Glossaire

The minimum variance hedge ratio, also known as the optimal hedge ratio, is a formula to evaluate the correlation between the variance in the value of an asset or liability and that of the hedging instrument that is meant to protect it. The minimum variance ratio is used by businesses and investors who hedge their exposure with futures contracts. Since perfect hedging does not exist, in some cases treasurers need to calculate the minimum variance hedge ratio to find out the suboptimal number of contracts in order to offset their exposure to the potential changes in the value of their underlying asset or liability. A typical example of this is an airline who, because their business is exposed to variations in fuel prices, might want to protect their margins with futures contracts. As there is no jet fuel futures market, the company will have to look for suboptimal contracts, that is, the futures contracts with the highest correlation with the underlying asset – in this case, jet fuel.

In the process of translating foreign-currency denominated assets and liabilities into a firm’s functional currency, monetary assets and liabilities are items that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency units. Foreign-currency denominated cash balances, accounts payable and receivable, and long-term debt are examples of monetary assets and liabilities. By contrast, non monetary items are physical assets such as inventory and fixed assets. In the monetary/non monetary method of translation for the balance sheet, monetary items are translated at the current rate, while non monetary items are translated at historical rates.

Multi-currency accounts are bank accounts that allow holders to send and receive payments in multiple currencies. In practice, they mimic a structure featuring multiple bank accounts, but with a single account number. Multiple currency accounts empower businesses to make and receive payments in local and foreign currencies without needing to convert as a result of each transaction. Multiple currency accounts are particularly useful for e-commerce firms running stores in different currencies, and, more generally, for firms with international operations.

Multi-currency notional pooling consists in creating a master account with a bank in order to offset balances in different currencies and optimise cash and liquidity management. Companies with subsidiaries in different countries can implement multi-currency notional pooling strategies due to their efficiency as a method to manage multi‑currency balances. The advantages include: – A single liquidity position to address most cash-management issues. – Minimal cash transfer fees, as transfers between accounts are minimised. – Reduced foreign-exchange transactions: offsetting credit and debit balances through a multi-currency balance, the pool minimises the need for FX transactions and their costs.

Multi-currency pricing is a technique used by AdTech firms that allows participants to choose their preferred currency, thereby aknowing exactly how much they are spending in their chosen currency. Dealing in multiple currencies allows participants to increase selling prices and margins or, alternatively, to gain competitiveness and expand sales in promising new markets. One of the main functions of Ad Exchanges, for example, is to automatically compare and select the correct winning bids from different demand players—which requires access to real-time market rates. This is made possible by Currency Management Automation solutions that not only provide real-time FX data, but also automates currency risk hedging in any currency pair, for any number of transactions.

In Currency Automation Management, a multi-currency system is a software solution that enables firms to manage their FX workflow in any currency, from the pre-trade phase to the trade and post-trade phase. Multi-currency systems allow companies to capture the benefits of buying and selling in their customers/suppliers/customers’ currencies, while keeping currency risk at bay. By pricing and selling in their clients’ currencies, firms ‘speak the language’ of their customers, allowing commercial teams to add promising new markets to the portfolio. Moreover, they are in a position to capture the price mark-up usually applied by clients who receive quotes in foreign currencies. Buying in suppliers’ currency allows managers to widen the range of potential suppliers and to bypass supplier markups, thus leading to higher profit margins. An effective multi-currency system presupposes effective FX hedging. Depending on a company’s specific parameters, Currency Management Automation solutions allow managers to design the hedging programs —and combinations of hedging programs— that best protect them for currency risk, in an automated manner.

A multilateral netting system is a settlement mechanism used by companies to pay for goods and services purchased from affiliated companies. The netting process consolidates intercompany transactions and calculates settlement requirements internally instead of using external payment systems. Multilateral netting systems are typically used by companies with a number of affiliates in different countries. By netting, they reduce bank fees, currency conversion costs, bank balances and improve operating efficiency. Reducing the number of cross border flows saves bank charges and reduces the number of foreign exchange transactions and the spread lost to intermediaries.

Natural currency hedging refers to a hedging technique that does not require the use of financial derivatives. For example, a holding company with subsidiaries can seek to maintain equal amounts of receivables and payables denominated in a foreign currency. To undertake natural currency hedging, a firm with FX-denominated receivables could borrow short-term in that currency. When translated into the firm’s functional currency, the depreciation (appreciation) of the foreign currency would result in a loss (gain) in the value of the receivables, but in a lower (higher) value of the liabilities as well. While theoretically attractive —because of the implied lower transaction costs that it entails—, natural hedging is much less precise than hedging with forward contracts. Besides, such a technique may not be always fully ‘natural’ but forced, i.e. the company would end up subordinating business decisions to risk management decisions.

In Hedge Accounting, net investment hedging refers to the practice of offsetting FX-related changes in the value of net assets of a subsidiary by using a derivatives instrument. For example, a company with EUR as its functional currency has a wholly owned US subsidiary whose functional currency is USD. At the date of hedge designation, the company can include the carrying value of the subsidiary’s net assets as a hedge item. The other two types of hedges authorised under hedge accounting are fair value hedges and cash flow hedges.

In general terms, netting refers to the practice of consolidating two different settlements in order to create a single value.

How does netting work?

For instance, if Company A owes $50,000 to Company B and Company B owes $40,000 to Company A, they can set a netting value of $10,000 (that Company A owes to Company B).

Foreign currency netting, also known as cash pooling is a common form of netting. Multinationals with subsidiaries in other countries might need to conduct frequent foreign exchange transactions between subsidiaries and the parent company.

In some cases, these companies can use a netting centre, which holds accounts in a reserve currency, while the subsidiaries hold accounts in their local currencies.To put it simply, this structure allows the firm to reduce payments from and between subsidiaries, as each subsidiary will receive payments from the netting centre, and make single payments back to the netting centre.

There are three advantages to reducing the volume of foreign payments:

1. Less money in transit means more money available for investment.
2. Fewer foreign currency payments mean reduced transaction risk.
3. A reduction in the commission paid on foreign exchange transactions.

A non-convertible currency is the monetary unit of a country where holders of the currency do not have the right to convert it freely at the going exchange rate into any other currency. A currency is considered as non-convertible if it fulfills one or more of the following three criteria about usability, exchangeability and market value: it cannot be used for all purposes without restrictions; it cannot be exchanged for another currency without limitations; It cannot be exchanged at a given exchange rate.