FX hedging is a fundamental element of every treasurer’s role, with the potential for large swings in financial results if hedging is absent or insufficient. Defining the right hedging policy for the business is essential, taking into account stakeholders’ risk management appetite and objectives. Once the overall approach to FX risk has been established, treasurers can then look at the most appropriate way of achieving this, and how to hedge in practice.

Different forms of hedge

The first challenge as part of an FX policy is to define when, and when not to hedge. There are typically three types of hedging: fair value hedging, which covers translation risk for net monetary assets and liabilities; cash flow hedging, which covers transaction risk on both actual and projected cash flows, and net investment hedging. Of these, the most complex business case for hedging is in the areas of projected cash flow hedging and net investment hedging. According to Citi’s 2010 CitiFX Corporate Risk Management Study, comprising 307 companies, 77% hedge net monetary FX assets and liabilities, 76% hedge forecast exposure while 22% hedge net investment exposure.

Hedging known exposures

Fair value hedging relates to existing financial assets and liabilities, and revaluation of these will have an FX impact on the P&L. Consequently, the business case for hedging is strong. The same also applies to a known transaction such as the purchase of machinery. The result of a hedge transaction is carried on equity, and matched on the P&L when the cash flow occurs, or on the initial asset cost. The accounting treatment of the hedge is determined according to its degree of effectiveness against the underlying cash flow. At TNT, we adopt a conservative approach to hedging, and hedge 100% of known commitments and net monetary assets and liabilities using FX forwards. We divide the world into developed and emerging markets. In the former case, where currencies are more liquid and easily tradable, we use on-line FX trading platforms to perform these transactions. In emerging markets, where currencies are less liquid and exchange controls may exist, we execute transactions directly with the bank via telephone.

Hedging uncertainty

For a forecast cash flow however, the business case is more complex. While the accounting treatment is the same, there are various factors that contribute to the decision to hedge. In the case of a one-off event, such as an  anticipated contract or an acquisition, treasurers need to decide whether to hold off hedging until it becomes a firm commitment, or to hedge according to the degree of certainty (e.g., hedging at 50% and increasing the hedge as it nears cash flow date). In the case of an  ongoing exposure in foreign currency, such as raw material purchases or sales in various markets, treasurers should consider whether any natural hedges exist, such as netting exposures against receipts in the same currency; in addition, over what period of time should a company hedge its projected exposures, and does hedging simply delay an economic reality to which every company will be subject?

Depending on the industry, shareholder appetite and business culture, companies will answer these questions in different ways. For example, a euro-denominated company reliant on USD revenues to invest in a major capital investment project at its headquarters, that will create long-term competitive advantage, is likely to hedge its USD flows to protect their value. An oil company that takes advantage of high oil prices to exploit greater exploration or drilling opportunities, but reduces investment during periods of low prices may decide that it has a natural hedge of investment versus oil prices.

In TNT’s case, we operate a discretionary hedging policy depending on the materiality and certainty of flow. We work closely with the business unit from which an exposure is derived and establish between us whether it meets the criteria for hedging, and if so, by what percentage. Typically, we use FX forwards or FX swaps to achieve this.

Net investment hedging

Net investment hedging is the most complex area of FX risk management. Net investment hedges will only affect equity and revaluation of the foreign subsidiary, and does not have a P&L impact. Investment in foreign subsidiaries is a long-term decision, and it can be argued that gains and losses will be offset over time. There is a stronger case for hedging, however, if the subsidiary is for sale, in order to protect potential proceeds. There are other factors to consider too. Care must be taken to avoid breaching covenants that take into account equity ratios. Shareholders’ interests must be taken into account, as they may be seeking exposure to certain markets and currencies. There may be natural hedges, such as local currency debt, and the challenge may be accentuated further in countries with weak economic fundamentals.

At TNT we compose natural net investment hedges by leveraging foreign currency denominated entities with local debt. This local debt level is geared toward current and future earnings potential by use of an internal credit rating model. That way we combine a natural hedge on future currency earnings with efficient levels of tax deductible interest at our local entities.

Other important factors to be considered while looking at net investment hedges are:

i) Accounting treatment, in particular whether a hedge would receive hedge accounting treatment;
ii) Economic risk. This is more subjective as we consider our activity in a country and anticipate how the business unit is likely to perform, including its forecast profits over the long term.

Sharing experiences

Hedging has a cost associated with it, both financially and operationally. Consequently, hedging decisions need to be taken carefully. Generally, identifying natural hedges across the business is the best option as there is no cost implication. Where hedging is identified as an appropriate action, exposures and hedges are commonly 100% matched for simplicity and to achieve hedge accounting treatment. However, if the value of an exposure fluctuates between the date of the hedge and maturity of the exposure, additional actions may need to be taken to ensure that the hedge remains effective.

Based on TNT’s experiences of hedging FX in a complex, international company, treasury has built up considerable expertise. One important issue is to distinguish between the business unit and treasury points of view. Business units may not necessarily understand the concept of hedging, and may only consider that cash inflows are good, while outflows are bad. However, for treasury, the objective is more to neutralise the effects of currency mismatches and increase flow certainty. Therefore, a hedging strategy must be consistent; for example, sales in foreign currency are always hedged, whether the ultimate impact of not hedging is positive or negative. This is not necessarily easy to explain to the business, particularly as the impact of FX volatility could be positive.

Conservatism over complexity

While most treasury departments operate as cost centres, as in TNT’s case, some remain profit centres. This can result in treasurers effectively having to predict currency movements, which is not necessarily the business purpose of the company. Treasury may choose to hedge only currencies with a lower cost of carry, or more volatile currencies. Alternatively, a portfolio approach may be taken, which takes into account other exposures such as interest rate and commodity risks, and considers correlation and variation across different types of risk. In TNT’s experience, operating as a cost centre is preferable as, typically, treasurers will take a more conservative approach to risk, while profit centres tend to take a less consistent approach to risk which creates volatility in results.

FX hedging can be a very complex discipline, but the complexity should be derived from the process of collating exposures and making hedging decisions, not the instruments used. The more diverse and sophisticated the hedging instruments, the less transparency there is, and more difficulties in valuation and reporting. The treasury team, and senior managers who are using information to make strategic decisions and to inform the market about company performance, need to understand how the hedging instruments work and how they benefit the company.

A consistent approach to hedging

Hedging brings value to corporations for a variety of reasons, not least as it enables strategic planning for investment, by adding greater predictability to financial results. Analysts and shareholders also prefer to see stable results, and reduced volatility results in lower weighted average cost of capital. There are a variety of factors involved in the decision of whether, and how to hedge. Hedging activity needs to be conducted according to a clearly defined policy that has been approved by the board. Hedges should be simple, to avoid unanticipated downside risks. The decision not to hedge, or indeed to over-hedge is a form of speculation, and few non-financial corporations are mandated to take unnecessary risks in non-core activities. Furthermore, by adding discretion to the hedging process, treasurers need to predict currency movements, which is again outside the sphere of responsibility of most treasuries. However, a conservative, straightforward and consistent approach to hedging can bring demonstrable benefits to the business.