Determining an Appropriate Hedge Period for Your Exposure Profile
When establishing a new cash flow hedge relationship, it is critical to determine the proper hedge period. There is, however, no single, hard and fast answer to this question; the appropriate hedge period can vary, based on four key variables.
Foremost among these is the predictability of the anticipated hedged item. Foreign salaries (and other foreign expenses, for that matter) can be relatively predictable for some companies. Since little forecast variation for each period is expected, a shorter hedge period can be utilized, creating a highly predictable outcome for FP&A planning purposes. Conversely, hedges for items with a higher degree of uncertainty (e.g., monthly or quarterly revenue) are typically more suited to a longer hedge period.
At Hedge Trackers, we generally see companies utilizing a slightly longer hedge period when the predictability of the hedged item to a specific period is less certain. This serves companies by increasing the probability of the hedged item occurring within a quarter, for example, as opposed to having to forecast accurately to a specific month. While increasing the length of a hedge period can be effective, companies must also balance the length of the hedge period with other variables in the relationship – including derivative type, expected date of the hedge item and the inclusion or exclusion of time value components – when considering this decision.
Derivative instrument type and time value considerations factor into the hedge period determination process up front. Certain instruments may work better for hedge relationships with larger gaps between the hedge and hedged item, such as forward contract, while smaller timing differences between the expected date of the hedged item and the hedge maturity work well for both forward and option contracts when including time value in the hedge relationship.
Longer hedge periods and gaps between the hedge and hedged item require careful consideration when including time value. Timing differences drive a significant source of ineffectiveness in both the accounting results and the effectiveness test itself (regression). When companies have certain objectives, certain derivative types may be desired. Under a longer hedge period (or gaps therein) you may need to exclude time value to accommodate an effective hedge relationship.
The corporation’s hedge program objective often drives the instrument type, which, in turn, often impacts the determination of the hedge period. Are you trying to reduce downside risk only (options), or are you trying to provide FP&A planning predictability (forwards)? Do you need to know the hedge rate by month, or is a blend for a quarter or year OK? The program objective will help determine the best hedge period based on those objectives.
For example, when providing a floor on expenses with options, the hedge period plays a more significant role in the hedge relationship when corporations desire to include the time value (premium) in the hedge relationship. Since this is common to avoid volatility in earnings, it typically impacts the hedge period decision. Different answers to questions like these point to different ideal hedge periods.
Effectiveness measurement results are impacted by the chosen hedge period. As stated previously, the timing of the hedged item and the hedge maturity will drive sources of ineffective¬¬ness in accounting results. So while a larger hedge period might be desired to allow for forecast error and flexibility, the length can be curtailed by the creation of ineffectiveness. The goal is to make the best choice given the derivative type, forecast profile, time value consideration and objective of the hedge program itself.
All told, it is essentially impossible to issue blanket recommendations on proper hedge periods; there are simply too many qualitative and quantitative variables at play depending on the individual exposure profile. However, much like the inclusion of time value components in cash flow hedge relationships, it is possible to make proper decisions on a case-by-case basis by carefully analyzing all factors and enlisting the help of experts. Need a hand? We’d be happy to help.