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Businesses need a sound strategy to manage the risk of fluctuating foreign exchange rates in a volatile market. Read how to reduce risk for your FX hedging strategy.

Forex Trading And Risk Management Strategies: Legal Aspects In Toronto

Forex Trading And Risk Management Strategies: Legal Aspects In Toronto

In our dynamic global economy, few businesses are immune to the risk of fluctuating foreign exchange rates. In fact, every organization that does business in a foreign country or conducts transactions with foreign companies faces the risk of currency exposure and volatility. So, as the next topic, how can you stay ahead of fast-moving markets? For many corporate treasurers, the answer involves hedging.

Guide To Managing Foreign Exchange Risk

Risk management strategies enable multinational organizations to identify their risks and reduce their exposure to them. Currency hedging can reduce the risks posed by FX market volatility by reducing income volatility and protecting future cash flows or asset values.

“You have to know what’s going on in the FX markets,” said Chris Brown, head of foreign exchange at US Bank. But for the corporate treasury team, the focus of any currency hedging program should be on risk mitigation, not market trading.

In fact, there is a real value to this kind of risk management. A five-year study of over 6,000 companies from 47 countries found that FX hedging is associated with lower volatility of cash flows and returns, lower systematic risk and higher market valuations (Bartram, Brown and Conrad). In their impressive study of US companies, Allayannis and Weston found that FX hedging increased market value by 4.87%.

“From a corporate treasury perspective, the goal is to provide stability, better planning and predictability,” explains Brown. “Public companies need to be careful about forecasting earnings and making sure they’re sending a message of potential earnings per share, and shorting helps them do that. Privately held companies share concerns about the stability/predictability of cash flows and prefer to short.”

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Although there are three basic hedging tools – spot, future and options – and a large number of combinations to implement them, the basics of FX hedging can be simplified by identifying the source of the risk and focusing on the main objective of the company. Cash flow volatility in functional currency terms or earnings volatility minus currency terms.

Despite the complexity of international trade, those sources of risk can be divided into five categories, each requiring its own solution.

To break down these exposures, Brown provides the table below, which identifies the type of risk with its associated impact on the income statement or balance sheet. Using that combination of factors, the grid identifies which strategies are most commonly used in a related mathematical model.

Forex Trading And Risk Management Strategies: Legal Aspects In Toronto

Before delving into any solution to the problem, you should think about each of these risks and how they relate to each other. “Before you can focus on a solution, you need to understand the underlying problem and how it affects the company’s income statement and balance sheet.”

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Although an organization’s risk factors may change over time, the two most common hedging methods often go hand in hand. Cash flow hedges and balance sheet hedges involve the same underlying transactions based on the timing and accounting assumptions of a given transaction.

The time and event when the sale or purchase is actually recognized on the income statement connects the two concepts. For example, when a sale is predicted, it has not yet occurred, and as such, is not recorded on the income statement. Because there is no hedge on the balance sheet, that forecasted transaction requires a cash flow hedge. As for forecasted revenue, once that sale is made, then it becomes a balance sheet item (accounts receivable) and requires a balance sheet hedge.

A company may be closed where the transaction is estimated or recorded – or both – depending on the risk and its accounting goals.

“Many companies think they have better information on the balance sheet,” Brown says. “It’s also less complicated from an accounting perspective, so accounting hedges are an easy place to start.”

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With a balance sheet hedge, the company remeasures the foreign currency receivable (in the example of a foreign sale) on a set of books with a dollar value. The foreign currency is dollar-denominated for FX fluctuations and the gain or loss in dollar terms goes to the other FX gain or loss line on the income statement. Balance sheet volatility is easy to shift with short-term rolling forward contracts. In this case, hedge accounting is not required, because you want the change in the market value to pass through to the income statement, compensating for the effect of the change in the position on the value of the asset (or liability).

Cash flow hedges, on the other hand, are used on speculative transactions, and hedge accounting is important in this case. To reiterate, the emphasis on hedge accounting is that the forecast transaction has not yet appeared on the income statement, which means that any changes in FX rates will not affect net income for the period. Therefore, the hedge symbol does not affect the net income for the market until the main transaction is recorded in the earnings. As such, the hedge does not create gain/loss volatility over the period of the hedge because the change in fair value is recorded in other comprehensive income (OCI), but the associated gain/loss is released from OCI to the income statement when the underlying transaction occurs. It is recorded in revenues to protect the margins of the underlying transaction.

How does it all work together? Consider an American company with a five-year contract paid in euros to produce windshields for a German car manufacturer. While there is a predictable euro cash flow, if the euro depreciates, the manufacturer may not be able to maintain its margins – especially if its cost base is in US dollars and it does not adjust for the decline in income caused by fluctuations in the euro.

Forex Trading And Risk Management Strategies: Legal Aspects In Toronto

In this example, it makes sense to use a cash flow hedge. By hedging a transaction not yet recognized as a sale or expense on the manufacturer’s income statement, it hedges the margins associated with the contract, although it does not introduce volatility.

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“As companies become more global or individual contracts become smaller relative to the size of the company, using cash flow hedges to reduce the risk to their profit margins becomes more important,” Brown said.

If a manufacturer decides to move its cost base to Europe by building a factory in Europe with a euro-denominated European subsidiary and repays an intercompany euro loan from a USD-denominated parent company, the parent will now have euro assets. A US dollar balance sheet hedger can easily hedge the US dollar equivalent of that loan. This example shows how and why accounting can be difficult. If left unrestricted, this euro intercompany loan would be measured against the parent’s US dollar earnings per period without equivalent compensation.

When the company starts manufacturing and selling windshields, they may start charging fees to the Euro subsidiary to better match their revenues with their costs. When you do this, you will no longer have forecast transactions that qualify for the cash flow hedge because the transactions are settled in the same currency as the entity’s functional currency. They have maintained their margins by aligning their revenues and expenses, but they still haven’t eliminated their exposure to currency fluctuations because the US dollar-operated parent company now has a European unit that stores profits in Euros instead of USD. The risk now shifts to the definition of foreign income and cash (the definition of income and net investment are now on the table).

“Each of these concepts interact with each other and understanding the impact of accounting is the starting point for building a good currency risk management program,” says Brown.

Pdf) Risk Management In Forex Market: Preparation Of Exchange Rate Fluctuation Anticipation Model

Although cash flow and balance sheet hedging comprise the majority of FX hedging, the complexity of international trading also requires an understanding of the other three types of risk management.

Remember to think about the economic and accounting impact when considering an FX hedging strategy. “What happens to the income statement if I hedge or don’t hedge? And what happens on the balance sheet? What is the benefit of hedge accounting? Brown says. “These are all important questions because all these things are connected together.”

With regulations that vary from country to country, multiple currencies to manage, and processes that differ significantly from domestic business, international business is a complex, fast-moving arena. This article briefly explores the five main sources of foreign exchange

Forex Trading And Risk Management Strategies: Legal Aspects In Toronto

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