Glossaire

Hedge effectiveness testing is the set of procedures that firms implementing Hedge Accounting under IFRS 9 are allowed to implement to test the effectiveness of their hedges.The two most commonly used methods of hedge effectiveness testing are the ‘Dollar offset method’ and the ‘Critical match method’. The dollar offset method is a quantitative method that involves comparing the variation in the fair value, present value or cash flow expectation of a hedged item, with the variation in the fair value, present value or cash flow expectation of the hedging instrument. The critical terms match method involves comparing the key terms of the hedging instrument and the hedged item, providing that both elements meet a set of specific criteria.

The hedge ratio is the ratio of a hedged exposure to the entire corresponding exposure. A firm with high forecast accuracy can apply a higher hedge ratio to distant exposures than a firm with low forecast accuracy. In hedging programs that combine budget hedging with hedging based on SO/POs, a given hedge ratio is applied while hedging is based on forecasts. As soon as certainty from the business is increased with sales/purchasing orders (SO/PO), a higher hedge ratio (for example, 90%) is applied on those firm commitments. The treasury team is in effect ‘switching programs’ and starts to hedge based on SO/PO. Such a combination can be supplemented by adding balance sheet items with (for example) a100% hedge ratio. The implementation and management of cash flow hedging programs may be quite burdensome for treasury teams that rely on manual execution and spreadsheets. However, Currency Management Automation solutions allows firms to run them smoothly, on a fully automated basis.

The hedge relationship is an accounting term that describes the accordance between all the key components of FX hedging, including: the firm’s objectives and strategies, the nature of the hedge, the hedging instrument, the hedged item, how the hedge ratio is determined and the analysis of possible sources of ineffectiveness. When applying Hedge accounting, the firm must provide documentation regarding all the elements of the hedge relationship. This documentation needs to be updated if the hedge ratio is rebalanced, when sources of expected ineffectiveness change and for changes to the effectiveness methods used.

Under Hedge accounting, a hedged item can be a recognised asset or liability (AR/AP, account receivable/payable), an unrecognised firm commitment (SO/PO, sales order/purchase order), a forecast transaction or a net investment in a foreign operation. The hedged item can be a single item (for example, an individual transaction) or a group of items (for example, the sum of forecast transactions). A hedged item can also be a component of such an item or group of items. The hedged item must be reliably measurable.

A hedging instrument is a financial derivative, usually a forward contract, used in FX hedging. When currency rates change, the hedging instrument creates an offsetting financial position that compensates the corresponding change in the hedged currency exposure. In Hedge Accounting, companies must provide documentation regarding the inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument.

The strategic division of forecasted foreign exchange exposure into distinct segments or portions, each governed by its own specific hedging parameters and execution criteria. This segmentation approach allows for more flexible and responsive risk management, enabling treasury teams to apply different hedging strategies to different portions of their exposure based on market conditions, timing requirements, or risk tolerance levels.

A widespread misconception regarding layered FX hedging programs is that they should conform to a 20% - 60% - 80% - 100% quarterly schedule for the hedge ratio. Rather than best practices, this approach reflects managers' doubts about forecast accuracy. 

Currency Management Automation makes it possible for treasury managers to choose from a wide range of solutions tailored to different goals and/or constraints. The table below displays some of the main possibilities. Adding partitions to the layered FX program allows treasury teams to take advantage of favourable moves in currency markets by increasing the length of the program and/or increasing the hedge ratio for near-term exposure.

This is accomplished by applying different partitions to the hedging program. The software solution monitors FX markets 24/7 to automatically increase hedge duration or hedge ratios when currency markets move in a favourable direction.

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A hedging strategy or program is a set of procedures that allows a company to achieve its goals in terms of managing currency risk. It is based on the business specifics of the company, including its pricing parameters, the location of its competitors, the weight of FX in the business. A hedging strategy or program also takes into account the company’s sources of information, IT systems, degree of cash flow visibility, and key decision makers (their risk tolerance, their familiarity with different risk management styles, etc.) The most widely used hedging strategies or programs include: static budget hedging, rolling hedging, layered hedging, hedging based on conditional orders, SO/PO (sales orders/purchase orders) and combinations of programs. Some of these programs and combinations of programs can be quite demanding in terms of calculations and/or currency trading, a real challenge for treasury teams relying on manual systemes. Their proper implementation and management requires, therefore, automated solutions provided by Currency Management Automation.

Hidden FX exposure is the amount of accounting, transaction or operating exposure that is not properly identified by the treasury team. Most FX surveys show that lack of visibility and reliability of FX forecasts is the biggest challenge in managing FX risk. Sources of hidden FX exposure include: manually executed data gathering and consolidation, use of spreadsheets gathered from many different sources, lack of transparency of internal processes, errors in the definition of the appropriate currency for translation purposes, difficulty in processing numerous intercompany transactions, and inaccurate or untimely monitoring of FX markets. To the extent that they automate the process of exposure collection and monitoring, Currency Management Automation solutions allow managers to mitigate the risks stemming from hidden exposures.

Hidden FX risk is the amount of accounting, transaction or operating exposure that is not properly identified by the treasury team. Most FX surveys show that lack of visibility and reliability of FX forecasts is the biggest challenge in managing FX risk. Sources of hidden FX risk include: manually executed data gathering and consolidation, use of spreadsheets gathered from many different sources, lack of transparency of internal processes, errors in the definition of the appropriate currency for translation purposes, difficulty in processing numerous intercompany transactions, and inaccurate or untimely monitoring of FX markets. To the extent that they automate the process of exposure collection and monitoring, Currency Management Automation solutions allow managers to mitigate the pitfalls created by hidden FX risk.

IAS 39 is the international accounting standard, established by the International Accounting Standards Board (IASB), which sets out the requirements for recognising and measuring financial assets and liabilities, as well as some of the contracts to buy and sell non-financial items.In this respect, IAS 39 also establishes the conditions to apply hedge accounting as well as the procedures for its application.According to IAS 39, financial instruments are recognised in the financial statement when the organisation is a party to the financial instrument contract. Financial liabilities are removed from the statement when the obligation established in the contract extinguishes. In the case of financial assets, these are removed from the financial statement when the entity's contractual rights to the asset's cash flows expire.Financial assets and liabilities are initially measured at fair value. During the life of the instruments, they can be measured at amortised cost or at fair value, depending on the category of the financial instrument.In 2014, IAS 39 was replaced by IFRS 9.

The IFRS 9 Financial Instruments are the new accounting standards introduced by the International Accounting Standards Board (IASB) in 2014, to replace the IAS 39 Financial Instruments: Recognition and Measurement, and their application has been mandatory from the 1 January 2018.These new standards determine the requirements for the recognition, measurement, impairment and derecognition of financial instruments as well as the conditions to apply hedge accounting.According to IFRS 9, financial assets and/or liabilities are recognised in a financial statement when the organisation becomes party to the financial instrument contract.At initial recognition, all financial instruments are measured at fair value. For financial assets or liabilities that are not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the asset or liability should also be factored in.Subsequent measurements are done at amortised cost, at fair value through other comprehensive income (FVTOCI) or at fair value through profit or loss (FVTPL), depending on the classification of the financial asset, which is determined at initial recognition. During the life of the contract, however, assets – but not liabilities – may be reclassified.