A Market-Based Approach To Balance Sheet Hedging

In the previous blogs of this series, we discussed three reasons why CFOs and treasury managers may want to remove the accounting impact of FX gains and losses, and the mistakes they often make as they implement the corresponding balance sheet hedging programs. 

It is time now to pull up our sleeves and show how it’s actually done according to best practices in currency management. The preferred solution takes the middle of the road between two programs discussed earlier: (a) hedging every single balance sheet item individually; (b) hedging accumulated balance sheet items at a set date.

Best practices: the role of conditional FX orders

To hedge accumulated exposures while removing FX gains and losses is best achieved by setting conditional stop-loss (SL) and take-profit (TP) orders. This allows for small pieces of exposure known as entries to accumulate into larger positions.

These positions are then hedged as soon as SL or PT levels are hit. A few things need to be said about conditional orders: 

• Risk tolerance. The corridor created by the distance between SL and TP should reflect the risk tolerance level set by the finance team. 

• Automatic recalculation. As new entries accumulate, SL and TP levels must be reset on the Weighted Average Exposure Rate (WAER) that results from new entries.
• ‍Traceability. Each element along the transaction journey —from entry to position to conditional order to operation to payment— should have a unique reference number.

Market-driven vs time-driven FX hedging programs 

The approach outlined here is market-driven. This means that hedges are executed only as currency markets hit the constantly changing SL and/or TP levels. In this sense, market-driven balance sheet hedging programs differ from types of FX hedging programs.

Take, by comparison, a layered FX hedging program. Whereas balance sheet hedging aims at removing the impact of FX gains and losses, layered hedging is concerned with creating a smooth hedge rate over time. The table summarises some of the differences: 

‍Secondary objectives: some valuable advantages 

Finance teams at different companies may have different objectives regardingin regard to their FX risk management policies. As we saw in the first blog of this series, Merck applies the full gamut of FX hedging programs, including balance sheet hedging to remove FX gains and losses.

It is worthwhile to note that, alongside the main objectives of a well-planned FX hedging program, finance teams also have a set of secondary goals in mind. And while the nature of these goals may differ according to the hedging program, it is a fair assumption that treasurers will require their hedging programs to perform in the following areas:

• Forward points optimisation. Reduce the cost of hedging in the face of unfavourable forward points while taking advantage of favourable forward points.

• Exposure netting. Take advantage of exposure netting opportunities to reduce unnecessary FX trading.

• Collateral management. In an area of shifting interest rates, reduce the amount of cash that is set aside in terms of collateral requirements. 

Removing FX gains and losses: the power of delay

The market-based approach to remove the impact of FX gains and losses outlined here is especially well suited to reach these objectives. Here, again, we see the importance of conditional orders to delay hedge execution. 

Delaying hedge execution with conditional orders allows finance teams to reduce the cost of hedging in the event of unfavourable forward points and to uncover exposure netting opportunities. It is also a way to optimise collateral management. 

Let us see this in more detail.

The fact that currencies trade against each other at various degrees of forward premium / discount plays a major role in FX risk management. There are two key rules of thumb for optimising forward points in currency hedging: 

• With favourable forward points. Anticipate hedge execution as much as possible. The hedge rate captures the positive impact of interest rate differentials. 

• With unfavourable forward points. Delay edge execution as much as possible with conditional FX orders. The hedge rate improves as hedging is postponed.

Note that, while delaying hedge execution with conditional FX orders, the underlying currency risk remains fully under active management as conditional stop-loss and take-profit orders must be monitored 24/7.

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Looming large: the automation imperative

We started this blog by describing best practices in balance sheet hedging to remove FX gains and losses as a middle-of-the-road approach between: (a) hedging accumulated exposures at arbitrarily set dates; (b) hedging each individual balance sheet item. 

We discussed the role played by conditional stop-loss and take-profit orders in allowing treasury teams to reach their principal objective —effectively removing the impact of FX gains and losses from the P/L— in accordance with their risk tolerance levels.

We then showed how delayed hedge execution plays an important role in terms of the firms’ secondary goals, including forward points optimisation, exposure netting and collateral management.

We’ve come a long way. But we’re not done yet. The next blog describes in detail what we call the automation imperative.