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Businesses need the right strategies to manage the risk of fluctuating foreign exchange rates in a volatile market. Read how to reduce risk for your FX hedging strategy.
Hedging Strategies In Forex Trading: Legal Aspects In Toronto
In our volatile global economy, few businesses are exempt from the risk of changing foreign exchange (FX) rates. In fact, every organization that conducts business in a foreign country or even conducts transactions with foreign companies faces currency exposure and associated risk of fluctuations. So how can they stay ahead of a market that can swing as fast as the next headline? For most corporate treasurers, the answer involves hedging.
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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, including reducing earnings volatility and protecting future cash flow or asset values.
“You should be informed about what is happening in the FX market,” says Chris Braun, Head of Foreign Exchange in the U.S. Bank. “But for corporate treasury teams, the focus of any currency hedging program should be on risk mitigation, not on market trading.”
In fact, there is significant value to this kind of risk management. A five-year study of more than 6,000 companies from 47 countries found that FX hedging was associated with lower volatility in cash flows and returns, lower systematic risk and higher market value (Bartram, Brown, and Conrad ). In an important study of U.S. companies, Allayannis and Weston showed that FX hedging increased market valuation by 4.87 percent.
“From a corporate treasury standpoint, the goal is to provide stability, enabling better planning and forecasting,” Braun explained. “Public companies really need to be careful in forecasting earnings and making sure that they’re messaging the likely earnings per share estimates, and hedging helps them do that. Privately held companies have shared concerns about stability/predictability of cash flows and will choose to hedge as well.”
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Although there are three basic hedging instruments – forwards, forwards and options – and a large number of combinations to apply them, the basics of FX hedging can be simplified by identifying the source of risk and focusing on the main objective of the organization, which is whether to reduce the volatility of cash flows in currency terms functional or earnings volatility in currency term reporting.
Although there are many complexities of international business, those sources of risk can also be broken down into five categories, each requiring its own solution:
To categorize these exposures, Braun provides the table below, which identifies the type of risk along with the associated impact to the income statement or balance sheet. Using a combination of those factors, the grid identifies commonly used strategies in relevant accounting models.
“You have to categorize and think about each of these risks and how they relate to each other before you dig too deep into any one solution to the problem,” he explains. “Before focusing on solutions, you really need to understand the underlying problem and how it impacts the company’s income statement and balance sheet.”
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Although an organization’s risk scenario may change over time, two of the most common hedging strategies often go hand in hand. Cash flow hedges and balance sheet hedges involve similar underlying transactions, depending on the timing of the transaction and the accounting considerations given.
The passage of time and the event when a sale or purchase is actually recognized on the income statement and balance sheet connects the two concepts. For example, when sales are forecast, they have not yet occurred, and therefore, are not recorded on the income statement. Since there is nothing left on the financial statements to hedge, the forecasted transaction requires a cash flow hedge. In the forecasted revenue example, when the sale actually occurs, it becomes a balance sheet item (accounts receivable) and requires a balance sheet hedge.
A company may hedge at the point where the transaction is forecast or at the time it is recorded – or both – depending on its risk and accounting objectives.
“A lot of companies think they have better data on balance sheet hedging,” Braun said. “It also doesn’t have a lot of complexity from an accounting standpoint, so balance sheet hedging tends to be an easier place to start.”
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With a balance sheet hedge, the company is re-measuring the basis of the foreign currency receivables (in the example of foreign sales) on a dollar-denominated set of books. Foreign receivables are marked to market in dollars for FX fluctuations and the profit or loss in dollar terms goes to the other FX profit or loss line on the income statement. Balance sheet volatility is easily hedged with short-term rolling forward contracts. In this case, hedge accounting is not required, as you want changes in the mark to hedge market to flow through the income statement, offsetting the effect of spot changes in the value of the underlying asset (or liability).
Cash flow hedges, on the other hand, are applied to forecasted transactions, and therefore, hedge accounting is important in this case. To reiterate, the focus on hedge accounting is due to the fact that the forecasted transactions have not yet appeared on the income statement, which in turn means that any change in FX rates will not impact the period’s net income. Therefore, mark-to-market hedges do not affect net income until the underlying transaction is recorded in income. Therefore, the hedge does not create a gain/loss uncertainty during the hedge period because the change in fair value is recorded in Other Comprehensive Income (OCI), but the related gain/loss is removed from OCI to the income statement when the underlying transaction. recorded in income to protect the forecasted transaction margin.
How does it all work together? Consider a company based in the U.S. with a five-year contract paid in Euros to manufacture windshields for the German automaker. Even if there is a predictable Euro cash flow, if the Euro depreciates, the manufacturer may not be able to protect its margins – especially if the cost base is in U.S. dollars. and does not offset the decline in revenue caused by the volatility of the Euro.
Using a cash flow hedge in this example makes sense. It protects the margin associated with the contract while not introducing volatility by hedging transactions that have not yet been recognized as sales or expenses on the manufacturer’s income statement.
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“As companies become more global, or individual contracts become larger relative to the size of the company, then it becomes more and more relevant to use cash flow hedges to reduce that risk to their profit margins,” said Braun.
If a manufacturer decides to shift its cost base to Europe by building a factory in Europe in its EUR functional European subsidiary and financing it with an intercompany Euro denominated loan from the USD functional Parent Co., the Parent will now have EUR assets in that company. USD balance sheet. It can easily hedge the USD equivalent of the loan using a balance sheet hedge. This example illustrates how and why accounting can be complicated. If not hedged, these EUR-denominated intercompany loans will be remeasured to income each period on the parent’s USD book without a corresponding offset from the hedge.
When the firm starts manufacturing and selling windshields, they may start billing out of the EUR subsidiary to better align their revenue with their expenses. By doing so, they will no longer forecast transactions that qualify for cash flow hedge accounting, as those transactions will be denominated in the same currency as the legal entity’s functional currency. By aligning their revenues and expenses, they have protected their margins, but they have not yet eliminated their exposure to currency fluctuations because the USD functional parent company now owns a European entity that accrues profits in EUR against USD. Risk now shifts to translation of foreign income and cash (Translation of Net Income and Investments is now on the table).
“Each of these concepts are connected to each other and understanding the accounting impact is actually the starting point for building a good currency risk management program,” Braun said.
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While cash flow and balance sheet hedging make up the bulk of FX hedging, the complexities of international business also require an understanding of the other three types of risk management.
When considering an FX hedging strategy, remember to think about the economic and accounting implications. “What happens to the income statement if I hedge or if I don’t hedge? And what happened to the balance sheet? What is the importance of hedge accounting?” Brown said. “These are all important questions because these things are all connected.”
With regulations that differ from country to country, multiple currencies to manage, and processes that differ significantly from domestic trade, international trade is a complex and fast-moving arena. This article briefly touches on the five main sources of foreign exchange
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