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Is your balance sheet hedging program up to scratch? Chances are it's not. Welcome to CurrencyCast. My name is Agustin Maclinlay, I’m the Senior Financial Writer at Kantox and your host. In this week's episode, we take a look at the most common approaches to balance sheet hedging and we reveal their weaknesses. This gap analysis is going to allow us to answer the following questions: how can you improve your balance sheet hedging strategy? and what is the best way to achieve all of your goals? In currency management,
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balance sheet hedging is concerned with removing the accounting impact of foreign exchange gains and losses. The main goal is to achieve a clean zero line in terms of foreign exchange gains and losses. Three things to consider. Number one, balance sheet hedging programs are meant to start the minute the item in accounts receivable, accounts payable, and invoice is recognized on the books of the company and lands on the ERP.
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Foreign exchange gains and losses stem from the time lapse between the moment of the recognition and the moment the underlying transaction is settled in cash. Here, the accounting principle is clear, we must use the spot rate at the moment of that recognition. Number two, the FX sensitivity. Most standalone balance sheet hedging programs are used by firms that are not particularly sensitive to FX.
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That is because they have either a high profit margin or low weight of FX, in terms of their overall business is not particularly considerable. Why do we say that? Because otherwise more attention would be paid to cash flow hedging programs aimed at protecting the firm's operating profit margins. And number three, the program effectiveness. Most balance sheet hedging displays a relatively high degree of program effectiveness.
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And that's mostly because the exposure is in the shape of items that are already recognized in the books companies. And not, they are not forecasts at all. Still, there is considerable room for improvement. Let us see why.
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We note the widespread use of two main approaches to balance sheet hedging. Number one is a time based approach. It consists in pulling out of the ERP balance sheet items during, say, an entire month and taking the corresponding hedge. This procedure is repeated month after month. The main pitfall is that there is still a time lapse between the moment the exposure is captured and the risk mitigation exercise.
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So the goal of achieving zero foreign exchange gains and losses is unlikely to be achieved. Number two, a basic micro-hedging approach consisting in hedging every single balance sheet item. Well, there are two main pitfalls here. On the one hand, this might be a resource-intensive and error-prone type of activity. On the other hand, while it might work in the event of favorable forward points, that is to say the difference between the spot and the forward rate.
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It will certainly not work in the event of unfavorable forward points. There is a middle ground between the two extreme approaches outlined here, a data driven approach to balance sheet hedging. Instead of hedging right away, we accumulate individual pieces of exposure known as entries into positions. We then set conditional FX orders with dynamic stop-loss and take-profit levels calculated at a distance from the weighted average rate of those positions.
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If currency markets trade within a corridor that reflects your own tolerance to risk, you will be in a position to delay the execution of hedges while still achieving your main goal of removing foreign exchange gains and losses. This brings the following two advantages Number one, more netting opportunities. And number two, you'll be able to reduce the cost of hedging in the event of unfavorable forward points.
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All the while, you obtain the benefits of perfect end-to-end traceability, as each element along the transaction journey from individual piece of exposure or balance sheet item, to position, to conditional order, to operation, to payment, will have its own unique reference number. Needless to say, the data-driven approach outlined here requires a great deal of automation.
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To execute it manually would be too taxing in terms of Treasury resources, to say nothing about the operational risks involved, like human error or spreadsheet risk. Yet there is another point that needs to be mentioned. When carrying out balance sheet hedging programs, we see many managers focusing exclusively on automating the trade part of the FX workflow, with the help of multidealer trading platforms, such as 360T.
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The goal is to reduce trading costs as much as possible, by using such features as best price execution that puts banks in competition with one another. Now, there's nothing wrong with that. But here's the problem. When you take a discrete automation perspective like that, you may fail to achieve a proper integration with other parts of the FX workflow, especially with the pre-trade phase.
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What is the point of achieving, say, an additional one-pip savings in trading costs when a defective program costs you ten or twenty pips each time you trade? To remove such siloed approaches is the main goal of end-to-end automation in balance sheet hedging. Currency managers need to pay special attention to the process of FX risk collection, exposure collection and exposure processing.
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Properly integrating these processes, with the help of currency management automation solutions, will help you to avoid costly mistakes and to double check the quality of your exposure data. And needless to say, it will help you to remove those pesky foreign exchange gains and losses.
