CurrencyHedging
Share the risk
Currency hedging and offsetting risk are so important to businesses trading in multiple currencies, writes Richard Crump
Recent political upheavals and unpredictable events, such as Joe Biden’s unexpected withdrawal from the US presidential race and the tumultuous elections in France, have driven managing the threat of currency movements up the agenda of finance professionals.
In a year when more than half of the world’s population across 80-plus countries will head to the polls, geopolitics is “heavily influencing” corporates’ foreign exchange (FX) hedging decisions, according to Eric Huttman, CEO of MillTechFX, an independent FX-as-a-Service.
Against this backdrop, corporates are hedging more of their exposure and lengthening their hedge windows – the timeframe during which the hedge is active and provides protection against adverse currency movements – to protect their bottom lines and secure more certainty.
“Should the election be a tight race or deliver a surprising result, volatility may rise over the short term,” Huttman says. “It’s also important to look at expectant fiscal policies which will impact interest rate policies and market expectations.”
Certainty
Currency hedging is used to protect against potential losses caused by fluctuations in exchange rates and is commonly employed by companies that have exposure to foreign currencies due to international transactions, investments or operations.
The main goal is to mitigate the risk associated with adverse movements in exchange rates. This helps in stabilising cash flows, protecting profit margins and ensuring more predictable financial outcomes.
Moorad Choudhry, former treasurer in the corporate banking division at Royal Bank of Scotland, suggests businesses consider FX hedging “at all times” to reduce uncertainty and not just during periods of volatility.
Choudhry, who has authored a series of books on the principles of banking, says businesses with a “material” FX exposure “should look to lock in their income, or at least remove uncertainty of income stream” by entering some sort of hedging transaction, such as an FX forward or cross-currency interest rate swap to remove uncertainty [see box below].
But whether the business is “willing to wear that risk”, or considers the exposure to be so material, is user specific. “All hedging comes at cost, but the minute it becomes material don’t wait for the volatility. Hedge now because that reduces uncertainty,” Choudhry says.
Why hedge?
The first step in assessing currency risk is to identify the various types of exposure to a company’s revenues and cost base, and the financial metrics that are most important to its strategy.
“The first question is, what does the business care about?” says Kern Roberts, who leads Chatham Financial’s global accounting advisory team. “Normally it is some kind of profit and loss metric, but sometimes it might be something outside of the financial statements like EBITDA [earnings before interest, taxes, depreciation, and amortisation].”
Roberts cites the example of a travel business selling holidays in Europe to UK customers that might be “worried about fixing their margin”.
“Because they quote their holidays at a fixed margin, their costs are largely in euros. So if currency moves, their margin gets compressed potentially,” Roberts adds.
Alternatively, a large listed company that is focused on earnings per share will evaluate the risk of every currency exposure that could impact earnings, whereas a private equity backed business might be focused on EBITDA.
“Depending on the business and the key metrics, some people might be more focused on gross profit and gross margin, or they might be focused on anything that hits P&L and contributes to earnings per share,” Roberts says.
Give and take
While currency hedging is beneficial, it also comes with certain drawbacks. The company gives up any kind of bonus in return for locking in certainty. Hedging also involves fees, premiums or other costs, which need to be weighed against the benefits.
“When you hedge you are making sure you are not going to lose from any unfavourable market movements, but at the same time you can’t profit from any favourable market movements as well,” Sourabh Verma, co-chair of ION Treasury’s hedge accounting technical taskforce, says.
But although the downside of hedging is that it eliminates any upside gain, Choudhry points out that corporate finance professionals “are not there to make money because the FX rate goes a certain way”.
“If you are making money because a rate went in your favour, that is a bonus. But if you are deliberately targeting a speculative gain, that is not what you are here to do,” he says. “If the rate goes against you, you are going to be asked why you didn’t hedge your FX risk.”
Companies also need to invest heavily in terms of resources and infrastructure because the process starts from identifying a verification of the exposure, gathering data, making sure they have enough insights on their exposures and then on executing their trades in the market.
“It is always that balance, whether you are able to save your overall FX P&L by way of trading in currencies and hedging yourself, and minimising hedging costs from premiums and the forward points,” Verma says.
Forwards, swaps and options
Forward contracts: Agreements to buy or sell a specific amount of foreign currency at a predetermined exchange rate on a future date. They provide certainty about future costs or revenues.
Futures contracts: Standardised contracts traded on exchanges, allowing the purchase or sale of a currency at a set price on a future date. These are similar to forward contracts but are more standardised and liquid.
Options: Contracts that give the holder the right, but not the obligation, to buy or sell a currency at a specified price before a certain date. Options offer flexibility, allowing companies to benefit from favourable exchange rate movements while limiting downside risk.
Swaps: Agreements to exchange cash flows in different currencies between two parties, often involving an initial exchange and a reverse exchange at maturity. Swaps are useful for managing long-term currency exposure and can be tailored to specific needs.
Hedge accounting
Kern Roberts, of Chatham Financial, advises that accountants need to consider whether they want to achieve hedge accounting – a method of accounting in which entries to adjust the fair value of a security and its opposing hedge are treated as one.
“If I do want to achieve hedge accounting, that is going to inform some of the products I enter into because some of the more convoluted strategies are less likely to work well for hedge accounting,” Roberts says.
According to Roberts, large listed businesses tend to have conservative hedging strategies because they are concerned about earnings per share and want to manage the hedge accounting impacts of any instruments they enter.
Under IFRS 9 and FRS 102, companies must also be able to prove an economic relationship between the hedged item and the hedging instrument. There are also certain restrictions on what qualifies as a hedged risk for FX risk.
“In particular, you need to have an exposure that is a foreign exposure for the entity facing the exposure. For instance, if I have a euro functional currency subsidiary that has US dollar sales then that entity can hedge those US dollar sales,” Roberts says.
“If, however, it is a euro functional currency entity that has euro sales then that is not considered an FX risk for that entity and it doesn’t have a hedgeable exposure.”
All hedging comes at cost, but the minute it becomes material don’t wait for the volatility. Hedge now because that reduces uncertainty.
Review
Understanding the effectiveness of the hedging strategy is key to striking that balance and requires frequent monitoring. Verma recommends that companies conduct self-assessment performance analysis every quarter, or prior to each important event in the market.
“You typically start from exposure aggregation or exposure identification. Once you identify and divide the exposures you can hedge internally before you go externally for executing some hedges,” Verma says.
“Systems can give you information on how much you are hedged on the next four quarters. If you are unhedged, or if you are under-hedged compared to your policy target ratio, then the system can automatically tell you how much you should be hedging.”
In terms of the metrics available to various companies for hedging, different firms have different ways to track it, according to Verma. One way is comparing the weighted average FX rate delivered for the year with the company’s deposit rate.
“One fair comparison would be at the end of the year looking back on what is your weighted average FX rate that basically was incurred by you in terms of hedging costs and how does it fare against the budget rate you had,” Verma says. “That is good indicator for you to assess the performance.”
Another indicator is performing a comparison analysis with the spot rate – the current market price at which an asset can be bought or sold.
“Whether you were able to consistently deliver stable earnings throughout the year is a good measure that you were able to avoid volatility in P&L,” Verma adds. “There is evidence that companies have been able to deliver consistent earnings on the back of a successful hedging programme.”
