Best Practices for FX Hedge Performance Reporting

You’ve spent hours and hours developing a hedging strategy, identifying exposures, forecasting, and verifying hedge accounting, but your efforts shouldn’t stop there. To inform management the job is done, and done well, you need to go to the next level: performance reporting.

Performance reporting allows you to evaluate the program against the hedge program objectives, to communicate the quality and complexity of data inputs, the importance of timely, relevant data, and the impact of the hedge decisions on the company’s results. Examining what is or, more importantly, what’s NOT working is the only way to make a hedging program better.

In this article, we’ll discuss how to establish and manage expectations as well as provide performance reporting ideas for your balance sheet and cash flow hedge programs.

Balance Sheet Hedge Performance Reporting

1. Define Objectives in Foreign Currency Risk Management Policy

It’s important to be very clear about the objectives of your hedge program. They should be documented in the Foreign Currency Risk Management policy as well as discussed with all parties involved.

Balance sheet hedges are intended to mitigate foreign currency gains and losses, but that statement will not suffice as the objective. This is a very low bar in that any gain that reduces re-measurement losses (or vice versa) to any degree (5% to 150%) would be “successful” in meeting the objective. Alternative objectives include:

• Hedge 100% of known exposures plus 50% of expected new transactions in a period,
• Hedge to offset period FX Gains/Losses by 75-100%, excluding forward point impacts.
• Hedge 80-100% of expected month-end exposures > $500K to hold quarterly FX Gains/Losses below $XXXX
• Hedge any transaction during the period greater than $250K USD equivalent
• Net all like but opposite exposures through natural hedges first and mitigate 100% of the remaining exposure with forward contracts
  • Secondary Objectives:
    • Deliver currency against required payments made to vendors & subsidiaries.
    • Minimize derivative volume based on required foreign cash flows and timing. Avoid rolling hedges.
    • Hedge to cash conversion dates.

2. Measure Performance Against Objectives

The next step is to measure performance against the agreed-upon objectives. If the objective is to hedge 100% of known exposure, then showing the hedge notional by currency versus the exposure balance by currency would establish how well that specific hedge program objective was met. Sharing performance over time is often useful. We recommend staying away from hedge performance in isolation (showing derivative gains and losses or derivative notionals out of context) and encourage tables or charts to visualize the performance.

3. Clearly Explain Residual FX Gains/Losses

The FX Gain/Loss result is rarely fully understood—by accounting or treasury. Therefore, to increase management trust and confidence, it’s best practice to provide a detailed allocation by category of the net (of hedge) foreign currency gain/loss. This also provides management insight into how to support treasury by driving data and process improvements that will reduce this residual gain and loss.

Classic categories of analysis include quantifying the impact of:

• over or under hedging,
• forward points,
• differences between accounting rates on new activity and rates on hedges to protect them,
• un-hedged currencies,
• currency conversions not coordinated with the hedge program,
• use of incorrect accounting rates or rates from other periods (credit memos, etc.)

Performance reporting focuses the hedging team on results and the hedge program should get tighter and perform better as each category is evaluated and addressed.

Cash Flow Hedge Performance Reporting

1. Define Objectives in Foreign Currency Risk Management Policy

For cash flow hedges, the objectives require even more granularity. Mitigating FX exposure isn’t even a realistic concept, as there is less likely an FX Gain/Loss value from which to measure the mitigation: changes from last year? changes from the budget? What is required is additional clarity that will lend itself to clear reporting on results. Unfortunately, hedge objectives for cash flow hedge programs may be limited by the types of exposures hedged, the availability, length and quality of forecast information and the ability to qualify for hedge accounting treatment (restricted by functional currency decisions or the structure of intercompany transactions).

Here are a few examples of different cash flow hedge objectives:

• Protect 100% the USD value of foreign backlog transactions >$1M and > 2 months through to cash flow.
• Deliver 60-90% of foreign currency revenues/expenses/net at budgeted rates.
• Smooth year-over-year revenue impacts by delivering 50% of next year’s revenue at this year’s rate
• Protect product margins for 80% of product sales in each season at the “Season Rate”
• Protect USD margins from currency risk at date/rate product price fixing
• Smooth the effect of currency rate movements (reduce rate volatility) on net income from one quarter to the next.
• Provide currency rate visibility by shifting the impact on the company out one quarter/two quarters/one year.

2. Measure Performance Against Objectives

As in balance sheet hedging, the next step is to measure performance against the agreed-upon objectives. Only very rarely do treasury departments communicate this level of sophistication. It is easy to meet “effectiveness” for special hedge accounting purposes, but that effectiveness has nothing to do with the corporate objective. In fact, US companies were highly concerned that the FASB would consider measuring accounting effectiveness based on the objective of the program.

If the cash flow hedge objective was to smooth year-over-year revenue impacts by delivering 50% of next year’s revenue at this year’s rate performance reporting would highlight the revenue value without the hedge, with the hedge, and what it should have been if precisely 50% hedged. Again sharing the performance over time would be useful. Detailing hedge performance in isolation (showing derivative gains and losses or derivative notionals out of context) would confuse readers of your performance reports by suggesting the objective is to make money.

3. Clearly Explain Missed Objective Inputs

When the actual results differ from the expected results, which is very likely to happen much of the time, the degree of miss and drivers of the miss should be detailed to indicate the impact of 1) over/under-hedging had on the results, 2) forward points and/or 3) the ability to capture the rate (budget, transaction, prior year).

Clearly articulating what the hedge program is designed to accomplish and then reporting very clearly on its ability to deliver that result will drive management trust and an increasing reliance on hedging.

Conclusion

Whether balance sheet or cash flow hedging, it’s important to evaluate and report on how your FX hedge programs are performing. To do this, you must set specific, measurable, achievable objectives and then actually measure and communicate the results to drive management engagement in the hedge program.

Performance reporting should be part of a formal report that documents the program’s performance each period. Even more important is that performance reporting can be used as a feedback tool to improve future results.

Need a hand with performance reporting? We can help you evaluate your FX risk management objectives and develop relevant, timely, insightful analysis into the success of your hedge programs.