Balance Sheet Hedging Health Check: 5 Essential Questions to Ask
Is your balance sheet hedge program doing its job? Sometimes, balance sheet hedging has hidden weaknesses and nuances that, when not periodically reviewed, can cause even more risk. Here are five questions you can ask to ensure your program is running well.
Balance sheet risk – also known as transaction accounting risk – is the most commonly hedged currency risk, resulting from monetary transactions recorded on the balance sheet in a currency other than an entity’s functional currency. Balance sheet hedging mitigates foreign currency gains and losses caused by the difference in currency rates. The hedge essentially neutralizes the P&L.
This type of hedging is common, but so are certain weaknesses that can slip through the cracks and create more risk or ineffective hedge results. Sometimes, companies mitigate certain aspects of currency risk while creating others. Other times, hidden aspects of a hedge program can cause problems.
There can be certain signs that a balance sheet hedge program is not what it seems. Here are five questions you should be asking about your balance sheet hedging to see how well it’s performing.
1. Are you delivering regularly on your hedge contracts?
A forward foreign currency hedge contract is the most common tool for hedging balance sheet risk. The derivative is intended to convert foreign currency into local currency or local currency into foreign currency sometime in the future.
The question to ask yourself about your hedge program is: Are we converting cash flows as expected? If not, why not?
If your hedge program continuously rolls hedges forward without delivering against all or a portion of them (converting foreign cash flows into local currency cash flows), there could be a problem with the hedge program.
For example, hedging a FIN 48/IFRIC 23 tax liability that’s never paid out can cause your hedge program to fail. This is not to say that currency gains and losses won’t be mitigated properly, but there’s more here than meets the eye.
An exposure that never settles has no economic risk (cash flow risk) to the company. As soon as treasury hedges the income impact away, they create an unintended economic risk. Forward contracts used to hedge currency risk must settle in cash, creating an economic risk for the company.
Think of it this way: The hedge program is paying out local currency to mitigate income statement volatility. The best balance sheet hedge programs are primarily cash flow “and” income volatility neutral.
2. Are you converting cash at the hedge rate?
A common hedge strategy is to net long and short exposure positions. This allows treasury to enter into fewer trades and reduce hedging costs. On the surface, this is a very good strategy, and it’s deployed by most companies today.
What’s not obvious, though, is that when assets are short-dated and liabilities are long-dated, the hedge program can break down.
Let’s assume a company nets its foreign accounts receivable (A/R) and lease payments so that it can hedge a smaller net amount. Let’s also assume the lease is five or ten years, so it’s larger than the A/R position. The company would be a net buyer forward of foreign currency (say, euro) to hedge this risk.
As accounts receivable is collected, it needs to be converted into local currency. If the hedge was “gross,” the company could deliver euros against the hedge, allowing cash to convert at the hedge rate. Alternatively, a sell-forward derivative could be net settled early by buying forward to the derivative’s maturity date (which may be a few days to weeks in the future) and simultaneously selling the collected euros at spot. The result will be the same: cash converted at the hedge rate because the cash gain/loss on the hedge plus the spot conversion equals the hedge rate.
But what happens in our example? A/R is collected and converted at spot and the buy forward hedge contract to account for the reduction in A/R is long-dated. It might go out five years. In this example, cash is not converted at the hedge rate but rather at spot. There is a disconnect between the spot conversion and the offsetting trade because it’s five years in the future.
This holds true for cash flow hedges as well, meaning that even though revenue is protected at the hedge rate, the resulting cash flows are not if converted at spot against long-dated liabilities.
3. Are you hedging away local currency?
Balance sheet hedging is supposed to hedge away currency risk.
If that’s true, why would global companies hedge away their reporting currency, too? It comes down to optics. A company’s consolidation currency held at foreign currency functional subsidiaries do create foreign currency volatility in earnings, but hedging reporting currency away makes matters worse than expected.
Global companies don’t face any economic risk when holding their reporting currency. If companies sell their company’s consolidation currency and buy foreign currency to mitigate income volatility, they are actually “increasing” the amount of foreign currency they are exposed to.
In order to effectively hedge away their income volatility, they need a strategy to hedge both the economics (keeping their local currency) and the income statement risk (re-measurement).
4. Can you explain away residual foreign currency gains & losses?
At the end of a period, treasury needs to reconcile any residual gains and losses from their balance sheet hedge program.
Many companies can figure out the easy items but often have trouble with the small or medium size misses that, when added together, can sink a hedge program.
It’s also important to understand your exposures and their accounting treatment.
In practice, we’ve seen items like a Brazilian tax payable recorded on the parent’s books. At first glance, one might expect a Brazilian Real denominated liability to create currency risk through re-measurement. But this liability was actually recorded on behalf of a Brazilian local currency subsidiary and required no re-measurement. So, hedging it would be a mistake. The derivative would have no offset in cash or income.
What can be done? The first boost to a balance sheet hedge program can be found in foreign currency risk management software. This technology can quickly categorize the sources of foreign currency gains and losses in a hedge program. This not only saves time but it also allows for more attention to be paid to resolving these issues in the future.
5. Are your inter-company hedges uneconomic?
Inter-company loan positions that are not actively settled can often result in uneconomic balance sheet hedges. These inter-company positions are a common reason why companies find themselves perpetually rolling over balance sheet hedge positions (and converting cash with spot contracts unrelated to balance sheet hedges), rather than more seamlessly taking delivery of the hedges at maturity.
Balance sheet hedges cover “monetary” positions. So, theoretically, a balance sheet hedge should correlate to cash needs. If inter-company activity such as inventory purchases between two subsidiaries is settled on a consistent basis, then foreign exchange cash flows will be occurring regularly as if these were third-party transactions. However, inter-company activity is often not settled regularly while still being classified as a “monetary” balance. Here are just a couple of examples:
A treasury center pools foreign cash, which is a natural hedge at first (foreign cash asset, inter-co payable). However, if the treasury center converts foreign cash to local currency to pay off debt, the inter-co payable remains an exposure. This causes the treasury center to buy foreign currency and sell local currency forward contract. This local currency-based company is now synthetically going long foreign currency that it wanted converted to local currency. Furthermore, these hedges are perpetually rolled as long as the inter-co payable position is not being settled with the subsidiary.
A foreign subsidiary has CAPEX or working capital needs and is funded by a parent entity. This was not setup as an equity/capital contribution for that hope that the money can be repaid tax-free in the not-so-distant future. It often becomes clear that the subsidiary will not be able to repay the parent entity anytime in the foreseeable future. In this case, the parent entity has a foreign inter-co receivable and perpetually rolls balance sheet hedges to cover the accounting risk of this “monetary” balance.
On the surface, a balance sheet hedge program can appear simple. Just create an offsetting exposure with a forward contract to mitigate currency gains and losses generated from a foreign currency exposure. However, more is going on under the surface.
Being able to explain balance sheet hedge results quickly and accurately goes a long way to creating more credibility and competence in the hedge program – and these questions are a great place to start.
Gather balance sheet exposures, identify sources of hedge ineffectiveness, and improve processes and inputs (and much more) with GTreasury’s enhanced FX risk management technology. Get a demo today to see how.