Getting You to the Top: Part III. Exposure Centralization

This is the third in a series of posts designed to give a top-line overview of the steps to establishing a balance sheet hedge program. Today, we’ll focus on centralizing exposures. You can see past entries at gtreasury.com/blog, or speak to us directly at AFP 2015 this October.

The communicative properties of math allow currency hedgers to consolidate positions, hedge the net and have a highly effective and more efficient balance sheet hedge program (these concepts hold true for cash flow hedging as well, but that’s a topic for another time). As a bonus, this also makes it easier to explain the hedge program results to management.

To net currency balance sheet exposures, the first task is to capture all global exposures in their relationships between exposure currency and functional currency – USD-EUR, USD-CHN, etc. The relationship can be evaluated in terms of one currency “long” and the other “short.” For example, a US entity that is USD functional has a 100 EUR asset (long) position/exposure we could characterize as long EUR/short USD. A French entity that is EUR functional with a 100 USD asset (long) position we could characterize as long USD/short EUR.

We can net the US’s long EUR position against the French short EUR position – but what rate do we use? Generally, it’s best to use the most recent rate. For instance, if the rate were 1.2, we would net the EUR 100 long at the US entity with the EUR 83 short at the French entity and recognize our net exposure as 17 EUR – which we could then hedge– or not. On the dollar side, we have a short USD 120 and long USD 100 position. Because we are a dollar company we won’t worry about hedging the USD net. (In fact we will be hedging all the other exposures captured into USD.)

Let’s take this up another notch. Let’s add a GBP 100 asset (long) exposure to both the US entity and the French entity. So now the US entity is long 100 EUR and long 100 GBP. The EUR entity is long 100 USD and long 100 GBP. Let’s assume the GBP is at 1.50. To make things a bit easier the positions are laid out in a table below:

This helps us understand our true exposure to a currency from an FX Gain/Loss perspective. In explaining to management our gains and losses, we now don’t need to try explain long USD positions or GBP/EUR crosses – we can clearly lay out our consolidated global exposure as a long GBP 200 and short EUR 108. The impact of a 5 percent depreciation of the GBP and a 2 percent appreciation of the EUR against the dollar is easily comprehended by the C-suite.

If you are thinking the math is going to get a lot more complicated when you add 100 entities and exposures to 35 currencies, fear not! We do all this math for you in Hedge Trackers’ CapellaFX SaaS solution.

All this doesn’t just make things easier on management. Rather than executing four trades to hedge these exposures:

Sell Euro/Buy USD for USD Entity
Sell GBP/Buy USD for USD Entity
Sell GBP/Buy Euro for EUR Entity
Sell USD/Buy EUR for EUR Entity

Treasury can cover all the exposures just executing two hedges:

Sell GBP/Buy USD
Sell USD/ Buy EUR

Centralizing the exposures simplifies a hedge program dramatically. It brings focus to the interaction of cross currency exposures. It provides a meaningful way of understanding and communicating a corporation’s exposures. In addition, it allows for a reduction in trading activity.

At some corporations, each entity must hedge its own exposures for tax purposes (keeping the FX Gains/Losses on the derivatives in the same jurisdiction as the exposures). This concept is easily managed in Hedge Trackers Back-to-Back trading feature in CapellaFX. Once the exposures are loaded the trader indicates which currency is being hedged, selects one, some, or all of the exposures to that currency and trades, then moves to the other currency (or currencies), until all the exposures are hedged.

Catch up on any of the parts from the Getting You to the Top series you may have missed.

• Part I. Exposure Collection
• Part II. Exposure Validation
• Part IV. Forward Contracts
• Part V. Performance Reporting & Analytics
• Part VI. Hedge Accounting