FX gains and losses series: Under and over-hedging; a delicate recipe
The issue of “Unhedged conversions“, and their impact on a company’s FX gains and losses are often related to a common flaw in currency risk management: the problem of under and over-hedging.
Under and over-hedging are the consequence of a mismatch between the volume of a company’s currency exposure and the amount covered by the financial hedging instrument (a forward contract, option or futures contract, for instance). In the worst-case scenario, an inaccurate hedging strategy might end up increasing currency risk, instead of minimising it.
The leading cause of under-hedging and over-hedging is the miscalculation in forecasting the company’s FX cash flows, either due to a lack of hedging knowledge by the finance team or to unexpected variations in the volumes of foreign currency payables and receivables.
It is a common practice for international businesses to use pre-trade hedging strategies to cover their exposure. For instance, in companies selling in different markets, the risk management team would forecast the company’s sales volume for a given period and purchase a hedging instrument for that estimated value.
With hedging, the virtue stands in the middle
The problem of pre-hedging is that it is hardly ever accurate. Let’s imagine a European company that sells travel packages to American clients. They forecast 1,000,000 USD in sales. They pre-hedge that amount for the upcoming season, but due to external reasons, they end up selling packages worth 1,200,000 USD. While the sales department will be happy, the company will be under-hedged by 200,000 USD and the company’s margins would shrink if the USD depreciated against the euro during the season.
More concerning, and perhaps contradictory, is that if the dollar decline exceeds the company’s profit margin, total revenue will contract even with a 20% increase in sales. Surely, the board would demand an explanation as to why greater-than-expected sales can create a loss on the books.
Hedging for a value larger than the company’s exposure has a similar effect. Using the example above, let’s say that the company only sold 800,000 USD-worth of packages instead of the 1,000,000 USD they expected when purchasing their hedging instrument. At the forward’s maturity date, their provider will penalise them by charging the market rate for the 200,000 USD shortfall. On the balance sheet, this gap translates into an FX loss line, which will increase the negative impact of the lower than expected sales in the firm’s overall P&L.
Covering 100% of the exposure with micro-hedging
Financial technology can close the gap between the volume of pre-hedged currency and the company’s actual exposure. Micro-hedging strategies allow businesses to cover their FX exposure as it emerges so that it simplifies cash flow forecasting by removing the impacts of the currency markets.
Instead of hedging an estimated volume of exposure in advance, companies with micro-hedging technology integrated into their accounting systems might cover the exposure generated by each operation, so that the hedged volume will always match the exact amount of the company’s monetary assets or liabilities.
For businesses making high volumes of small trades in different currencies, individual hedging transactions are not practical. In these cases, the risk management team can define a system of maximum limits of exposure in each currency, and the platform will execute hedges once meeting these volumes; no need to monitor the market or the accumulated exposure.
Traditionally FX gains and losses related to over and under-hedging depended on the quality of company forecasts, micro-hedging breaks this connection and allows to keep the over and under-hedging under control. In the next article, we will explain how to solve the issue of timing.