“Balance sheet hedging”
Balance sheet hedging is a corporate treasury method used by businesses operating with foreign currencies to reduce the potential impact of exchange rate fluctuations in their balance sheet.
Main aspects of balance sheet hedging
- Measuring the impact of exchange rate volatility on the value of monetary assets and liabilities denominated in non-functional currencies;
- Forecasting these assets and liabilities in advance to set up appropriate hedging strategies;
- Ensuring that the liquidity provision, either in local or in functional currency does not exert a negative impact on the balance sheet.
One of the most common methods to hedge balance sheet items, such as foreign currency denominated payables and receivables or cash holdings is to purchase a financial instrument, such as a forward, future or options contracts for the same amount and maturity.
Hedging balance sheet items involve complying with accounting standards, which compel the company to recognise the changes in the value of the hedge contract as well as the changes in the underlying asset on the balance sheet. The value of both the hedged asset and the hedging instrument have to be translated into the functional currency using the current spot exchange rate at every reporting period.
If the hedging instrument is appropriate to cover the exposure of the underlying assets, the variations in the value of the one get offset with opposite variations in the value of the other. Thus the resulting FX gains and losses are minimal.
For instance, a European importer agrees to purchase products for the value of 100,000 USD to a U.S. provider. As the contract is has a settlement date in 6 months’ time, the European importer buys a 6-month USD forward for 100,000 USD. In the meantime, the negative impact in the account payable of any appreciation of the USD against the EUR, will be offset by the FX gains of the forward contract and vice versa.