For any company that is part of today’s global economy, exchange rate volatility can have a swift and adverse impact on financial performance. Not surprisingly, mitigating the effect of exchange rate fluctuations and reducing foreign exchange gains and losses, has also gained more importance on the corporate agenda and become a major point of friction for treasury teams. According to the 2016 Deloitte Global FX Survey, 52% of Treasurers admitted that FX volatility was the main business challenge they faced.
Why do FX gains and losses occur?
Multinationals routinely incur FX gains and losses caused by rate fluctuations, within even a relatively short period of time. This stems both from transaction exposure (when a business transaction is made in a foreign currency) and from translation exposure (when assets or liabilities are converted into a company’s presentation currency during the consolidation process). Companies are legally obliged to record their books in their functional currency, so both assets and liabilities in a foreign currency must be recorded in the functional currency value – usually by using the corresponding exchange rate.
Currency volatility can create a sharp difference between the exchange rate applied on the invoice date and that which is applied when payment is subsequently made – in some cases, 90 days later. Markets can, and do, shift significantly over the interim period. The resulting FX gains and losses potentially impact on the company’s financial performance and create a distorted picture for investors and other stakeholders.
How can companies reduce FX gains and losses?
Hedging offers a means of limiting the impact of FX volatility. Companies operating across several countries can use “natural hedges”, whereby revenue generated in a foreign currency by a subsidiary is allocated to pay costs incurred in the same currency. However, this option is often not practical for a complex corporate with a presence in many countries, extensive subsidiaries, and a global supply chain.
A more sophisticated hedge – often in the form of either a forward exchange contract or option – is a financial instrument or type of derivative taking its value from an underlying asset. Hedging provides a means for companies to reduce or eliminate their FX risk by locking in an agreed exchange rate to protect against future volatility.
Hedging the invoice until the moment of payment by using financial instruments (i.e. using forwards or futures, to reduce FX gains and losses and protect future cash flows in foreign currencies against FX variations), is a practice employed by many companies. However, this does not always offer an optimal hedging strategy for all businesses.
Certain industries must adopt alternative strategies to better manage their FX risk, since the real economic exposure is generated some time before an invoice is issued. A good example of this is the travel industry, where a Tour Operator’s transactional risk begins long before they receive an invoice from a supplier.
Efficiently managing foreign exchange, currency hedging and international payments, are therefore essential skills for any CFO, Financial Controller or Treasurer at any company that’s doing business internationally. He/she and their treasury team will usually employ various risk management strategies to minimise the related risk exposures.
The role of hedge accounting in mitigating FX gains and losses
Hedge accounting is often used by corporate treasury teams, with the objective of reducing temporary P&L volatility caused by the accounting treatment of the hedged item and hedging instrument.
It clearly sets out the effect of using financial instruments to manage exposures relating to specific risks that could impact the company’s P&L or other comprehensive income (OCI).
Hedge accounting effectively modifies the normal basis for recognising gains and losses – or revenues and expenses – on associated hedging instruments and hedged items, so that both are recognised in either P&L or OCI in the same accounting period.
The benefits of hedging and hedge accounting
One of the primary benefits of using hedging and hedge accounting principles together, is the reduction of FX gains and losses.
By reducing earnings volatility, corporate treasury teams, CFOs and CEOs can also reap additional benefits, including:
- Improved enterprise value – as earnings volatility is perceived negatively by investors
- Risk management – as statements reflect how FX risk is managed better and more accurately
- Creditworthiness – is strengthened, as predictability in future earnings is a positive factor
- Executive compensation protection – as when tied to performance – for example, based on quarterly earnings – this can be adversely affected by earnings volatility
Both enable companies and their treasury teams to effectively manage and reduce FX risk, while protecting the income statement from P&L volatility.
Dynamic Hedging is an automated micro-hedging solution that can either be used alone, or combined with Hedge Accounting, depending on your company’s business model and specific requirements.