash flow hedges and balance sheet hedges involve similar underlying transactions depending on the timing and accounting circumstances of a particular transaction.
The passage of time and the event when a sale or purchase is actually recognized in the income statement and balance sheet connect the two concepts. For example, when a sale is forecast, it has not yet occurred, so it is not included in the income statement. Since nothing is yet hedged in the financial statements, a cash flow hedge is required for that forecasted transaction. In the case of projected revenue, when the sale actually occurs, it becomes a balance sheet item (receivable) and requires a balance sheet hedge.
Depending on the risk and accounting objectives, the entity may hedge when the transaction is anticipated or when it is recorded (or both).
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“A lot of companies think they have better data on balance sheet hedging,” says Braun. “It’s also less complicated from an accounting perspective, so balance sheet hedging is usually an easier place to start.”
With a balance sheet hedge, a company revalues receivables denominated in a foreign currency (in the foreign sales example) in a set of books with a dollar value. Foreign receivables are marked to market in dollars subject to fluctuations in exchange rates, and the dollar gain or loss is included in the other foreign currency gain or loss line on the income statement. Balance sheet volatility is easily hedged with short-term forward contracts. In this case, hedge accounting is not required because you want the change in the value of the hedge to pass through the profit and loss account, offsetting the effect of the direct change in value of the underlying asset (or liability).
Cash flow hedges, in contrast, are used for forecast transactions, so hedge accounting is important in this case. Again, the focus on hedge accounting is that the forecast transaction does not yet appear on the income statement, which in turn means that any changes in exchange rates will not affect net income for that period. Therefore, the mark-to-market of the hedging transaction does not affect net income until the underlying transaction is included in income. In principle, the hedge does not create profit (loss) volatility during the hedging period because the change in fair value is recorded in other comprehensive income (OCI), but the related gain (loss) is included in the profit (loss) in the income statement when the underlying transaction is entered into. is recorded in earnings to protect the margins of the anticipated underlying transaction.
How does it all work together? Consider a US-based company with a five-year contract, paid in euros, to produce windshields for a German car manufacturer. Although there is a predictable cash flow in euros, if the euro depreciates, the manufacturer may not be able to protect its margins – especially if its cost base is in US dollars and does not offset the drop in income due to fluctuations in the euro.
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In this example, using a cash flow hedge makes sense. It protects the margins associated with the contract while not creating volatility by hedging a transaction that has not yet been recognized as a sale or expense on the manufacturer’s income statement.
“As companies become more global, or
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