Glossary

A company’s FX policy mandate is the document that sets out: (a) management’s strategic objectives in terms of currency management; (b) the goals of the firm’s FX hedging program. Given the FX policy mandate, the finance team spells out the practical steps needed to execute the firm’s hedging program. For example, a firm in the industrial machinery space that expands into emerging markets can include, in its FX policy mandate, the instruction to price in local currencies, and the goal of hedging the corresponding FX risk in a way that creates savings in terms of the cost of carry.

An FX Policy Template is a document that sets out a firm’s strategic objectives in terms of currency management, as well as the goals of its hedging program or combination of programs. The FX Policy Template also enumerates the resources allocated to the finance team in order to execute FX hedging. In firms that automate part or most of their FX hedging, the FX Policy Template should provide a detailed ‘FX Workflow’ framework, a step-by-step description of the procedures involved in the pre-trade, trade and post-trade phases of the FX hedging execution.

Foreign exchange rate alerts (FX alerts) are programmed email or message notifications of a pre-established exchange rate level. Set by currency risk managers, foreign exchange rate alerts cut out the time and commitment required to follow exchange rate movements and reduce the risk of missing a desired rate. By triggering the execution of forward hedges, Currency Management Automation solutions go a step beyond simple Foreign Exchange alerts. In effect, these are turned into ‘take profit’ and ‘stop loss’ orders that are automatically executed at the predetermined levels.

FX transaction costs or ‘foreign exchange transaction costs’ represent the expenses incurred by buying and selling and foreign currencies from a foreign exchange broker/dealer. In currency markets, transaction costs comprise commissions charged by foreign exchange brokers and ‘spreads’ charged by both brokers and foreign exchange dealers. While operational costs are easily identifiable by customers, the spread is often hidden in the exchange rate. To properly evaluate FX transaction costs, a firm should examine the mid-market rate at the exact time when the transaction was concluded, and compare it with the rate applied by the bank or FX dealer. The difference in the exchange rate plus the operational costs (commission) gives a clearer view of the effective FX transaction costs.

Hedge accounting allows companies to recognise gains and losses on hedging instruments and the exposure they are intended to hedge, with both being registered in the same accounting period. This procedure reduces income statement volatility that would otherwise arise if both elements were accounted for separately.The financial instruments standard that deals with the accounting of FX hedges is called IFRS 9. Issued by the International Accounting Standards Board (IASB), IFRS 9 requires firms that implement hedge accounting to provide detailed documentation on their risk management objectives, hedging instrument, hedged item and the nature of the risk hedged, as well as the results of tests that determine the effectiveness of the hedging relationship and the sources of ineffectiveness.

Hedge effectiveness is the extent to which changes in the value of a given exposure (the hedged item) are offset by an opposing change in the value of the financial derivative (the hedging instrument). Under hedge accounting, hedge effectiveness is measured with three criteria: Economic relationship. There must be an inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument. Credit risk. Changes in the credit risk of the hedging instrument or hedged item should not be large enough as to dominate the value changes associated with the economic relationship. Hedge ratio. The appropriate hedge ratio should be maintained throughout the life of the hedge.

The hedge effectiveness ratio —in a typical cash flow hedge of a forecast transaction— measures the accuracy of a hedge by comparing, at each reporting date, the fair value of the forecasted transaction and the fair value of the hedging item. For example if, three months after inception, the fair value of the forecast transaction increased by 100 and the fair value of the hedging instrument decreased by 110, hedge ineffectiveness was the fair value change of the forward was 10 because the fair value change of the forward was higher (by 10) than the fair value change of the forecast sale.

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.