Getting You to the Top: Part IV. Forward Contracts
This is the fourth in a series of posts designed to give an overview of the steps to establishing a balance sheet hedge program. Today, we’ll focus on forward contracts. Why are they the most popular and relevant tool for this exposure, and how can they be used most effectively?
Traditionally, corporate FX hedge programs have overwhelmingly preferred forward contracts to other instruments, especially for balance sheet exposures. They are, after all, a great way to “lock in” the value of future currency flows. However, many hedge programs are in a rut, following strategies that were put in place generations before – or copying a strategy that was. In addition, uneconomic accounting risk and market dynamics occasionally invite even the most conservative of hedgers to evaluate other strategies.
In a standard corporate hedge program, receivables, payables and intercompany balances (as well as other monetary assets/liabilities) have little influence on operating margin, as gain/loss is frequently reported as Other Income & Expense. As a result, it usually makes sense to lock in the value (in functional currency terms) with a forward contract. This mitigates volatility in earnings and should eliminate the need to talk about the FX Gain/Loss line in earnings discussions.
This de facto selection of forwards presupposes three facts. First, the exposure can be identified in a timely enough fashion for the hedging to be relevant. Second, the exposure being hedged is economic; there is, indeed, an expectation of cash flows/exchanges. Third, the cost of hedging is perceived as lower than the risk of loss.
Balance sheet exposures are created, or at least captured in the financials, between the period that a non-functional currency transaction is recorded and its settlement. Understanding the rate-setting mechanism and the settlement process are critical to an effective hedge program.
Some exposures are created and settled in very short time frames. For example, for many Internet-based revenues foreign currency third-party revenue is recognized, a receivable created and immediately relieved by a credit card into currency, then a processing house converts the currency to USD (used as the functional currency unless otherwise noted). The revenue/receivable may be created using a daily rate set by the corporate (usually a day old), then the conversion is out of corporate control at a rate set by the processor (not transparent) that likely involves more than just published exchange rates. Trying to hedge this very short, externally controlled exposure is essentially impossible; being lucky would be most important.
Generally, exposure management is a bit easier. We are creating exposures with enough information to hedge them before they are actually booked, with a chance to catch something close to the rate at which they are created. Or we wait until they show up on the books and expect them to be around long enough (and to have control over their settlement) to make hedging a rational exercise.
Tax strategies have led to interesting exposure profiles – frequently not economic. This case involves cost-plus strategies, where a company pays its subs 100 percent plus a spread for all of their costs. (Better said, they owe the subs 100 percent of their costs plus the spread.) For large entities, the amount the parent owes can grow and grow over time. Not many companies are motivated to pay their Indian (INR functional) or Singapore (SGD functional) sub all that extra cash, so they let the intercompany grow. This creates an FX Gain/Loss that many companies run out and hedge without understanding that this particular intercompany isn’t going to ever end in a conversion … or at least it shouldn’t. The parent will eventually send the sub the funds and immediately want to repatriate them back as a dividend (which is why they are stuck as an intercompany balance). There would be no need to convert the currency since it’s coming home again after a little round robin and a tax haircut.
By hedging this exposure, Treasury is taking USDs and synthetically converting them into INR or SGD. Why does a U.S. company without a true economic exposure want to hedge and convert its USD into INR or SGD? The easy answer: to avoid reporting FX Gains/Losses in earnings. Do investors understand that companies are protecting earnings by turning USD assets into foreign currency? Does management understand it? Unlikely, when even Treasury frequently doesn’t understand. So, what can be done given the following goals?
- Goal 1: We want to hedge to protect earnings.
- Goal 2: We don’t want to hedge because it’s uneconomic because that will actually create an economic exposure for the company.
Generally we believe this is a functional currency election problem, but that is for another article, another time. In the short-term, Hedge Trackers has been recommending an easier solution we call a “Restoration Swap” strategy which restores the economics of an uneconomic balance sheet hedge. The swap generally works in cost-plus scenarios and a few others. The treasury department executes the balance sheet hedge – a buy-currency-forward in the cost-plus scenario. Then simultaneously, in a “swap,” the company sells forward the same amount in a net investment hedge. A company must jump through the related special hedge accounting hoops and be sure that their assets in the target sub(s) exceed their liabilities by the amount they need to (un)hedge, but this second point isn’t generally an issue for cost-plus structures as the intercompany receivable is frequently the dominant value on the sub balance sheet.
For companies with large amounts of cash held offshore in foreign functional subs (and who hold that cash in local currency), Treasury may want to evaluate the benefits of fixing the value of that cash in USD. For instance, one company with much of its corporate cash tax-constrained in Europe wanted to present stakeholders with a constant (or at least predictable) USD cash balance at each reporting period. As a result of a quarterly-forward contract hedging the cash under net-investment hedge accounting and settling at the end of the quarter, it was able to reliably predict global cash balances. (An added benefit purely reflecting the currency directions at the time was to effectively transfer some of that cash to the parent.)
Another “structure” that can be valuable in hedging the balance sheet is a zero-cost collar. When companies are purchasing currencies and receiving the forward points, there may be an advantage in setting the strike on the call at the current spot rate and allowing the put to be struck at a rate more favorable than the forward rate. For example, if the MXN spot rate is 17.35 and the 6M forward is 17.55, rather than executing the 6M forward a company could buy a call at 17.35 and sell a put at 17.90, so the company protects the FX Gain/Loss while taking advantage of the .35 opportunity.
The 6M forward raises another point. Corporate hedgers are notorious for rolling their hedges every month. The action is usually justified by indicating that they don’t know what the balance is going to be. That same logic frustrates Treasury people when asking Tax how much of an exposure they are going to record in the coming period; they don’t know exactly, so they aren’t comfortable sharing. So how do you determine just how far out to hedge, and how much?
Start with your conversions. How much currency does your company convert into the currency, and how frequently? You do cash flow forecasting – this is simply a cash flow forecast by currency … and gross amounts work. If you have a CAD50M net asset exposure and the company generally sells CAD10M per month, then you should have five CAD10M forwards 1-5 months out. Use the hedge or adjust the hedge when the conversion activity happens, put on a new hedge for the new net asset position being created in the period and set it for the next unhedged month-out. If you get CAD12M instead of CAD10M in a month, then sell the $2M spot and buy it back forward to the next delivery month. You are now rolling CAD2M rather than CAD48M.
We at Hedge Trackers recently reviewed the resume of an FX corporate trader who was highlighting the billions in currency he traded a year. We were surprised by the number as it represented something substantially in excess of 100 percent of the company’s revenue, and the company was not doing all their business off-shore or in foreign currency. Since that time, we have recommended companies evaluate their trading volume in light of their annual conversion activity. If you find you are hedging 4 or 5 times your conversion rate, there is plenty of room for improvement. If you find that you are not converting currency or converting very little of the amount hedged, that is a red flag your hedges may not be economic.
Forwards will remain the main strategic tool for balance sheet hedging. Nonetheless, the use of forwards in your treasury organization should be evaluated for efficiency and economic effectiveness.