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Businesses need the right strategy to manage the risk of fluctuations in the volatile foreign exchange market. Read how to mitigate risk for your FX hedging strategies
Hedging Strategies For Reducing Risk And Enhancing Profits
In our volatile global economy, few businesses are exempt from foreign exchange (FX) risk. In fact, every organization that does business in a foreign country, or even does business with foreign companies, is associated with currency exposure and the risk of volatility. So how can they stay ahead of markets that can fly by as quickly as the next movie? For many buyers, the corporate response involves closing.
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Risk management strategies allow multi-national organizations to identify their risk and reduce their exposure. Currency hedging can mitigate the risks created by FX market volatility, including by reducing expected volatility and protecting the value of future cash flows or asset values.
“You know what’s going on in foreign FX,” says Chris Braun, Head of Foreign Exchange at US Bank. “But for the corporate team, the focus of any currency closing account is risk reduction, not trading.”
In fact, this kind of risk management is tangible. A five-year study of more than 6,000 companies from 47 countries found that FX hedges were associated with lower volatility in cash flows and returns, lower systematic risk and higher market value (Bartram, Brown, Conrad). In the benchmark study of the companies of America, Allayannis and Weston said that the FX hedge market valuation increased by 4.87 percent.
“From the point of view of the physical store, the goal is to provide stability in order to better organize and provide,” Braun explains. “Public companies really need to be careful about forecasting profits and make sure that they share probable earnings through valuation and closing helps them do that. Private companies are concerned about the stability/predictability of cash flows and have communicated that they wish well.”
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Although there are three main hedging tools – spot, forward and options – and a number of combinations to apply, the basics of FX hedging can be simplified by accepting the source of the risk and organizing it in the main objective, which is either. to reduce the volatility of cash flow in the operating financial conditions or the volatility of earnings in reporting currency terms.
Despite the many implications of international business, those sources of risk can also be broken down into five categories, each requiring its own solution;
To clarify these exposures, Braun has provided the table below, which identifies the type of risk along with the impact to the income statement or balance sheet. Using that combination of factors, the grid identifies which designs are more commonly used in the associated conceptual models.
“You have to think about each of these risks and how to tell them, before digging too deep into any solution to the problem,” he explains. “Before putting a solution in place, you really need to understand the underlying problem and how the company’s income statement and balance sheet are impacted.”
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Although risk management scenarios may change over time, two of the most common strategies often go hand in hand. Cash flow hedges and balance sheet hedges are similar to those involved in the underlying business, depending on the accounting and transaction data types.
The location of the time and the event when the sale or purchase is actually recognized in the income statement and the balance sheet connects the two concepts. For example, when a sale is anticipated, it has not yet been made, and thus is not reported in the income statement. Because there is still nothing on the financial hedge, the forecasted transaction requires a cash hedge. An instance of revenue is anticipated when the sale actually takes place, then the balance sheet (accounts receivable) is created and requires a hedge balance.
The company could hedge at the point where the event is anticipated or at the point when it is recorded – or both – depending on the risk and the purpose of the plan.
“Many companies think they have better information on the closing balance sheet,” says Braun. “It also doesn’t have as much complexity in terms of calculation, so closing the balance sheet tends to be an easier place to start.”
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In closing the balance sheet, the company re-posts the underlying foreign currency receivable (for example, foreign sales) in a set of dollar books. Foreign receivables are marketed in dollar terms for FX fluctuations and the profit or loss in dollar terms goes to the other FX profit or loss line on the income statement. Balance sheet volatility is easy to hedge with short-term rolling forward contracts. In this case, the hedge system is not necessary, because the force of the change in the mark-to-market hedge flows to the income statement, stabilizing the impact of the local change in the value of the underlying asset (or liability).
The collection of cash flow, on the other hand, in the forecasted events, and thus, the hedge system is very important in this case. To reiterate, the focus is often on the account due to that anticipated event not yet showing up in the income statement, which in turn means that any changes in FX rates will not impact the net income for that period. Therefore, mark-to-market often do not affect net income until the underlying asset is recorded in earnings. As such, hedge gain/loss volatility during the hedged period does not result in a change in fair value in Other Comprehensive Income (OCI), but the associated gains/losses are released from OCI to the income statement when the underlying transaction occurs. It is recorded in earnings to protect the margin underlying the forecasted transaction.
How does everything work together? Consider a US-based company with a five-year cash contract to manufacture windshields for a German automaker. While there is a predictable cash flow in Euros, if the Euro depreciates, the manufacturer cannot protect its margins – especially if its base is priced in US dollars and the income does not hedge against the fluctuation of the Euro.
Using cash flow to close in this example makes sense. It protects the contract’s related margins while not introducing volatility by limiting transactions that have not yet been recognized as sales or expenses in the manufacturer’s income statement.
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“As companies become more global, or individual contracts become larger for the size of the company, then it becomes more and more relevant to use cash flow to reduce risk to profit margins,” says Braun.
If a manufacturer decides to transfer its base to Europe, manufacturing a factory in Europe to its European operating subsidiary in EUR, and funds it with an intercompany Euro denominated by the USD operating Parent Co., the parent will now have an asset in its euro. USD balance sheet. It can be easily hedged, the value of the loan is USD-equivalent, using the hedge balance. This example shows how and why the system is smart. Unhededo, this EUR-denominated intercompany loan earnings will be paid each period in the USD books of the parent without the corresponding links from the hedge.
When a firm starts manufacturing and selling windshields, they can start billing subsidiaries to better align their income with their expenses. Having done so, they will no longer be able to foresee transactions that are denominated in order to account for the cash flows of the hedge, since the transactions will be denominated in the same currency as the functional currency of the legal entity. By aligning income and expenses, they maintained their margins, but still did not eliminate their exposure to currency fluctuations, because the parent company now owns a USD-functioning European entity that results in EUR rather than USD. The risk now transfers to the translation of earnings and foreign currency (Earnings Translation and Net Investment are now on the table).
“Each of these concepts connects to the other and understanding the impact of the concept is really the starting point for building a good currency risk management program,” says Braun.
How To Balance Hedging Costs And Benefits
Although cash flow and balance sheet closing comprise the largest part of FX hedging, the complexities of international business also require an understanding of three other types of risk management.
When considering an FX hedging strategy, remember to think about the financial and accounting impact. “What happens to the income statement if I hedge, or if I don’t hedge? And what happens in the balance? What is meant by the hedge system? Braun says. “All of these issues are very important because they bring all of this together.”
With regulations that vary from country to country, multiple currencies to regulate, and processes that differ greatly from domestic commerce, international commerce is a complex, fast-moving arena. This article briefly touched on the five main sources of foreign exchange
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