Currency risk has been in the news all year as more and more companies report negative impacts from volatile FX movements. Earlier this year, the Swiss National Bank removed its floor on EUR-CHF, the European Central Bank introduced negative interest rates and China weakened its currency in response to economic deceleration.
Some companies were prepared for such events having implemented currency hedging programmes, while others have been caught in the rapid return to volatility.
In a recent analysis that we conducted of FTSE 350 listed companies, the indications were that 88% of those firms with currency exposure were in fact hedging it. Such a high-level statistic can be misleading, though, as myriad types of currency hedging programmes exist in practice. Here, we will describe five common approaches that are used by corporates globally.
Any entity with monetary assets or liabilities (cash, receivables, payables, debt, etc) in currencies other than its functional currency experiences FX remeasurement risk.
Revaluing the non-functional currency monetary assets and liabilities back to the functional currency can be done relatively easily by converting the item at the prevailing spot rate, and typically such changes in the rate (between booking date and valuation date) are captured in FX gains and losses in the income statement.
Balance-sheet hedging programmes aim at reducing the volatility introduced by FX remeasurement. In essence, this programme focuses only on the exposures that have been booked, rather than those forecasted for the future. While the balance-sheet hedging programme cannot easily reduce remeasurement to zero, they can reduce the associated ‘volatility’ in the income statement.
Many companies with currency exposure apply a balance-sheet hedging programme as they are typically easiest to implement. Once exposures are known and gathered within enterprise resource planning systems, the hedges typically consist of short-term forward contracts.
Furthermore, no special hedge accounting treatment is required as the profit and loss impacts from the derivative and the underlying item(s) are already recognised at the same time.
Many companies will extend their hedging programmes beyond booked monetary assets and liabilities into forecasted revenues and expenses. Often, this is done by taking all foreign currency exposures of the entity and hedging the largest ones that can be reasonably forecasted.
The objective of such programmes is to remove the risk from operational flows, with the ultimate goal of protecting the entity’s operating margin.
The major benefit of this type is the ability to reduce the exposure at subsidiary entities over longer periods of time.
The critical step for any firm looking to establish or revamp currency hedging programmes is to clarify what the organisation is trying to achieve
For example, many firms will use their cash-flow hedging programme to inform their budget rate for the upcoming year to ensure that earnings forecasts are linked to their hedge programme.
Unfortunately, these types of programmes may not perfectly hedge the parent company, since, in some cases, the exposures are hedged back to the functional currency of the subsidiary rather than to the parent company’s functional currency.
Managing the volatility at group level is the responsibility of the central treasury: it should oversee the programmes implemented by the subsidiaries and provide guidance and coordination.
Additionally, running such a programme requires the application of specific accounting treatments to align the derivative’s gains and losses to the appropriate income statement line item.
Whereas the cash-flow hedging programme reduces the currency risk at a specific subsidiary, some companies may be more focused on hedging translation risk on earnings, or EBITDA, at group level.
Such an approach can lead to very different choices of the exposures to hedge, in particular when considering the aggregated risk profile of the group and with respect to ‘phantom’ risk.
Aggregating the exposures from all subsidiaries allows the group treasury to assess whether cash flows in one entity are offset by opposite, or correlated, cash flows in another entity of the group – such an analysis allows to hedge only the net, residual risk and generates savings by reducing the number of transactions and the hedged notional.
Phantom risk, instead, arises when a subsidiary has:
[Image:hedging_bi.gif class=”left right20” alt=”Chart illustrating parent sub and transaction relationship in phantom risk”]
Most headlines regarding the FX role on weakened revenue or earnings are driven by the translation impact. While many private companies tend to hedge translation risk, relatively few public companies choose to do so.
This divergence may seem surprising, but often has to do with covenant calculations embedded within most private company credit agreements, as movements in FX rates could cause a breach on debt to EBITDA ratio or affect a firm’s credit rating.
A reason for companies not to hedge might be the misconception that translation does not affect the cash position of the group; in reality, it does have an impact when the subsidiary’s cash is repatriated – ie, to pay dividends or service debt – as the foreign earnings transferred within the group vary with FX rates.
Irrespective of the effect on cash, it is important to highlight that translation does impact the consolidated company’s earnings.
Another traditional belief is that exposures to various currencies usually offset each other and remove the translation risk. In reality, if exposures are in the same direction and to currencies that are correlated (ie revenue concentration in NOK, SEK and DKK), or in opposite directions to currencies that are negatively correlated, the risks from translation are compounded.
Another approach common in privately held firms is to hedge the risk of changes in enterprise value due to FX movements. Such an approach is also commonly used by public companies applying net investment hedging, particularly in advance of divestures of foreign business units.
One of the most popular methods of hedging enterprise value currency risk is through the development of a debt capital structure that mimics its currency exposure profile. When this is not possible to do ‘naturally’ due to debt capital market restrictions, companies can use cross-currency swaps to ‘synthetically’ create the targeted debt capital structure.
One of the additional benefits of enterprise value hedging is creating a short currency position with foreign debt (either natural or synthetic) to offset the long EBITDA being generated in the foreign currency.
The most sophisticated firms tend to utilise an approach that may be unfamiliar to most. Firms such as Procter & Gamble and Royal Caribbean use models to understand the link between their individual currency exposures and even their commodity exposures.
In some cases, significant offset between the two allows the firms to streamline the hedging programme, and reduce the number of transactions and the cost of hedging significantly.
In order to pursue such a strategy, a company needs to have buy-in from senior management and the ability to model, monitor and analyse changes on a regular basis in the currency and commodity markets – an exposure management system can manage the whole process.
But even more critical is the ability to communicate clearly to investors – many more private companies utilise this sophisticated approach, as their investor base is more concentrated and allows for deeper discussion of the risk management approach at the Board or investor level.
No single approach for currency risk management is definitively better than another. As evidenced by the many companies using each different type of programme, there is no right or wrong in currency risk management.
The critical step for any firm looking to establish or revamp currency hedging programmes is to clarify what the organisation is trying to achieve. Once this is determined, the efficiency of the programmes listed above (or perhaps even others) may be assessed against the objectives.
Paolo Esposito is director of European corporate advisory at Chatham Financial
