Monetizing FX Hedges to Boost Cash Flow: Essential Strategies

Under stable market conditions, most corporate foreign currency hedgers have a “set it and forget it” hedge strategy.

Whether it’s cash flow or net investment hedging, once the hedges are in place, the majority of companies hold onto their derivatives through maturity. It’s an understandable practice as the best hedgers usually deliver currency against their hedges. This preserves the hedge rate in margin and converts cash at the same hedge rate.

Under volatile market conditions, hedges will continue to perform and protect company risk but, from time to time (like now), opportunities may present themselves from an economic perspective.

Deeply In-The-Money Derivative Assets Offer Quick Cash

Let’s assume that a company had hedged its forecasted GBP revenue stream out 1 year at a rate of 1.35 with a sell forward foreign currency hedge contract.

A basic cash flow hedge strategy would be to hold onto the hedge until maturity, which locks in a USD revenue rate of $1.35 for every pound recognized. So far so good. But what if 2 months into the hedge, the rates move dramatically for the currency pair, leaving the derivative a material asset of the company?

Assume the GBP rate falls to 1.15 or 1.10. That means the company’s hedges are in-the-money, and they could be worth millions of USD today. Is there something corporate hedgers can do to tap the cash value of those gains in a time of financial dislocation? Maybe you need the cash flow for operations now, or maybe you want to stash the cash away for a rainy day.

In a second scenario, companies have been executing cross-currency swaps to hedge an investment in foreign operations. Corporates also use this instrument type to generate net interest income throughout the life of the net investment hedge based on interest rate differentials for the hedged currency pair. At the derivative’s maturity, the company exchanges the hedged currency amount with its counterparty. As in the scenario above, a company could be sitting on a material gain as the demand for US dollars explodes across the globe, strengthening the USD. The newly very low USD interest rates and strong dollar presents an opportunity for these companies — especially for those strategies focused on interest differential benefits. Consider monetizing the swap and replacing it with a USD swap, harvesting the interest benefits without the spot rate exposure.

The challenge that will, unfortunately, become commonplace over the coming months for many hedge strategies is a dramatic drop in forecasted hedged items. Perhaps future forecasted revenues have been delayed well past the hedge period plus the allowable two month grace period due to supply chain constraints (rather than a drop in demand). Is there an opportunity for a monetization approach here? Again, treasury can close out and net settle the current derivative and execute a new hedge (at new rates) to the new expected date.

Proactive Risk Management

As we said, corporate hedge programs commonly follow a set and forget approach, but this is a time to rethink your hedge process and, perhaps, strategies. What if you could take a more proactive approach?

Hedge Trackers never recommends trading currencies for profit—and doesn’t here—but what if a once in a generation opportunity presented itself? As a fiduciary of the company, most corporate treasury teams would want to evaluate what’s best for the company given today’s market conditions. If the company is sitting on huge hedge gains in its derivative portfolio, they should evaluate the benefit of monetizing those gains (converting that asset to cash by liquidating the derivative).

Maybe a company needs cash, or maybe debt covenants need bolstering. Monetizing hedge gains may be one way to provide operating liquidity and to shore up a balance sheet. The liquidated derivative is then replaced with a derivative at current rates. This allows the old hedge to be monetized while the new hedge continues the protection of the old hedge through maturity.

Accounting Guidance

ASC 815 guidance is very specific on what is and what is not allowed when it comes to accounting for monetized cash flow hedges.

For example, a hedge contract can be de-designated at any time, but the gain or loss on the hedge recorded to AOCI cannot be reclassified into income at will.

The first two scenarios above can be de-designated for accounting purposes at any time. In the first, the gains would remain in AOCI until the hedged item is recognized in earnings, but even though the gain remains deferred, cash can be collected by closing out the hedge position. In the second example, the gains would remain in AOCI until the substantial liquidation of the subsidiary. The third example (and the most common), demonstrates a hedge relationship where the underlying’s status has changed from being “probable to occur within the hedged period plus two additional months“ to ”possible“ of occurring.

Whether the derivative contract is monetized or not, the hedge relationship must be de-designated. Gains/losses on the derivative prior to de-designation will remain in AOCI until the originally documented hedge period unless the hedged transaction becomes probable not to occur. The same derivative could be redesignated, or monetized and replaced with all prior amounts in AOCI.

815-30-40-4

“The net derivative instrument gain or loss related to a discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter…..”

Seeking Advice

At Hedge Trackers, we are available to help clients evaluate situations such as these. This could be a windfall opportunity for companies, and waiting until the crisis is over may turn out to be too late if currency rates normalize once dollar demands subside. If you’re thinking about monetizing gains in a hedge portfolio but aren’t sure of how to do it or how to apply the hedge accounting rules governing it, we stand ready to assist you and your team. Also, if you’re a software user, your client support desk can show you how to manage these derivatives in the system so that the accounting for de-designated hedges is correctly managed.

Conclusion

After a hedge program is implemented, it often runs the same way each period. Risk management policies dictate what can be hedged and also how and what derivatives can be utilized.

On rare occasions, it might be advantageous to evaluate generational opportunities that could benefit the company with your risk management team. If your company needs additional working capital or cash flow, there may be a way to fill the coffers without taking on additional debt and without additional interest expense.

Hedge Trackers can assist your company in evaluating these unique scenarios. We also speak with Boards and members of the C-suite should you need to make the case to management. Please contact us for help.