by Helen Kane
Hedge programs are generally very effective at locking in (forwards) the value of the company’s revenues or costs or insuring (options) those revenues/costs against negative movements in currencies: but are you locking in or insuring the appropriate rate? Frankly, when you hedge is just as important a decision as if you hedge. Getting the timing right requires delving into operations, cash flows and financial statement presentation. The following is an unusual exposure situation in which a company appears naturally hedged, but the timing of the costs versus the sales invalidates the natural hedge assumption—and a hedge restores it. In fact, the same hedge executed at 3 different points provides 3 different financial statement results.
Company C has an R&D center in a foreign country and expects to continue R&D efforts at that location for many years to come. The company has annual sales equal to the R&D expenses, but most of the sales occur in the last month of the year. The company considers itself “naturally hedged”: cash outflows equal cash inflows for the year. However, both the timing of the conversions and the currency accounting rules (ASC830) will not provide a natural hedge in the financial reporting. (Assume USD reporting currency for entity.)
There are two approaches to hedging these exposures that reflect the company’s desire (or lack of desire) to predetermine the future revenue and cost rates. If the rate isn’t critical, then each time the company purchases currency to pay for expenses, it should execute a swap and sell that currency amount forward as a designated cash flow hedge, locking in the rate experienced on currency costs for the future currency revenues.
This first approach works great economically, but what if the company were sensitive to remeasurement gains and losses? They would have been experiencing FX Gains and Losses on the payable from the time/rate it was recorded through to conversion. To avoid this, they would move the timing back to the payable recording date and execute a forward swap, buying forward to settle the payable at a future date (expected payment date) and simultaneously selling forward as a designated cash flow hedge to the start of next year when receivables would be available to deliver. This locks in the same rate for the cost/payable and revenue/receivable and protects against reporting gains and losses. To move beyond the economics and protect the timing and income statement geography of the strategy, the forward sale in each case would need to be designated as a cash flow hedge.
If management wanted to lock in current rates for both the future costs and the future revenues, the timing of the forward swap would move back in time. At any point prior to the recording of the costs, the simultaneous execution of a forward currency purchase and a forward currency sale both designated as cash flow hedges would lock in the reported values of both the foreign currency costs and revenues at the hedge rate.
At Hedge Trackers we are pressing our clients to step back from their routines and to evaluate their hedge program for economic effectiveness, as well as accounting, effectiveness. This quick example highlights the risks and opportunities of standard hedge programs. Company C is naturally hedged, but a quarterly hedge program or a revenue (only) hedge program would not have preserved the economics.