5 Balance Sheet Hedge Challenges That Create Risky Positions
Once a company establishes a balance sheet program, it likely runs on auto-pilot from then on. Exposures are gathered, forecasted, netted, hedged and adjusted inter-month, and the results of the program are reported — but rarely is there a “review” of the hedge program from top to bottom.
To help you continuously improve your balance sheet hedge program, we have identified some not-so-obvious weaknesses that we’ve seen in hedge programs.
The accounting of foreign transactions that give rise to gains and losses can diverge from the economics associated with currency risk. We call these uneconomic exposures. These transactions won’t result in a cash settlement, but hedging them will create even more currency risk.
Here are the top 5 uneconomic hedges creating weaknesses in your program that you can fix right now:
Weakness #1: Hedging U.S. Dollars
You may be thinking, “We don’t hedge U.S. dollars.”
But a closer look at your program probably reveals that you or your team are inadvertently hedging U.S. dollars (cash or receivables). Why? When local currency functional foreign subsidiaries sell in and hold U.S. dollars or a U.S. dollar-denominated intercompany, it creates foreign currency gains and losses in the P&L. A typical balance sheet hedge program will recommend selling USD and buying the local currency to prevent them from hitting the P&L.
While the P&L risk is mitigated by the hedge, treasury just created an economic risk by buying foreign currency forward, synthetically converting those dollars into a foreign currency. Your company is now even more exposed to FX risk. To eliminate both the accounting and economic risks when hedging USD in a foreign subsidiary, try a restoration swap.
Weakness #2: Hedging Certain “Tax” Liabilities
The tax department is responsible for estimating and accruing certain tax liabilities. Some of these liabilities are true currency risks, such as a value-added tax (VAT) payable. VAT is paid to municipalities in the currency accrued, making it an economic risk.
On the other hand, some tax liabilities are never paid out but are rather adjusted up or down in anticipation of what “might” be a risk in the very long-term. A FIN-48 liability is a classic example. Although tax accounting allows the re-measurement of this liability to impact taxes, most frequently, we see the revaluation creating FX gain/loss in the P&L and the FX gains and losses are rarely settled in cash. Hedging a non-cash item only creates more currency risk, since the hedge will settle in cash, and the liability probably won’t. A restoration swap may be an option to restore the economics when hedging an uneconomic foreign tax liability.
Weakness #3: Hedging a Long Dated Contingent Liability
From time-to-time, multinational corporations need to account for large contingent liabilities. The size of these liabilities can be problematic because while the hedge will do a good job of protecting the currency risk associated with the liability, the forward points paid out can add up to a significant sum. Forward points get paid out again, and again over time, creating P&L noise and a drain on cash can occur at settlement when the hedge matures as well. To mitigate risk and neutralize these cash outflows, try a restoration swap.
Weakness #4: Hedging Cash Pooling Inter-company Transactions
When companies pool cash overseas to consolidate investments or to pay down debt, they generally create inter-company loan transactions that are subsequently hedged. The hedge mitigates currency gains and losses, but is there an exposure? If pooled cash is used to pay down debt, it is likely to be excess cash being held until tax is ready to dividend the amount—thus it is unlikely that inter-company loans will be permanently repaid. If this money that is collected and managed in USD is a prepaid dividend, why would the company want to turn it into foreign currency? There is no foreign cash until the hedge synthetically converts the USD advance back into foreign currency. To restore the economics when balance sheet hedging an uneconomic inter-company transaction, try a restoration swap.
Weakness #5: Hedging Non-Monetary Account Balances
Too often, treasury works in a bubble. They gather exposures for their balance sheet hedge program and hedge them systematically each period. But what if a transaction looks like an exposure but isn’t? How can you tell the difference?
Sometimes a transaction looks monetary, but it isn’t. Are you hedging deferred tax assets and liabilities? Is your tax department parking foreign liabilities on the U.S. books that belong to local currency functional subs? Hedging these transactions will only create more risk since the associated exposure will not re-measure. See our article on Understanding Balance Sheet Exposure for more information on this topic.
Company balance sheet hedge programs target eliminating currency gains and losses from income. But, from time to time, the accounting of foreign transactions that give rise to gains and losses diverge from the economics associated with currency risk. We call these uneconomic exposures. They are exposures that produce foreign currency gains and losses but do not often settle in cash (or at all).
By hedging an uneconomic risk, such as USD cash held at a foreign functional subsidiary, a company increases rather than decreases its exposure to foreign currency.
In addition to these types of exposures, there can be confusion around certain types of foreign “monetary-looking” transactions. These are transactions that would otherwise create a gain or loss in income but won’t due to circumstances. If treasury hedges a transaction that doesn’t re-measure, they just created an exposure. So, it’s best to communicate about any one-off or unusual items with the accounting team before putting on the hedge.
Lastly, should you encounter an uneconomic exposure and feel compelled to hedge away the income statement noise, Hedge Trackers has developed a way to restore the economics of the hedge program while still being able to mitigate income statement volatility and cash impacts – we call it a restoration swap.
Hedge Trackers specializes in restoring the economics of an uneconomic hedge program. More information on these and other surprising topics can be found in our blog.