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Businesses need the right strategy to manage the risk of fluctuating foreign exchange rates in a volatile market. Learn how to reduce the risk of your FX hedging strategy.
Hedging Strategies In Forex Trading: Legal Aspects In Tennessee
In our volatile global economy, few businesses are exempt from the risk of changing foreign exchange (FX) rates. In fact, every organization that does business in a foreign country or even conducts transactions with foreign companies faces currency exposure 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 finance managers, the answer involves hedges.
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Risk management strategies allow international organizations to identify their risks and reduce their exposure. Currency hedging can reduce the risks posed by FX market volatility, including reducing the volatility of earnings and protecting the value of future cash flows or asset prices.
“You have to be informed about what’s going on in the FX markets,” said Chris Braun, Head of Foreign Trade at U.S. Bank. “But for a corporate treasury team, the focus of any capital pooling program should be on risk mitigation, not on market manipulation.”
In fact, there is tangible value in this type of risk management. A five-year study of more than 6,000 companies from 47 countries found that FX folding was associated with lower volatility of cash flows and returns, lower systemic risk and higher market prices (Bartram, Brown, and Conrad). In a landmark study of U.S. companies, Allayannis and Weston showed that FX hedging increased market value by 4.87 percent.
“From a corporate treasury perspective, the goal is to provide stability, enable better planning and predictability,” explained Braun. “Public companies really need to be careful about forecasting earnings and making sure they’re messaging on an earnings per share basis, and defense helps them do that. Private sector companies have shared concerns about the stability/predictability of cash flows and will also opt for hedging.”
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Although there are three basic hedging tools – spot, forward and options – and a large number of combinations to use them, the basics of FX hedging can be simplified by identifying the source of risk and focusing on the main objective of the organization, which can be to reduce the volatility of cash flows in terms of working capital or the volatility of profits in reporting cash terms.
Despite the many difficulties of international business, those sources of risk can be divided into five categories, each of which requires its own solution:
To break down these exposures, Braun provided the table below, which identifies the type of risk and the associated impact on the income statement or balance sheet. Using that combination of elements, the grid identifies which techniques are commonly used in the relational computing model.
“You have to separate and think about all these risks and how they relate to each other before you dig deep into any solution to the problem,” he explains. “Before focusing on a 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 profile may change over time, two common integration strategies tend to go hand in hand. Cash flow hedging and balance sheet hedging involve the same basic transactions, depending on the timing of transactions and accounting considerations.
The passage of time and the occurrence of a sale or purchase being recognized on the income statement and balance sheet link these two concepts. For example, if a sale is forecast, it has not yet occurred, and therefore, it is not recorded on the income statement. Because there is nothing currently in the financial statements to be hedged, those forecasted sales require a cash flow hedge. In the case of forecasted income, once that sale has occurred, it becomes a balance sheet item (accounts receivable) and requires a balance sheet hedge.
A company may hold a hedge at either a forecasted or a recorded rate – or both – depending on its risk and accounting policies.
“A lot of companies think they have better data on balance sheet hedging,” Braun said. “And it’s not that complicated from an accounting perspective, so balance sheet hedging is often an easy place to start.”
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With balance sheet hedging, the company re-measures the underlying foreign currency receivable (in the foreign auction example) with a set of book value dollars. Foreign receivables are marked to market in dollars for FX transactions and the profit or loss in dollars goes to another FX profit or loss line on the income statement. Balance sheet volatility is easy to hedge with short-term forward contracts. In this case, hedge accounting is unnecessary, because you want the change in the mark-to-market of the hedge to pass through to the income statement, which reduces the impact of a local change in the value of the underlying asset (or debt).
Cash flow hedging, in contrast, is used for forecasted activities, therefore, hedge accounting is important in this case. To emphasize, the focus on hedge accounting is because the forecasted transaction has not yet appeared on the income statement, meaning that any changes in FX rates will not affect the income for that period. Therefore, the hedge signal to the market does not affect the income until the underlying activity is recorded in profit. As such, the hedge does not create a change in profit/loss during the hedging period as the change in fair value is recorded in Other Comprehensive Income (OCI), but the related gains/losses are removed from OCI to the income statement when the underlying transaction is recorded in profit to hedge the margins of the forecasted transaction.
How does it all work together? Consider a company based in the U.S. with a five-year contract paid in Euros to make windshields for a German car manufacturer. Although there is a predictable distribution of Euro cash flows, if the Euro depreciates, the manufacturer may not be able to protect its margins – especially if its cost base is in U.S. dollars. and we exclude the decrease in income caused by the fluctuation of the Euro.
Using cash flow hedging in this example makes sense. It protects contract-related margins while not introducing volatility by blocking activity 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, then it becomes more and more appropriate to use cash flow hedging to reduce that risk to their profit margins,” said Braun.
If a manufacturer decides to shift its cost base to Europe by building a factory in Europe in its European EUR subsidiary and financing it with a Euro intercompany loan from the USD functional Parent Co., the Parent will now have EUR assets in its portfolio. USD balance sheet. It can easily hedge the USD equivalent of that loan by using a balance sheet hedge. This example shows why accounting can be difficult. If not reserved, this EUR intercompany loan will be remeasured to net income each time on the parent’s USD books without a corresponding release from the hedge.
When a company starts producing and selling windshields, it may start denominating the subsidiary in EUR to better match its revenues with its costs. By doing so, they will no longer be able to have forecasted transactions that qualify for cash flow hedge accounting, since the transactions will be carried out in the same currency as the functional currency of the legal entity. By aligning their revenues and expenses, they have protected their margins, but they have not cut their exposure to currency fluctuations because the USD operating parent company now has a European business that profits in EUR rather than USD. The risk now shifts to the translation of foreign earnings and cash (Earnings Translation and Net Investment are now tabulated).
“Each of these concepts is connected to the other and understanding the impact of accounting is the starting point for building a good financial risk management plan,” said Braun.
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While cash flow and balance sheet hedging make up the bulk of FX hedging, the complexities of international business also require an understanding of the other three types of risk management.
When considering an FX hedging strategy, remember to think about the economic and accounting impact. “What happens to the income statement if I hedge or not? And what happened to the balance sheet? How much is hedge accounting?” Braun says. “These are all important questions because all these things come together.”
With regulations that vary from country to country, multiple currencies to manage, and processes that differ greatly from domestic trade, international trade is a complex, fast-moving field. This article briefly touched on five major sources of foreign exchange
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