5 Common FX Risk Management Mistakes
As companies implement and run foreign currency (FX) risk management programs, they need to be aware of some common mistakes. Not all treasuries will encounter every mistake, but they are sure to encounter at least one of these—if not now, then in the not-too-distant future.
These are the top five FX risk management mistakes we see made by corporate foreign currency hedge programs.
Mistake #1 – Not Including All Company Exposures
Some companies balance sheet hedge only the largest business units’ exposures and leave the smaller ones un-hedged. This can be due to the size of the exposures at the smaller entities or due to a large volume of small entities, making the exposure gathering process cumbersome. What tends to happen when the global exposure picture is not fully known is that treasury can end up over-hedging.
For example, suppose the balance sheet exposure of the top five legal entities is long euro by 10M. Most companies would hedge (sell forward) 10M euros as a balance sheet hedge. This will certainly protect the five subsidiaries and mitigate any FX Gain/Loss from those sites. But what if there are also 15 smaller entities that, when viewed alone, have small-short euro positions? And what if you added up all 15 and they aggregated to a 3M euro short position?
By selling 10M euros, the company is now over-hedged by 3M euros. Not only are they over-hedged in total, but also they will incur a greater amount of forward point noise and utilize their credit lines to a larger extent. The company may even violate its Risk Management policy under some circumstances, depending on how it is written.
Mistake #2 – Shadow Balances
Shadow balances are a very common mistake. These originate in the accounting organization but ultimately throw off treasury’s balance sheet hedge program adding Cash and P&L risk to accounting risk.
A shadow balance occurs when a foreign currency monetary asset or liability is closed in a different currency from the original currency. What ends up happening is that there is a debit in one currency and a credit in another, giving the appearance that the closed transaction remains open. When this happens, the transaction continues to remeasure and treasury will likely pick up the debit (or credit) as an exposure from the general ledger and hedge it. In essence, revaluing and hedging a closed transaction.
This happens quite frequently with VAT Payables. For example, the VAT Payable is accrued in GBP but paid out of a USD Cash account. The GBP VAT Payable would remain on the books offset by a USD debit. The balance in the account might look right, with almost offsetting entries, especially if the balance sheet remeasurement is recorded in another account.
This issue is so common we think most companies have shadow balances on their books. It’s worth finding and fixing them for two reasons:
- Shadow balances create false foreign currency gains and losses in the income statement.
- You might hedge them: It’s not a good economic hedge as there is no real exposure, but it will make the P&L look better, right up until the error is identified and reversed.
Mistake #3 – Reconciling-To-Zero
When companies balance sheet hedge away their re-measurement risk, there is always some level of ineffectiveness or noise leftover. Typically, management wants to know what the “miss” consists of and why the FX Gain/Loss line isn’t zero. So, treasury hunts and pecks and finds out what caused it.
The mistake they make is twofold.
First, rarely do they reconcile all or most of the residual Gain/Loss every month. They might find a few big items and stop there.
The second thing they don’t think about is that the small items missed or left unidentified this month can become large next month. Exposure management turns into “wack-a-mole”.
The proper approach is to reconcile most if not all sources of foreign currency Gains/Losses every period. By doing this, one can learn where the weaknesses in the hedge program are as well as weakness in any particular accounting result.
Reconciling the FX Gain/Loss is a good accounting control as well, because FX can be a “dumping ground” for expenses that have nothing to do with FX Gains and Losses. We’ve even seen golf memberships, excess and obsolete inventory and an international sales conference “dumped” in the Gain/Loss line over the years.
It’s best to use a tool to do the reconciliation. There are so many line items to review, doing it by hand can be arduous and require a specialist in FX. Software tools help raise the competency of the entire treasury department and relieve the chance of losing the review process altogether if someone moves on in the organization.
Mistake #4 – Rolling Hedges
Another very common hedging mistake is rolling hedges on a monthly basis. You’ll be popular with your counterparty, but companies that roll hedges every month are inefficient.
The best way to set your maturity dates depends on your cash requirements. A basic balance sheet hedge program should have hedges maturating when the conversion of currency is expected. Balance sheet hedges should be laddered out to expected conversion dates. See Mistake # 5 below if no conversions are expected.
For example, if the company plans to collect and convert accounts receivable in 90 days, then a hedge should at least go out 90 days or maybe a bit longer in case of a timing slippage. There is no reason to hedge it for one month and roll it forward 3 or 4 times. When the company is hedging its revenue on a cash flow hedge basis, then the hedge should mature not to the revenue recognition month but to the cash collection date. As the cash flow hedge is used (when revenue is recorded), it will automatically turn into a balance sheet hedge, protecting the resulting accounts receivable at the income statement rate through to cash conversion.
Mistake #5 – Economics Vs. Accounting
One of the most meaningful mistakes treasuries make is not evaluating both the accounting risk and the economic risk of a currency exposure.
A simple example is when a foreign subsidiary (let’s assume euro functional) holds U.S. dollars. This circumstance creates an accounting risk via re-measurement: an FX Gain/Loss. Most treasuries balance sheet hedge this “risk” away. But by doing so (selling USD and buying euro), the company synthetically converts the USD to EUR and increases the organization’s risk to the euro. After all, a US corporation holding USDs is not a currency risk from an economic perspective.
Another example of an accounting risk to evaluate is a FIN 48 tax liability. It re-measures but is rarely, if ever, paid out. Little or no economic risk exists. To address this situation, companies should search for hedge strategies that can do both: 1) protect the accounting risk, and 2) protect the economic risk.
Not all companies will have all five of these practices, but the fact is many have instituted procedure that we would call missteps. We encourage you to evaluate your hedge program for opportunities to improve efficiency and reduce risk.
At Hedge Trackers, we’ve seen and resolved many foreign currency risk management challenges for our clients. If you find yourself needing to address these or other foreign currency risk management issues we can help.
Click here to schedule a consultation tailored to your circumstances.