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Picking the Right Hedge for the Right Exposure

There are many exposure types and an even greater number of hedge strategies that can be deployed to mitigate their potential risk.

This article describes a basic framework for assessing which hedge strategies might best be suited to cover various exposure types. Essentially, this process comes down to a few relevant questions:

Exposure Types

Step 1: Understand the risk profile for the exposure you plan to mitigate.

What does my exposure look like? When does it begin (and end)? Is it anticipated and probable to occur, anticipated but only a 50/50 chance of really occurring, or is it already on the books? The type of exposure you have and the timing of when it begins/ends dictates which hedge strategies are appropriate for your firm for hedging purposes.

For example, a non-functional currency monetary asset exposes a corporation to re-measurement risk which results in typically undesirable foreign currency gains and losses in the P&L. Alternatively, the profile of a foreign acquisition that “might” occur this month or might not occur at all differs greatly from the previous. One exposure is impacting the corporation today while the other may or may not impact it in the current or future periods.

Hedge Objectives

Step 2: Understand the motivation for the hedge objective.

Hedge objectives differ based on hedge instrument and the corporation’s perspective. When deciding on a hedge objective, one must first think about what it wants the hedge to accomplish.

Is it going to fix the price of a floating price commodity? Is it going to convert fixed rate debt to floating rate? Do I want to protect the downside and leave an opportunity for the upside? How much am I willing to pay up front for this upside benefit? Do I want to average in to smooth out rate change impacts or put a stake in the ground now? Does management have a rate or price change expectation (a view)?

The objective of the hedge will differ based on the exposure and risk preferences; these factors will generally dictate the types of hedges that will be required to obtain the desired result.

Putting Them Together

Step 3: Once the exposure is fully understood it can be paired with a hedge objective in a hedge strategy.

Several factors are relevant for consideration prior to strategy execution.

Consider the accounting treatment of the hedge. In the case of an anticipated foreign acquisition, a corporation must be mindful of the economics (protecting the USD purchase price) and the accounting presentation of changes in the derivative’s valuation (P&L impact with no offset). Under this scenario the anticipated acquisition does not impact the financial statements unless executed, while the derivative impacts income each period the derivative is outstanding.In other cases “special” hedge accounting treatment can be elected to align the accounting timing of the impact of both the hedge and hedged item on the financials. If special hedge accounting treatment is preferable, you must also determine if your company is prepared to address the required effectiveness testing and documentation requirements needed for special accounting.

Some derivatives, like options, have an upfront out-of-pocket cost while others, like forwards, do not. This “cost” must be considered in evaluating a hedge strategy.

Evaluate the derivative cost for your firm. Some derivatives, like options, have an upfront out-of-pocket cost while others, like forwards, do not. This “cost” must be considered in evaluating a hedge strategy. How will the derivative’s cost impact margins? Will it be above or below the line? Combinations of derivatives can be used to mitigate certain upfront costs but may do so at an opportunity cost (i.e. decreased upside). A corporation must evaluate each hedge strategy combination against the core objective of the hedge strategy to determine if the payoff profile continues to address the hedged risk as desired.

Understand the limitations of the Treasury and Accounting organizations. Sometimes simpler is better. Plain vanilla derivatives are traditional instruments used to protect risk and they usually qualify for “special” hedge accounting treatment. They can be evaluated, accounted for, controlled, and easily understood by most finance teams. More complex structures and strategies can be useful in certain situations but can also be more taxing on an organization. Things to consider include: Can we value and account for the derivatives? Do we know the right price to pay? Will they qualify for “special” hedge accounting treatment? What are the derivative’s benefits vs. a simpler strategy, and does it continue to achieve our strategy objectives?

While this is but a high level framework for matching exposures with hedge objectives, one can see selecting the right hedge for the right exposure need not be overly complicated, though it requires a thoughtful approach to evaluating the exposure, developing the hedge objective, and selecting the hedge strategy that best achieves the objective, while being mindful of the accounting, cost, and complexity.

For more information on determining the right hedge strategy for the right exposure, contact us.

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