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.
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?