Hedging Strategies In Forex Trading: Legal Analysis In San Antonio

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Businesses need an appropriate strategy to manage the risk of fluctuating foreign exchange rates in a volatile market. Read how to mitigate the risk of your FX hedging strategy.

Hedging Strategies In Forex Trading: Legal Analysis In San Antonio

In our volatile global economy, few businesses are immune to the risk of fluctuating exchange rates (FX). In fact, any organization that does business in a foreign country or transacts with foreign companies has currency exposure and volatility risk. So how can they stay ahead of markets that can change as quickly as the next headlines? For many corporate treasurers, the answer involves hedging.

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Risk management strategies enable multinational organizations to identify their risks and reduce their exposure to them. Currency hedging can mitigate risks created by FX market volatility, including reducing earnings volatility and protecting the value of future cash flows or asset values.

“You should be informed about what is happening in the FX markets,” says Chris Braun, Head of Foreign Exchange at US Bank. “But for a corporate treasury team, the focus of any currency hedging program should be risk reduction, not market trading.”

In fact, this type of risk management has tangible value. A five-year study of more than 6,000 companies in 47 countries found that FX hedging was associated with lower volatility of cash flows and returns, lower systematic risk, and higher market value (Bartram, Brown, and Conrad). In an important study of US companies, Allayannis and Weston showed that FX hedging increased market valuation by 4.87 percent.

“From a corporate finance perspective, the goal is to provide stability, allowing for better planning and forecasting,” explains Braun. “Public companies need to be really careful with their earnings forecast and make sure they’re delivering a probable estimate of earnings per share, and hedging helps them do that. Privately held companies have shared concerns about cash flow stability/predictability and will choose hedging as well.”

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Although there are three basic hedging instruments – spot, forward and options – and there are many combinations of their application, the basics of FX hedging can be simplified by identifying the source of the risk and focusing on the main objective of the organization, which is reducing cash flow volatility in functional currencies or earnings volatility in foreign exchange terms.

Despite the many complexities of international business, these sources of risk can be divided into five categories, each requiring its own solution:

To categorize these exposures, Braun has provided the table below that identifies the type of risk along with the associated impact on the income statement or balance sheet. Using this combination of factors, the network identifies which strategies are commonly used in the associated accounting model.

“You should categorize and think about each of these risks and how they relate before you get too deep into a solution to a problem,” he explains. “Before you can focus on the solution, you really need to understand the underlying problem and how it affects the company’s income statement and balance sheet.”

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Although an organization’s risk situations may change over time, two of the most common hedging strategies tend to go hand in hand. Cash flow hedging and balance sheet hedging involve similar underlying transactions depending on the timing of the given transaction and the accounting considerations.

The passage of time and the events of what is actually recognized in the sales or purchase results accounts and on the balance sheet link the two concepts. For example, when a sale is anticipated, it has not yet occurred, so it is not recorded in the income statement. There is still nothing to cover in the financial statements, the planned transaction requires cash flow coverage. In the case of projected revenue, when that sale actually occurs, it becomes a balance sheet item (accounts receivable) and requires balance sheet coverage.

A company may hedge the transaction at the forecast point or at the time it is recorded (or both) depending on its risks and accounting objectives.

“A lot of companies think they have better data on balance sheet coverage,” says Braun. “It’s also less complex from an accounting perspective, so balance sheet hedges tend to be an easier place to start.”

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With balance sheet hedging, the company is re-measuring the underlying foreign currency receivable (in the example of a foreign sale) into a dollar-denominated set of books. The foreign receivable is marked in dollar terms for FX fluctuations and the gain or loss in dollar terms goes to the other FX gain or loss line in the income statement. Balance sheet volatility is easily hedged with short-term permanent contracts. In this case, hedge accounting is not necessary because you want the change in the mark-to-market of the hedge to pass through the income statement, offsetting the effect of the change in value of the underlying asset (or liability).

Cash flow hedges, on the other hand, are used in forecasted transactions, so hedge accounting is relevant in this case. To reiterate, hedge accounting focuses on the fact that the forecasted transaction is not yet reflected in the income statement, which means that changes in FX rates will not affect net income for that period. Therefore, the mark-to-market of the hedge does not affect net income until the underlying transaction is recorded in earnings. Accordingly, the hedge does not create profit/loss volatility during the hedging period, as the change in fair value is recorded in Other Comprehensive Income (OCI), but the associated gain/loss is taken out of OCI to profit or loss when the underlying transaction takes place. is recorded in earnings to protect the margins of the underlying transaction.

How does it all work together? Consider a US company with a five-year contract paid in euros to manufacture windshields for a German automaker. Although Euro cash flow is expected, if the Euro appreciates, the manufacturer may not be able to protect its margins, especially if its cost base is in US dollars and does not offset the decline in revenues caused by fluctuations in the Euro.

Using cash flow hedging in this example makes sense. It protects the margins associated with the contract, while not introducing volatility, by covering a transaction that has not yet been recognized as a sale or expense in the manufacturer’s profit and loss account.

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“As companies become more global or individual contracts become larger relative to the size of the company, it becomes increasingly important to use cash flow hedging to mitigate this risk to their profit margins,” says Braun.

If the manufacturer decides to shift its cost base to Europe by building a factory in Europe its European functional subsidiary in Euro and Parent Co in USD. if it finances the functional with a euro intercompany loan, the Parent will now have a euro asset. USD balance. It can easily cover the USD equivalent of that loan using balance sheet coverage. This example shows how and why accounting can be tricky. If left unhedged, this intercompany credit will be measured each period against earnings on the parent’s USD books, without any corresponding offset from the hedge.

When the company starts manufacturing and selling windshields, it may start invoicing from the EUR subsidiary to better align revenues with expenses. Doing so will no longer have planned transactions eligible for cash flow hedge accounting, as the transactions will be denominated in the same currency as the legal entity’s functional currency. By aligning their revenues and expenses, they have protected their margins, but have not yet removed their exposure to currency fluctuations because the functional USD parent is owned by a European entity that earns profits in Euros rather than USD. Risk now shifts to foreign earnings and cash translation (Earnings translation and net investment are now on the table).

“Each of these concepts connects to the other and understanding the accounting impact is the starting point for building a good currency risk management program,” says Braun.

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While cash flow and balance sheet hedging make up the majority of FX hedging, the complexity of international business requires an understanding of three other types of risk management.

When considering an FX hedging strategy, remember to think about the financial and accounting implications. “What happens to the income statement if I hedge or if I don’t hedge? And what about the balance sheet? What is hedge accounting? says Braun. “These are important questions because all these things tie together.”

With regulations that vary from country to country, multiple currencies to manage, and processes that are very different from domestic trade, international trade is a complex and fast-moving field. This article briefly touched on the five main sources of foreign exchange

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