Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
Balance Sheet Hedging: what many companies get wrong
In the context of the firm’s commercial exposure, FX gains and losses reflect fluctuations in exchange rates during the time lapse between the moment an FX-denominated transaction is recognised as receivable or payable in the firm’s balance sheet, and the settlement of the corresponding transaction.
To remove the impact of FX gains and losses from the P/L, firms can implement balance sheet hedging programs. The most common setups include:
- Standalone programs: They are run by firms whose principal FX goal is to reduce/remove the impact of FX and losses on the P/L. These are firms with solid profit margins and/or reduced weight of foreign currencies in their operations, i.e., firms with low FX sensitivity.
- Combinations of programs: For firms with higher FX sensitivity that hedge forecasted revenues and expenditures, balance sheet hedging programs are mostly deployed as a complement to existing cash flow hedging programs.
In this and in the following blog, we provide an answer to the following questions: How do firms run their standalone balance sheet FX hedging programs? Do they follow a time-based approach, or do they attempt to hedge every single piece of exposure?
Finally: Is there a more convenient, middle-ground approach that makes a better use of FX automation solutions?
The ECB exchange rate
When a firm recognises an FX-denominated transaction as a balance sheet item, the basic accounting principle is clear: the receivable/payable must be booked at the spot rate of the day. For European companies, this often means the ‘reference rate’, also known as ‘ECB reference rate’.
What is the ECB reference rate?
The reference rate is published daily by the European Central Bank (ECB) on its website at around 16:00 CET. Its levels are set after consultation between central banks across Europe, reflecting market conditions around 14:10 on weekdays. As the ECB is careful to remark, reference rates are for information purposes only, i.e., not for transaction purposes.
How to remove FX gains and losses
When we consider the FX risk map in the context of balance sheet exposure, the ‘pricing moment’ and the ‘firm commitment moment’ are already in the past. What matters is the exposure that arises from the recognition of the balance sheet item until the settlement of the corresponding transaction.
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To manage this exposure, firms usually hedge with forward contracts. Some companies may choose to partially or completely hedge that exposure. We know, for example, that the German global health care company Merck hedges balance sheet items in full, a practice that started in the 1990s as the firm sought a way to lower the cost of equity capital.
As balance sheet items are revalued alongside the hedging instrument, changes in opposite directions offset each other. If the currency of a receivable appreciates against the firm’s functional currency —displaying an FX gain—, the reverse happens to the forward contract, as the foreign currency was sold, by definition, at a less favourable rate.
Removing FX gains and losses: things to consider
- Reduction/removal of FX gains and losses: Balance sheet hedging removes the variability of the FX gains and losses line on the P/L
- Standalone or combined programs: Balance sheet programs are either ‘standalone’ type, or combined with a cash flow hedging program.
- No need for Hedge Accounting: As the FX impact is mutually offset, there is no need to apply Hedge Accounting under IFRS9.
- Cash flows are still at risk: When ‘standalone’ balance sheet hedging programs are implemented, cash flows may remain unprotected from FX risk.
Pitfalls of removing FX gains and losses: hedging at set dates
The most common method used by companies as they seek to remove the impact of FX gains and losses is to take currency hedges at a given, arbitrarily set date. This method consists in pulling, out of the ERP, accumulated pieces of exposure —i.e., FX-denominated balance sheet items— and then taking the corresponding hedge with a forward contract.
The process is then repeated at one point in the month, usually at the end of the month. The main pitfall of this procedure is easy enough to figure out: there is still a time lapse between the moment the exposure is captured and the corresponding risk mitigation exercise. This results in FX gains and losses, undermining the main goal of the program.
Balance sheet hedging: Hedging at set dates
We often see that, if the balance sheet item has a maturity of 90 days until settlement, then probably about 75 days are effectively hedged, which leaves —on average— two weeks with open FX risk. In some currencies, this can represent a material P/L impact — Antonio Rami, Kantox Chief Growth Officer
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Pitfalls of removing FX gains and losses: basic micro-hedging
Some companies use a different method altogether. Instead of hedging accumulated positions at fixed dates, they attempt to hedge every single FX-denominated balance sheet item. Needless to say, this is quite a resource-intensive activity.
Members of the finance team are constantly collecting and hedging the exposure. The cumbersome nature of this technique is a shortcoming because it may force the finance team to neglect some currency pairs. These could well turn out to create a P/L headache for the finance team.
In the event, the goal of removing FX gains and losses would not be achieved. This approach also fails to reduce the cost of hedging in the presence of unfavourable forward points. A EUR-based or USD-based firm that immediately hedges a receivable in the Brazilian currency will leave a good deal of money on the table.
This is because BRL trades at a 6% one-year forward discount to EUR on account of the gap between BRL and EUR interest rates. As we will see in our next blogs, there are better ways to deal with such forward discounts/premiums.
Towards a market-based approach to removing FX gains and losses
The two traditional approaches to removing the impact of FX gains and losses on the P/L present flaws. For different reasons, both of these approaches ultimately may fail to achieve the goals set by finance teams.
On the one hand, hedging at arbitrarily set dates does not completely remove FX gains and losses due to the time lapse between the moment the exposure materialises and the risk mitigation exercise.
On the other hand, attempting to hedge every single item in isolation is a resource-intensive activity that is only adapted to a situation of favourable interest rate differentials between currencies.
Our next blogs explore a way out of these intricacies.
