by Jim Shepard
Companies exposed to commodity, currency, or interest rate risk typically hedge those risks by asset class. Yes, there is the occasional need to use cross-currency swaps or other hybrid products to mitigate multiple risks in a single hedge relationship, but that has not been the norm for corporate hedgers—until recently.
Over the past year Hedge Trackers, LLC has noticed a significant increase in the desire (or need) to hedge commodity price risk denominated in a currency other than the Company’s functional currency. This arises in one of two ways. Either the commodity exchange is denominated in a foreign currency, such as canola seed futures traded on the Intercontinental Exchange (ICE) in CAD$, or a local currency functional foreign entity deals in USD denominated exchanges, such as metals (gold, copper) or fuel (diesel, natural gas).
When companies are faced with both commodity price risk and currency risk, the hedge strategy and effectiveness testing increase in complexity. Under ASC 815, the currency component of the commodity bought or sold can be bifurcated and hedged independent of all other risk factors. Not so for commodity price risk. Commodity price risk must be hedged based on the change in the “overall price” of the commodity.
Our experience is twofold in this area. We’ve seen hedgers use two derivatives (one commodity and one currency) to protect against the change in overall price of the commodity, and we’ve seen companies hedge the commodity price risk with a single derivative against the change in the price to the functional currency without executing a currency hedge. In the latter example, the effectiveness test under ASC 815 compared the change in price of the foreign denominated underlying to the change in price of the USD based derivative. As long as the company can show on a statistical basis that the change in prices are highly effective and produce an R2 of >.80, the relationship qualifies for special hedge accounting.