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Businesses need the right strategy to manage the risk of fluctuating foreign exchange rates in a volatile market. Read how to reduce risk for your currency hedging strategy.

Hedging Strategies In Forex Trading: Legal Aspects In San Antonio

Hedging Strategies In Forex Trading: Legal Aspects In San Antonio

In our volatile global economy, few companies are exempt from foreign exchange (FX) risk. In fact, every organization that does business in a foreign country or even transacts with foreign companies faces currency risk and the associated risk of volatility. So how can they stay ahead of markets that can swing as fast as the next headline? For many corporate treasurers, the answer involves hedging.

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

“You have to be informed about what’s going on in the foreign exchange markets,” says Chris Brown, head of foreign exchange at U.S. Bank. “But for the corporate treasury team, the focus of any currency hedging program should be on risk reduction, not market trading.”

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

“From a corporate treasury perspective, the goal is to provide stability while enabling better planning and forecasting,” explains Brown. “Public companies really need to be careful about forecasting earnings and making sure they’re reporting expected earnings per share, and hedging helps them do that. Private companies share concerns about stability/predictability of cash flows and will also choose to hedge.”

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Although there are three main hedging instruments – spot, forward and options – and a large number of combinations for their use, the basics of currency hedging can be simplified by identifying the source of risk and focusing on the main objective of the organization, which is: reducing the volatility of cash flows in the functional currency or earnings volatility in the reporting currency.

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

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

Hedging Strategies In Forex Trading: Legal Aspects In San Antonio

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

Derivatives And Hedging

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

The passage of time and the point at which a sale or purchase is actually recognized on the income statement and balance sheet combines the two concepts. For example, when a sale is forecast, it has not yet occurred and as such is not reflected in the income statement. Since there is nothing yet to be hedged in the financial statements, this projected transaction requires a cash flow hedge. In the case of projected revenue, when this sale actually occurs, it becomes a balance sheet item (receivable) and requires a balance sheet hedge.

A company may hedge at the point where the transaction is forecast or at the point when it is recorded, or both, depending on its risks and accounting objectives.

“A lot of companies think they have better balance sheet hedging data,” Brown says. “It’s also less complicated from an accounting perspective, so balance sheet hedging is generally easier to get started.”

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With a balance sheet hedge, the company revalues ​​the principal receivable in a foreign currency (in the example of a foreign sale) against a set of books in dollar terms. Foreign receivables are valued at market dollar equivalent for exchange rate fluctuations, and the dollar equivalent gain or loss is transferred to another foreign exchange gain or loss line in the statement of financial performance. Balance volatility is easily hedged with short-term forward contracts. In this case, hedge accounting is not required because you want the change in the market value of the hedge to be reflected in the income statement, offsetting the effect of the spot change in the value of the underlying asset (or liability).

Cash flow hedges, on the other hand, are used for forecasted transactions, and therefore hedge accounting is important in this case. To reiterate, the focus on hedge accounting is due to the fact that the forecasted transaction is not yet reflected in the income statement, which in turn means that any changes in currency rates will not affect net income for the period. Therefore, the mark-to-market valuation of the hedge does not affect net income until the underlying transaction is reflected in earnings. Therefore, the hedge does not create profit/loss variability during the hedge period because the change in fair value is recorded in other comprehensive income (OCI), but the related gains/losses are released from OCI to the income statement when the underlying transaction is recorded in revenues to protect the margin of the underlying projected operation.

How does it all work together? Consider an American company with a five-year contract, paid in euros, to manufacture windshields for a German automaker. Although there is a predictable stream of euro cash flows, if the euro depreciates, the manufacturer may not be able to protect its margins, especially if its cost is based in US dollars and does not offset the decline in income caused by fluctuations in the euro.

Hedging Strategies In Forex Trading: Legal Aspects In San Antonio

Using a cash flow hedge makes sense in this example. It protects the margin associated with the contract and does not introduce volatility by hedging a transaction that has not yet been recognized as a sale or expense on the manufacturer’s income statement.

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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 hedges to mitigate this risk to their bottom lines,” says Brown.

If a manufacturer decides to move its cost base to Europe by building a plant in Europe at its European subsidiary operating in euros and financing it with a euro-denominated intra-firm loan from the functional parent in USD, the parent will now have assets in euros on your Balance in USD. It can easily hedge the US dollar equivalent of this loan through a balance sheet hedge. This example illustrates how and why accounting can be complicated. Left unhedged, this euro-denominated intercompany loan will be revalued in each period’s US dollar income of the parent without the corresponding hedge offset.

Once the firm starts producing and selling windshields, it can start billing its subsidiary in euros to better match its revenues with its costs. At the same time, they will no longer have forecasted transactions that meet the criteria for cash flow hedge accounting, as the transactions will be denominated in the same currency as the functional currency of the legal entity. By aligning their revenues and costs, they have protected their margins, but they still haven’t eliminated their vulnerability to currency fluctuations because the parent company, which operates in US dollars, now owns a European company that calculates profits in euros rather than US dollars. The risk now shifts to the restatement of foreign earnings and cash (earnings restatement and net investment are currently under review).

“Each of these concepts is related to the other, and understanding the accounting impact is really the starting point for building a quality currency risk management program,” says Brown.

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

When considering a currency hedging strategy, keep in mind the economic and accounting implications. “What happens to the income statement if I hedge or don’t hedge? And what happens to the balance? What is the significance of hedge accounting?’ Brown says. “These are all important questions because these things are all connected.”

With regulations that differ from country to country, multiple currencies to manage, and processes that differ significantly from domestic trade, international trade is a complex, fast-moving arena. This article briefly touches on the five main sources of foreign currency

Hedging Strategies In Forex Trading: Legal Aspects In San Antonio

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